Investor concerns about inflation and rising interest rates are likely exacerbating selloffs and volatility in certain segments of the Australian share market. In this episode, Dushko Bajic, Head of Australian Equities Growth at First Sentier Investors unpacks some of the risks ahead and shares some potential investment opportunities for investors.

 

Transcript

Paul O’Connor:

Welcome to the Netwealth Portfolio Construction Podcast series. My name's Paul O’Connor and I'm the head of investment management and research. Today, we have Dushko Bajic with us from First Sentier Investors who is the head of Australian equities' growth based in Sydney. Good morning, Dushko, and thanks for joining us for today's podcast.

Dushko Bajic:

Good morning, Paul. Thank you.

Paul O’Connor:

First Sentier is one of Australia's largest investment managers and was previously known as Colonial First State prior to the rebranding. As of 30th of June 2021, First Sentier had 241 billion in funds under management that's managed on behalf of institutional investors, pension funds, wholesale distributors, investment platforms, financial advisors, and clients worldwide. The Australian equities' growth team has been managing portfolios for well over 20 years. And as of 30 June 2021 managed over 15 billion in funds under management across both large and small cap funds geared and imputation funds. The First Sentier Australian equity growth team uses a fundamental bottom-up research approach to identifying growing companies that generate consistent investment returns above their cost of capital. The growth investment style has been consistently applied since the fund's inception. The growth team considers industry dynamics to be a key input into what drives stock performance and fundamental industry analysis as a key component of the investment process. The focus on industry dynamics sounds rational and a differentiating feature when compared to many other Australian equities' growth style managers, and I'll be interested in discussing different industry dynamics with Dushko today.

Paul O’Connor:

Dushko has over 25 years of experience in the investment industry and leads the Australian equities' growth team with responsibility for the implementation of the investment process across a range of strategies. He's also the portfolio manager for the wholesale Australian share fund. The wholesale concentrated Australian share fund, the X20 Australian share fund, and concentrated an X20 separately managed accounts. Prior to joining First Sentier in July 2014, Dushko was equity partner at Orion Asset Management, where he led portfolio management responsibilities for ASX 300 Australian equity funds, and was also the portfolio manager for the small cap Australian equity fund. Prior to Orion, Dushko worked at Credit Swiss Asset Management as an Australian equities' portfolio manager and analyst. Dushko holds a bachelor of economics with joint honours in economics and econometrics and from the University of Sydney and is the CFA charter holder. There are 13 First Sentier on the net, super and IDP investment menus, including five funds managed by the Australian equities' growth team.

Paul O’Connor:

Both Australian and international equities have experienced one of the longest bull runs in history that dates back to the end of the financial crisis in 2009. This bull market has been driven by company fundamentals, earnings, growth, rising valuation multiples, and particularly on growth stocks, and the extraordinary monetary policy implemented by many central banks in developed countries. But is this now coming to an end? Whilst we've seen an increase in market volatility in recent months, the resilience of markets appear stronger than ever given the heightened geopolitical risk and rising inflation environment. My long held view during the decade long bull run has been that rising inflation will lead to a normalisation of monetary policy that will in turn lead to market multiples re-rating.

Paul O’Connor:

But as bond yields have risen rapidly in 22', this has not resulted in a significant sell-off equity markets. So I'll certainly be interested to discuss these concerns with Dushko, given your expertise and as growth stocks appear to be more vulnerable based on valuations. Maybe to start with Dushko, share markets are pricing in a series of rate increases this year and next year. So what impact is this having on markets and what segments of the share market are most impacted? And I guess, also, what sectors are most sensitive to rising bond yields? And I think I noted the other day, the Aussie 10-year bond yield hit over 3%.

Dushko Bajic:

Yeah, absolutely. So this year, yeah, we had a bit of it a year ago, but this year the bond yields have really risen and kept rising through the start of the year, whereas they backed off last year. And when you look at sectors that have done well, they are also the sectors that are most sensitive to rising bond yields. And on the positive side, it's essentially utilities, materials, energy, telcos, insurance companies and banks, to a certain extent. Although it's a little bit less the case for banks because it hasn't been just a sell-off in the long end of the curve. Clearly cash rates are going up, or the expectation of that is rising. So you still got a fairly flat yield curve, so it's not as universally positive for banks, but generally speaking, still they've done well.

