There are two modes of human thought. The first is fast, instinctive, and emotional, while the second is slower, more deliberative, and more logical. Thousands of years ago, the former helped us survive; for hundreds of years, the latter has helped us prosper. Psychologist Daniel Kahneman, winner of the 2002 Nobel Prize in Economic Sciences for his work on the psychology of judgement and decision-making under uncertainty, has enlightened us on the subject in his praise-worthy book, Thinking Fast and Slow. Seen as a decision-making aggregator, the stock market could be considered an extension of the behaviour of human thought. There is a fast-moving first level that seeks immediate results in the extreme short term (minutes, hours, days) based on news, rumours, perceptions. Then there is a second, more fundamental level, whose objective is to buy and hold; in other words, to buy companies based on quality and valuation and accompany them over time as their businesses grow.
Currently, the balance is shifting toward the first mode: fast, instinctive, and emotional. The increase in trading algorithms in a frantic attempt to filter any new information not yet reflected in prices has caused a notable spike in volatility, often divorcing the share price from its actual value and further amplified by passive management driving more and more flows toward index-linked products that discard detailed analyses and valuations.
Over the course of the year, we often wonder why the market or a specific share is up or down. And we have no response. Many times there is no fundamental answer; it is merely the result of flow movements—beyond our control. It is the psychology of the market. What we can analyse is the quality of the listed companies’ management teams, the strength of their businesses, and their capacity to generate profitable growth over time. That is where the second mode of thought comes into play: slow, deliberative, logical. And this is the basis of our management style.
We benefit from the volatility generated by immediacy when it allows us to buy good businesses at low prices and gives us the opportunity to sell excellent companies above their fair valuations.
Profits began rebounding in 2021 despite problems with the supply of components and sharp energy increases in Europe due to rising gas prices and higher-then-expected inflation, factors that can temporarily destabilise markets, but that are better withstood with a selection of quality companies. Thus, in 2021 our EDM Inversión L Spanish equity fund yielded +15.1%, outperforming the +10.3% obtained by the IBEX-35 NR benchmark index (with reinvestment of dividends).
The current year begins with the expectation of interest rate hikes in the United States and concerns about whether they will also rise in the European Union, though the European Central Bank says rates will remain at current levels. High inflation in 2021—6.5% in Spain—is another factor penalising companies unable to pass on higher costs to their customers. The threat of a conflict between Russia and Ukraine exacerbates this uncertainty and puts added pressure on gas prices. Taken together, these three factors generate market uncertainty and translate into volatility.
Meanwhile, the Omicron variant that appeared in November has begun to subside in several countries, prompting the World Health Organisation to announce recently that 2022 could see the end of the pandemic, including the easing of mobility restrictions, a reversal in supply chain bottlenecks, and a recovery in spending on goods and especially services. In addition, inflationary pressure should ease as the year progresses, concluding with price increases of 2%-3%. These factors should alleviate market concerns.
Moreover, if we broaden the focus, we see that in the last two years companies have accelerated the implementation of their digitised processes, optimised operating costs, and streamlined investments toward profitable organic growth. Through inorganic growth, opportunities to acquire value-generating, small- and medium-sized companies will arise. In addition, companies enjoy excellent financing terms, with regard to extending maturities and reducing the cost of debt. Lastly, they will benefit from the tailwind of Next Generation EU (NGEU) funding in Europe and of Biden’s infrastructure plan in the United States. Spain will be the second largest recipient of NGEU funding with EUR 70 billion in subsidies and 70 billion in loans with very favourable terms. The total is equal to 14% of the country’s GDP. The economic recovery and the injection of European funds will boost Spain’s GDP by 6% in 2022, leading growth among OECD economies.
EDM Inversión faces 2022 with a very attractive portfolio in terms of quality and valuation. It trades at a 2022 P/E ratio of 13x, equal to a return of 7.6% and compared to the Spanish 10Y bond at 0.6%. Never has it been so inexpensive in relative terms. Based on current prices and our profit growth estimates for the selected companies, we expect the fund could double its net worth in five years.
Albert Fayos,
Co-Manager EDM Inversion
