Weekly Market Commentary By H.E.R.O. (20 to 24 Dec 2021)

Markets rebounded in choppy trading on thin volume during the holiday-shortened week, although the pain below the surface is brutal. Over the past few weeks, most stocks fell into a 10% correction, clean energy green stocks and newly minted shares sank into a bear-market decline of 20%, and the group of profitless technology firms plunged over 30% and more than 300 unprofitable companies that have fallen more than 50% from recent highs. Signs that omicron may not be as lethal as other virus strains clashed with steady news of business closures and travel restrictions around the world that threaten growth. The omicron variant accounted for 73% of all sequenced Covid-19 cases in the U.S. (92% of cases in New York and New Jersey), surging from around 3% last week. A newly hawkish Federal Reserve, slowing earnings growth and a relentless pandemic and supply chain disruptions are adding to the lack of conviction that characterized December. The S&P 500 has alternated between gains and losses every week, each with moves exceeding 1%. Doubts remain about the path of omicron and how central banks will fight inflation, with economists sounding the alarm on the risks to growth for 2022 as the tidal wave of stimulus is now receding. Biden’s US$1.75 trillion signature economic and clean energy plan suffered a crucial blow after Senator Joe Manchin surprised the White House and fellow Democrats Sunday by announcing his opposition to the Build Back Better Act, which would have included a record US$550 billion for climate measures, including key tax credits for renewables.

Market outlook gets gnarly for 2022 with rising skepticism and caution, though the prevalent market narrative remains that it is too early to get bearish because corporate fundamentals are going to continue to come in strong. In particular, a narrowing, more selective, stock market environment in 2022 is good news for high-quality structural growth stocks and dividend growth stocks and bad news for the ‘index fund’ crowd, since they have traditionally prospered in such periods. Midterm elections will also usher in a divided Senate/House/government that Wall Street is craving. However, the market’s optimism is increasingly tempered by the deeper scrutiny into net, rather than gross, buybacks, given its emphasis by market commentators as a key driver of U.S. market performance. Net buybacks refers to how many shares have been repurchased after deducting the number of new shares that have been issued, which reflects genuine changes in the supply of stocks. Year to date, major U.S. corporations have announced nearly US$1.2 trillion of repurchases, eclipsing 2018, which held the previous record of US$1.1 trillion. And, yet, at the end of the third quarter the total number of shares actually outstanding at S&P 500 companies was more than at the beginning of the year — not less, i.e. companies have actually issued more shares in 2021 than they have retired. Negative net buybacks mean the stock market’s longer-term prospects have fallen.

In China, Beijing locked down its 13 million population in Xi’an city after over 200 cases were detected as it scrambles to prevent an omicron wave ahead of the Winter Olympics. Chinese companies trading in the U.S. must disclose more about the risks they can pose for investors, according to new guidance from the SEC on Monday, and added that SPACs should disclose whether their sponsors or majority of executives are based in China, or whether a merger target is located there. After China's year of unprecedented crackdowns, roiling markets and halting deals, bankers and lawyers expect tighter scrutiny to continue in 2022. In a sign of new measures to come, Reuters reported last week that regulators are planning to ban online brokerages from offering offshore trading services to mainland clients due to concerns about data security and capital outflows. These regulatory moves come as China heads into a critical year with Xi almost certain to secure a historic third term as Communist Party leader. Alibaba extended its decline following reports that China’s IT regulator disciplined the company for failing to report an open-source security vulnerability to the government and suspended a partnership with Alibaba for six months. China’s biggest livestreaming and e-commerce platforms saw shares drop after the country slapped an unprecedented tax evasion fine on a top influencer, intensifying its crackdown on celebrities responsible for shifting millions in merchandise on the Chinese Internet. Debt problems major Chinese property developers from Evergrande to Kaisa have now spilled over into a vital artery of the nation's industrial engine - the steel sector - and started to ripple through to other critical parts of the economy. The spreading balance-sheet crisis at real estate firms is a warning for policymakers as a swing in the fortunes of the steel industry would have significant repercussions for China's economy, with cement, glass, and household appliances all vulnerable to demand drops. Property-related sectors are the single biggest contributor to China's economy, accounting for 28% of GDP in 2021 and have been the engine of China's economy for over two decades now.

As euphoric traders piled into the trendy Cyclicals/Value Traps, we believe that there is a high probability of downside risk in chasing and catching them at exactly the wrong time after their sharp run-up from being blinded by the fiscal stimulus hopes and vaccine euphoria — the light at the end of the tunnel — and things can turn very nasty suddenly, as markets tend to underestimate how long that tunnel is, and how dangerous that tunnel is. This situation is very vulnerable for cyclicals to degenerate or revert back into its true ugly colors as cheap-gets-cheaper Value Traps once the vaccine euphoria fades or something negative happen on the mass vaccination roll-out or the vaccine does not prevent people from carrying and spreading the virus to others or new mutated virus strains erupt to render the vaccines ineffective. Once the vaccines actually start being administered at scale and the pandemic recedes, a lot of investors are going to wake up to the fact that the global economy is still dogged by a host of thorny problems that both predate and have been exacerbated by the virus. The current unsustainable market euphoria over Cyclicals, Value Traps, Zombies (companies who cannot cover their interest expense with cash from operations) and Vampires (junk-rated corporations with negative EBITDA) has created opportunities for long-term investors in the inexorable rise of a selected group of fundamentals-based structural growth innovators. These winners solve high-value real-world problems to generate visible and vigorous quality earnings growth before and during the pandemic, as well as are poised to enjoy continued healthy demand and staying power in a post-pandemic future when the world recovers painfully and slowly to transition from the Pandemic Health Crisis to the next crisis – the PTSD Post-Pandemic Growth Crisis. Our portfolio companies have shown resilience and scalability during this tumultuous environment and the management continue to make key strategy decision to expand their market leadership in their respective fields. The quiet HE.R.O. innovators have invested wisely in innovations that sharpen their exponential competitive edge for long-term value creation, strengthened their market position in the value chain that supercharged their cashflow dynamics, developed new channels, new markets and new customer base for revenue growth while improving their profitability at a time when most businesses are struggling, and nurtured their human capital and corporate culture to foster innovation and ESG sustainability. While the short-term day-to-day price movement can be volatile, what continues to be crystal clear is that the quiet structural growth H.E.R.O. innovators remain the most visible and vibrant pathway in a foggy, volatile, whipsawing, uncertain market to deliver sustained outperformance with their healthy fundamentals results.