Dushko Bajic:

So they're the positives, if you like. And then on the negative side, it's more the longer duration growthier stocks where the markets obviously got a high discount rate on those future cash flows. And so it's the tech sector, consumer services and parts of healthcare some parts have done well and some journalists as well. So they're the parts of the market that have been negatively impacted by rising bond yields. But like I said, it's not just as simple as that because we've had both the short end and the long end of the yield curve go up pretty aggressively. So I've actually got a pretty flat yield curve, it actually went negative a few weeks ago.

Dushko Bajic:

And so when you look at episodes of a negative yield curve, and that means it's simply just cash rates to your interest rates are higher than 10 year bond yields. What happens there, and I hacked back to your earlier comment in the intro, Paul, where you very accurately said that notwithstanding this at the aggregate level markets have still done okay. And interestingly, even through a rate rise cycle and the early part of this curve version markets tend to do okay and just looking at the US market as a bellwether with the US yield curve, being the dominant one globally influencing all over yield curves. You know, when you look at the yield curve inversions and I've got a couple of them here in front of me. So there was one in 78 to 90 and S&P up was up 8% in between September 1980 and August 1981.

Dushko Bajic:

We had a rising rates in the yield curve inversion and S&P was up 4%. And between January 88' and August 1990, the S&P did plus 30%, even though the yield curve bond sold off in the yield curve and flattened it inverted. Between 98' and 2001 again, S&P did positive 4%. The one yield curve in version that didn't do so well for the market was the Fed 2000 to April 2001. And that was the remnants of the TMT bubble and the market there was down 18%, but then the more recent yield code conversions in 2006 to 2008 market did past 14% and August 19 to March 20, the end market in the US was positive 3%. So ironically at the aggregate level, the market does okay. But obviously beneath the surface, sectors rotate, sector performance is quite vastly different as I've outlined on this occasion. You know, it's really been the utilities, materials, and energy companies and telcos that have done well.

Paul O’Connor:

Yeah. Interesting, interesting there, and I do wonder too, what impact that central bank policy is having, obviously, the whole point of quantitative easing has been to bring the yield curve down and to push investors further out on the risk spectrum there. But I do think those comments are still relevant there about the inverted yield curve. It's interesting, I hadn't realised that equity markets had performed as you just explained there during other periods of inversion of the curve. So, yeah, interesting. But I think it's certainly positive that the curve does appear to be not only lifting, but hopefully normalising and that people are paid for duration in bonds.

Dushko Bajic:

Yes.

Paul O’Connor:

You've experienced a number of market downturns during your career, such as the Asian financial crisis in the late 1990s, the tech selloff or the TMT bubble in the early 2000s, and obviously, the financial crisis. So does this period remind you of any other period when you consider current valuations, earnings, and cash flows and how are these things being priced into markets at present?

Dushko Bajic:

Yeah, it's a good question, Paul. I mean, the pandemic itself has assembled nothing that any investor company management team or government has experienced or lived through in their careers. It was a genuinely unique event. You know, we saw a big pull forward of demand for anything that assisted with working from home whether it was digital purchasing or workflows or CapEx to promote that we had a surge in physical goods' consumption because all of our incomes held up. So either you're in an industry like ours where the incomes held up, or even if you are in a severely disrupted industry like the small business fraternity who was most directly impacted, you are still very supported by extraordinary stimulus payments by the government. So yeah, like I said, a huge surge in digital workflows and purchasing in capital expenditure are big surge in physical goods because we still had income coming through our accounts.

Dushko Bajic:

And we purchased what we could, which was physical goods. So everybody upgraded their laptops and their screens and their desks and invested in a home office. So that's all very focusing on physical good consumption, but there was a big drop off clearly in services and leisure consumption. But the biggest theme really was that corporates and the government both thought that this was going to be a repeat of the GFC. And so they got out their GFC playbook and assumed that we were headed into yet another liquidity crisis, but in fact, nothing could have been further from the truth. And we ended up having a liquidity glut to your points and the question. We had governments generating 40% of GDP fiscal deficits. We had central banks going to zero rates. We had eye-watering liquidity in terms of quantitative easing.

Dushko Bajic:

And we sit here today with a Federal Reserve balance sheet of nine and a half trillion US dollars. Yes, trillion. It's doubled in a couple of years and like I said, record fiscal deficits. And then the corporates themselves, what do they do? They did especially in Australia and probably more in Australia than any other market interestingly was they did a whole lot of capital raising if you recall, through March, April, May, June, in 2020. But outside of the travel sector, in hindsight, none of that capital was really required, but there was just a big push to not be caught short on liquidity because that was what killed companies and caused issues in the GFC through 2008 and nine. And so in this environment, actually, when you look at our portfolios quality growth companies, companies that have got structural growth and can run their own race and not to depend on the underlying economies, they did really well.

Dushko Bajic:

And so calendar year 2020 was a burn for us and we sort of outperformed the market by over 20 percentage points, a real sweet spot for our clients. And we're really pleased that we were able to preserve and grow their capital through a really challenged period when they really needed it. And that happened because the revenues and the earnings of that group of companies, we own continue to grow and even accelerate in some instances. But since then, we've got to pay for the confetti of liquidity that's been showed on consumers and corporates. And we've had two very sharp reversals. And by that, I mean, sharp rises in interest rates in line with Apache reopening of the economy is the movement restrictions and health restrictions have come on and off.

Dushko Bajic:

And we've got various waves of the coronavirus coming through. The most recent one has got a lot the first repricing, if you like from October 2020 through to April 21, it was more bark than bite because yes, we had inflation and we had rising rates, but then it sort of tailed off in the second half of the year because we had a very patchy reopening, but this year it's been very different. The last six months you've had bark and bite, so to speak. And by that, I mean, the expectation of continued high inflation and then the policy response to that. And so higher short rates, higher long term rates. And as you say, 3% Aussie bond yield.

Dushko Bajic:

So in that context, what does the last six months remind me of? Well, if you didn't know what was happening and you just came in and sat behind your desk and looked at what happened to the various stocks and sectors and looked purely at the price changes, it very much looks like the 99, 2000 tech bubble, frankly. And that in itself can throw up some interesting opportunities which we can talk about in a moment, but right here, right now, the last six months looks very much like that.

Paul O’Connor:

Yeah. Interesting those comments there Dushko, and particularly what struck me, there was your comments around the liquidity glut and with onsite, the extraordinary fiscal and monetary response may not have been required particularly in Australia. But I think then we saw that move into all areas of the local economy and real assets and property prices continued to roar along and anything considered half collectible also has just gone through the roof in value. So I think the liquidity found its way into those areas. It wasn't quite required in markets like we all thought it might be when the COVID-19 first hit, but yeah, really interesting that theme around the liquidity glut. So what is unique about this period? And what's your view on how the market might be interpreting or potentially misreading some of these broader issues such as the health of the economy and likely interest rate changes?

Dushko Bajic:

Yeah. Good question, Paul. So whilst I say that the last six months looks and feels like the 99', 2000 tech bubble, the real question is, should it look and feel like that? And I think it shouldn't actually. Like I said, it wasn't the GFC, even though people thought it might be a repeat of the GFC, in fact it ended up being quite the opposite rather than a liquidity crisis was a liquidity glut. And just like the bubbles pricked in valuations of tech companies 99', 2000, in many cases, this was entirely appropriate because we had very mature business models that weren't converting into profitable companies, but had a lot of capital thrown at them. And the difference this time is we definitely have companies that are converting into strong profitability and businesses that will have a long successful and profitable life.

Dushko Bajic:

But the pricing action is fairly indiscriminate in terms of marking down this whole group of stocks. And so I can talk to it later that does throw up some opportunities. But what this really reminds me of, Paul, is more like Y2K. And that's something that pretty much, I think everyone's forgotten. And if you recall Y2K was in 2000 and there was that whole concern about the coding not being able to convert from 1999 to 2000 and a whole-

Paul O’Connor:

Computers were going to stop and planes would fall out of the sky.

Dushko Bajic:

And food shortages, apocalyptic end of the world scenario. Of course, that was a wonderful con by all the consultants out there to get businesses to spend against the perceived threat of that. But the really important thing here, and this is why I think Y2K is the best analogy for the last few years is the fact that because of that scare, there was a huge pull forward of spend, capital expenditure, business expenditure. People were purchasing food and storing it much like we did through the last two years for a different reason, but we had a huge pull forward of demand and especially for physical goods. And that's essentially what the demand side of what's caused inflation. And then, of course, there's going to be a consequence to this pull forward of demand and that is exactly what happened after Y2K.

Dushko Bajic:

And that was an air pocket because we'd over-consumed and pulled forward our consumption, when we got out of it on the other side, there was a bit of a hole both here in Australia, it was also post Sydney 2000 Olympics. It was a really sort of weaker period in the economy there because there was that air pocket because of the pull forward of consumption because of the perceived thread of Y2K. And we've had to pull forward on the good side here because of the pandemic and the policies of the pandemic. And so there's going to be a price to pay. And I think in the second half of this year and into 23, we're going to get an air pocket of demand for physical goods more broadly, not only in Australia, but globally. And I think that's what starts to on the demand side, pull in inflation all by itself. Okay? Plus we now have a Fed and global central banks actually tightening into what I think is already a slowdown that's in train.

Paul O’Connor:

Yay.

Dushko Bajic:

So I think the demand side will be quite a bit weaker in and of itself because of this air pocket effect. And we can talk later about a couple of examples, which I can point to which are canaries in the coal mine, but then the other interesting. So it's quite a complicated situation because there's also been significant supply side disruption at the same time, so it's quite hard to... The aggregate outcome, people are not disentangling into its individual components and then analysing what happens to which components. So on the supply side, we've had all most of the inflation now that we're experiencing now, as opposed to a year ago. A year ago it was the pull forward of demand. Now it's all about disruptive supply chains, businesses stock piling, because of those disruptive supply chains and then wartime sanctions, frankly, off the back of the Russia Ukraine conflict. So yeah, I think Y2K actually best describes it, even though markets are pricing in a different fashion.

Paul O’Connor:

Yeah. I hadn't considered really that bring forward of consumer demand over the last 18 months, I guess there. But yeah, it makes sense that consumer demand then may be muted over the shorter term just to catch up because of the extraordinary spending and then you add the supply side issues and the supply chain blockages, and you can see a perfect confluence in really underpinning and driving inflation. So, interesting, interesting. So we've just been through the earnings reporting season. So what are some of your key takeaways and how have you used these insights into recent portfolio decisions?

Dushko Bajic:

Yeah, so it was a reasonable reporting season, Paul. I think again, just as people are surprised that markets do okay in the initial part of rates rising at the yield curve inversion in aggregate of it. People were surprised that the last three halves of Australian profit earning season have been pretty good. In fact, I think although August reporting season last year was probably one of the better reporting seasons in the last 20 years. So again, slightly counterintuitive, but it's because of the tremendous stimulus that's been provided and the fact that companies had good and strong balance sheets and even balance sheets that were too strong in many cases. So it led to reasonable very reasonable earnings outcomes and good growth in many respects. But I think the key feature of the most recent reporting season was weaker cash flow.

Dushko Bajic:

So not withstanding the fact that you've had a very good revenue and earnings growth in aggregate, especially from the resource companies from higher commodity prices. We've had it run into a period of week of cash flows and that's because business has done two things they've built inventories in response to disruptive supply chains and reliance world is a good example. They do all the plumbing pipe fittings and big markets in America, UK, and Australia in particular. And they had a lot of demand and couldn't necessarily fulfil it at all parts in every quarter of the last two years. And so they built up a whole lot of inventory and so that took the edge off the cash flows. And then also higher CapEx, businesses are retooling. You know, if you were a retailer who wasn't omnichannel, it didn't have both a physical storefront and a digital footprint to accept orders, you had to retool if you're a restaurant, but only had dine in and didn't have takeout, you've had to retool.

Dushko Bajic:

And so many businesses had to retool and reinvest and that's sort of higher capital expenditure to be able to thrive in this new environment that we're all living through. And so at the margin cash flow was weaker because of inventory build and higher CapEx. We still had quite high commodity prices, but actually weak production and you just look at BHP and RIO in the last week, they've had really poor production outcomes sort of minus 8% production across cast iron and copper, which is disappointing. But of course, that also fuels better prices because there's less supply of those commodities coming through. And that part of that is just supply chain issues, but also issues with staff and labour in terms of the pandemic and isolation rules hitting production, but the more important stock-specific observations outside of those broader ones.

Dushko Bajic:

Paul, I think you could see in a couple of stocks and I sort of call them in coal mine. And on one side, even before reporting season started, you had Ansell a week beforehand in the first week of every come through the earnings down rate, it was a pretty big one 30% earnings down grade. And of course, it was a tremendous beneficiary of a pull forward of demand and a pull forward of demand for physical goods. And of course, in the case of Ansell, gloves, which were clearly in great need. And so the pricing of gloves was up by a factor of five times in terms of what you got per glove or more in some instances, but what we've had is what I've sort of been hinting at earlier. And that's the air pocket that we're going to live through after the pull forward of demand.

Dushko Bajic:

And the 30% EPS down upgrade was largely just those glove prices falling away because you've had a supply response, so all the factories in Malaysia have gotten through the bulk of their staff issues from all the virus variants and productions up to very high levels. And so supplies now reacting to demand from last year, but demand is actually now falling. So demand last year was peak demand for gloves. And in fact, as the pandemic abates, the demand for gloves has fallen, but the companies are responding to last year's demand pulse and supplying at last year's demand level. So what happens to price? Well, those glove prices are down by over 60%. And so this is a good example at the company level that I think will start happening in the economy more broadly in these physical goods where the price of those items starts to fall because supply is supplying at last year's demand.

Dushko Bajic:

Last year's demand is way higher than normal levels because of the pull forward. And so even without rates going up, there'll be a whole series of physical prices living through the air pocket. Yet at the same time, the movement of companies finally supplying more than the supply chain issues abate. And so I think we'll see more of that in subsequent reporting seasons in the next 12 to 18 months. Then on the other side, you've had the other beneficiaries of the growth stocks that have had a pull forward, an acceleration of their market share and demand and Fisher & Paykel was a great example, it didn't report its earnings in February, it's got a match year end it did come through a profit downgrade there. And that's just because they were too successful in a sense. They've got two years of such strong growth in their machine and masks that year on year, they're going to be negative.

Dushko Bajic:

And so there's just a bit of that indigestion effect of the poor forward of demand, which accelerated a bit. They're already very strong structural growth drivers, just meaning that they're going to go negative for a year or two as demand for their goods and normalises. And when we observed what happened with Ansell, we actually took the opportunity to sell out of Fisher & Paykel more than a month or more than a couple of months ahead of the profit downgrade, which was a good move. So we're sort of always trying to work out if this is happening in this company, what does it mean for other companies and should we be doing something about it? And Fisher & Paykel is a very high quality franchise and we'll look to re-buy that in the course of time as the shared price has adjusted and the market forecast become more realistic about the next couple of years, but they're good examples of what can happen in a reporting season and what can trigger and moves in the portfolio.

Paul O’Connor:

And I guess real examples about the economy readjusting to the extraordinary, both supply and demand side issues of the last couple of years. So we never get it right exactly as an economy. So your comments around retooling and some companies now still reacting to last year's demand and what have you, and it really is just an outcome of the extraordinary couple of years we've lived through and the impact COVID has had on all of our lives there. But really interesting insights there Dushko. I think many fund managers and investors do not spend enough time evaluating investment philosophies of various fund managers, or even their own philosophy. Given they are the beliefs and the principles that really guide all investment decision-making. Can you talk a bit about the growth teams core philosophy, and how this feeds into how you value companies in the context of the current market?

Dushko Bajic:

Yeah, it's a really good point, Paul, because if you don't have a disciplined consistent process with all the noise and all the market movements, you can easily lose your head and that leads to poor decision-making. So having a very clear and focused investment philosophy process and strategy is key to shifting out what's noise from what's a real signal and focusing on what you should be investing in both now and into the future. So we really focused on companies that can grow their revenues strongly, but that's not enough, you've got to be able to convert that strong revenue growth into strong. Earnings growth per share, because of course, you've got to quite often apply capital to your business in order to generate that top line revenue growth and then filter it down through a good margin and good cost structure to generate solid earnings.

Dushko Bajic:

So companies that can grow their revenues well, and then also grow their earnings for share well, and then of course, very importantly, companies that can generate a very strong return on invested capital. So it's really important for us that the companies are generating a return that's above their cost of capital, because it's when you're able to do that the magic happens and the magic is when you're earning above your cost of capital, you are generating capital organically yourself, and then you can reinvest that back into your business, back into your products, your services, or your geographic footprint, or your innovation and sustain your competitive advantage. And able also sustain those sort of above cost of capital excess returns. And that's what generates strong share prices over long periods of time. And so we are really focused on companies that can do that.

Dushko Bajic:

We're also focused at the margin and also looking at companies and how the change on return on capital is running through their business. And we always like companies that are having increasing return on invested capital and we are closely analysing companies that have reducing return on invested capital. And that can be a really good prompt for both a sell and a buy discipline on existing stocks in the portfolio, but it can also generate new ideas in terms of stocks in the portfolio. And then the final thing that's really important is how we go about doing this work. And it's really important that we do a deep-dive on the industry structure of each company and many companies are not just in one industry, they may be in multiple industries and micro industries where the supply and demand dynamics are different.

Dushko Bajic:

So we pride ourselves on doing a really important financial modelling, a very detailed profit and loss cashflow balance sheet statement that we fold out into a consistent DCF, discounted cash flow valuation approach that we run across all stocks and all sectors so that we can rank opportunities, but none of that means anything unless you understand the industry that a company's in. And so we do a lot of company visits. We do a lot of calls with industry experts and people that have worked in the industry. You can't just push a spreadsheet and for that spreadsheet and push those numbers around a spreadsheet and pretend then actually that you understand how company's products work and what the positives and negatives are and how the profit pools are generated.

Dushko Bajic:

And so we interview both over the phone video calls and physically people who have spent their careers in this industry both listed competitors, unlisted competitors, people who are retired from the industry who can give us insights into the products that we get a deep understanding technically of how it works, the economics and the costco's and the profit pools. And also, of course, being in the market for over quarter of a century, we've got a Rolodex of industry contacts of our own plus great exposure and knowledge of board and management teams and how they've performed over the years and whether they have your interests at heart and our interests are clearly, those are a minority equity holder sweating the capital and generating returns as opposed to some sort of VA glory of their own reputation and careers, and just wanting to get bigger for the sake of it.

Dushko Bajic:

So that's a mix of all those things that come into our decision-making and we just really want to pick the eyes out of essentially undervalued growth stocks and you can have a high multiple, but still be undervalued because the market is underestimating even the degree of your growth and how long it will last for, or what the rate of growth is. And then also what kind of rates of return you can earn now and into the future. So it's putting those things into a discipline financial model that forecast, and then values a company, but informing that with really strong industry insights and not just pushing around some numbers on a spreadsheet, but understanding how these businesses work and what motivates the management in board.

Paul O’Connor:

Yeah. I think as you were talking there, Dushko, I think it's clear that the First Sentier Australian equities' growth team is very centred on a clear investment philosophy that then permeates into process. And I think it gives you clarity. And I guess personally, I've always found that again where if you have a very clear investment philosophy, our industry is full of so much noise and the latest and greatest trend and human nature and herds moving in various areas. And I've found the older I get that my philosophy up front just sort of immediately says I'm not interested, or yes, I need to look at this more closely there. So yeah, I think it's very clear when you stop and you really think about a philosophy, does the manager actually live and breathe that philosophy? And I guess this gets back to my old fund manager research days and understanding there Dushko, but it certainly makes sense your comments there.

Paul O’Connor:

Maybe moving on to the other side of the active management coin there, value has had what? Over a decade of under-performance against growth stocks during the bull run. But in recent months, growth stocks have had a difficult time and we have seen areas of value coming back into the market in terms of re-rating of the valuation. So do you think we're finally seeing a rotation shift to value or is this a little more transitory and I guess an outcome again, of the extraordinary couple of years that we've experienced courtesy of COVID?

Dushko Bajic:

Yes, Paul. So like in simple terms higher interest rates disproportionately impact the valuations of growth stocks or longer duration stocks that are on higher evaluations for whom the cash flows are being discounted back at a higher rates. It has a disproportionate impact on the valuation. And so higher PE high evaluation stocks get hit by the denominator in the evaluation equations your discount rate higher interest rates. And so that's the principal impact has been on valuations, not so much on the cashflow in the earnings, which have still held up very well. But because the group of value stocks that have done well, also have a bit of a cyclical bet to them. So the gap, if you like, the excess revenue and earnings of growth stocks just in the last six to 12 month period.

Dushko Bajic:

Yeah. The degree by which those growth rates are higher than value stocks has closed right in because of the cyclical bet of value stocks. And what's been helping the cycle of many of these downtrodden value stocks to struggled to get their top line, their revenue and their earnings growing for a long period of time is the glut we talked about earlier, the liquidity glut. So the thing that you need to understand is I think it's fair for the repricing to happen, but from here, I think it's normalised and it's much more even playing field, but just think about what had to happen to get some of these value stocks up off the deck so to speak, to get some revenue growth. You needed clearly to get your top line gifted to you by strong inflation that was itself generated by record stimulus, fiscal stimulus 40% of GDP deficits, zero interest rates and a nine and half trillion Federal Reserve balance sheet.

Dushko Bajic:

So record everything thrown at you. And finally, there's a bit of a pulsing in revenue and earnings. And so the market is reflecting the fact that the excess returns and growth of growth stocks versus the value other parts as closed right in, not so much because there're downgrades in the structural growers, but more that the cyclical pulse and the benefit of all this reckless stimulus has fallen into the lap of some of these beaten down and more cyclical stocks. And plus you've had the valuation impact on the denominator of higher discount rates. So that's the perfect storm and that's why it looks and feels in terms of price action a lot like that CMT bubble. What's different this time is, like I said, these are real business models that aren't going to disappear in the way.

Dushko Bajic:

So many companies disappeared 25, 20 plus years ago. The market has matured and these businesses are providing very essential services and products to the companies who are retooling their businesses and really required these products in order to succeed. So, yes, the valuation part is there, but the fundamental part's missing because the revenues are sustainable and will keep growing. And there hasn't really been that much in a way of downgrades, but the gap has closed. And so the other thing I'd make an observation of well sharing, I think is just if you look back through all these cycles, whenever you've had an extended period of value under performance versus growth, whenever that rubber band eventually breaks and re-balances such as we've had this year and a small version of it, same period a year ago, it's fast and furious.

Dushko Bajic:

Okay. Value outperforms in a blazingly large order of magnitude. So a huge out-performance. And I think values outperformed MSCI growth for the last four months by 25% point. So it's a massive catch up, but it does happen in a fairly short period of time. So I think we're at the point where it's a much more even playing field. And I think as we run into the end of this year and into 23, you'll have a slowing economy because of that air pocket effect of the pool forward of demand. Plus you've got budget deficits reducing and central banks raising rates. And a year later you'll have the dampening impact on the economy. And interestingly, the inflation now is not so much demand-driven, it's supply-driven.

Dushko Bajic:

So policymakers are giving you a demand-focused policy response to inflation, which is interesting rates and reducing demand to an inflation problem that is now almost exclusively supply side. So there's going to be some reckoning there. And I think there's going to be a mismatch in terms of what economy is and that'll reveal itself. And in that environment, I think we will be moving from what was a very slanted playing field in favour of value in very recent times in the next few quarters to something that's a little bit more even. And then something into next year, that'll be more I think in favour of structural growers because the underlying economy will be weaker and those value companies will not be gifted their top line in the way they have to date been by the stimulus.

Paul O’Connor:

Well, I think on that note, we'll draw the podcast to a conclusion there. I get the feeling we could go on all day there Dushko. And certainly your passion and your knowledge for the companies that you hold and that you cover there certainly comes through very clearly there, but I certainly thank you for the time and the insights you've provided myself and the listeners this morning based on the economic view. And I guess the issues around Covid's impact on the economy and the liquidity lags you articulated earlier in the podcast. So again, thank you very much for joining us and spending the time this morning.

Dushko Bajic:

Thanks, Paul.

Paul O’Connor:

To the listeners, thank you very much again for joining us on the Portfolio Construction Podcast Series. I hope you enjoyed today's podcast as much as I've enjoyed the discussion with Dushko. I wish you and your family's all the best. And I look forward to joining you on the next instalment of the Netwealth Podcast Series. Brilliant.