FPM-Comment Reducing the Noise by Martin Wirth: 1/2023 dated January 19th 2023

Check off the year 2022 and look ahead!

• Looking back at the market and the FPM Funds
• What counts now for looking ahead?
• Many companies well prepared
• Crises and their impact on prices and valuation
• Competitiveness and the banished risk of insufficient energy supply
• Positive outlook - despite it all

The year 2022 is history, and the vast majority of market participants should be happy about it. With most asset classes, one had the best chances of losing money. However, the differences in performance were massive, with the result that many rather manageable price declines are likely to be temporary, while some investments may have brought permanent losses. This makes the difference in the longer term: Are you still in the game, or have you been knocked out?

Looking back at the market ...

On the German stock market, the few winners were the companies that benefited business-wise from the outbreak of war and previously had a low valuation, as well as the companies that benefited from rising interest rates, first and foremost of course banks and insurance companies.

The majority of shares recorded noticeable double-digit losses, even if the development of the actual business was solid. On the other hand, the former high-flyers, especially from the growth sector, were hit particularly hard when high valuations met with weaker-than-expected business developments. In such cases, it was possible to experience a share price loss of 50 to 90 %, in some cases without the business model of a company being fundamentally impaired. Here, the effect of value investing was on full display: Nothing is so great that you should pay any price for it. However, we now see greater opportunities in this area again, to be clear.

... and on the FPM Funds

Last year, the FPM Funds recorded losses in line with the various indices. The range of performance of the investments was significant, from significant gains to significant losses. Furthermore, from a relative point of view, the funds were hurt by the comparatively good performance of stable equities, which we have been avoiding for years in view of their high valuation. The performance of a number of second-tier stocks was also poor. Although their business performance was decent, many market participants sold them in order to reduce risk, mostly only because they were second-tier stocks. In relative terms, on the other hand, it was very helpful that the formerly expensive growth stocks and the profiteers of low interest rates, such as real estate companies in particular, were only represented in the portfolio to a below-average extent: In some cases, the losses there were very heavy. All in all, share prices fell and so did valuations, with the result that portfolios are now even more attractively valued than they were a year ago.

The big picture: Putting it into context

Looking at the general framework, the losses on the German stock market are even almost bearable. In the past, far smaller problems have caused significantly higher share price losses and, as I said, a whole series of not exactly small companies have even been able to record share price gains.  In our view, this clearly speaks for a sustained low valuation of the asset class "German equities", which has obviously been abandoned for good by many investors last year, i.e. until the next strong performance of the market.

Among the obstacles are first and foremost the war in Ukraine, then the whole combination of rising energy and food prices, skyrocketing inflation figures, central banks throwing their zero interest rate policy overboard, and of course continued Corona restrictions, especially in China, affecting global value chains, as well as geopolitical tensions everywhere. This should actually be enough for a veritable crisis, and this was then also the case: However, not so much on the stock market, where one could get used to distortions in the last two decades, but on the bond markets, where one could otherwise always feel comfortable even in the darkest hours and where the central banks helped out in case of need. On the German bond market, the gains of almost the last ten years have gone up in smoke within a few months. As a result, attractive interest rates are now by no means being offered, as should actually be the case after price collapses: Interest rates continue to be more or less significantly below current and expected inflation rates. Real losses are therefore almost guaranteed for the next few years.

What counts now for looking ahead?

In an extremely difficult situation, Germany and Europe have so far come out of the woodwork far better than feared. The consistent stance against Russia and the support for Ukraine as well as the cohesion in NATO with the USA are a remarkable political development that could not necessarily have been expected a year ago. The associated cessation of Russian gas supplies was largely compensated for in the short term, with the state stepping in to compensate for short-term hardship. A looming nightmare turned into an opportunity to dynamize the energy transition, perhaps to reduce the rampant bureaucracy and focus on the essentials, which was perhaps grasped even more quickly in the private sector than by many in politics and administration.

Many companies well prepared

The looming recession feared by all sides has been anticipated for at least six months, measures taken, inventories reduced, fewer risks taken. This should noticeably slow down the recession, if it does come: A recession is always most unpleasant when no one saw it coming and no preparations were made. On the negative side, many companies are still benefiting from the order backlogs accumulated during the corona pandemic, which are now gradually running out. Rising interest rates will also take their toll on debtors, often only gradually as low-interest loans expire. On the other hand, creditors are the winners of this development (in nominal terms, not in real terms, see above) on the one hand, and the fact that interest rates are still not high in the longer term on the other: Companies that are already having problems under the current circumstances should perhaps fundamentally rethink their business model.

Inflation and the role of China

Two key positive aspects from an equity market perspective are the inflation outlook and the lifting of corona measures in China. Inflation dynamics are pointing steeply downward, and last year's price bubbles have largely disappeared. Gas in Europe costs about the same as before the Ukraine war, oil prices, transportation and logistics costs, used car prices are all in reverse. As the chaotic lockdowns in China come to an end, supply chains will continue to normalize and shortages will be eliminated or reduced. This should put downward pressure on interest rate expectations, which in turn will be good for stocks. In China, growth is likely to accelerate again, which will also support global growth.

Crises and their impact on prices and valuation

Like everyone else, we don't know how the next few quarters will play out. What we do know is that, despite the recent recovery in prices, a great many stocks are still valued quite low under reasonably normal circumstances. Thus, the recession, should it come, should already be reflected to a large extent in prices, but a recovery should not. As already mentioned, this is supported by the fact that German and European equities have performed reasonably well despite the extremely difficult conditions and have outperformed U.S. equities for the first time in more than a decade. No comparison with the losses of, for example, the dot.com crisis 20 years ago, which was actually a non-event from an economic point of view, or the banking and European sovereign debt crises, which could be solved by simply "printing money". Today, as in the Corona crisis, the actual and feared problems are and were more existential. And this has also been reflected in the valuation: The price DAX, i.e. the DAX, which is calculated in a comparable way to the S&P index, namely without the dividend payments, has just exceeded the high of 2000. German national income has almost doubled since then, and the fact that German companies are now much more international than they were then and have been able to benefit from higher global growth is also not reflected in the share price performance.

Dividends are at record levels, as are dividend yields, and here companies tend to be reluctant to cut back unless they absolutely have to. Many stocks, even with very solid business models, are trading at a discount to book value, something that used to be reserved for companies that were losing money. The fact that inflation is expected to be higher than in the last ten years is also in favor of equities: companies are the ones that can raise prices. In this respect, nominal growth is achievable for more companies than was the case in the last ten years, which in turn argues in favor of "value stocks". The scarcity premiums for stocks that can achieve growth in an environment with very low inflation should thus fall, which makes these stocks look less attractive in view of the still high valuation premium after, as already mentioned, the winners of low interest rates such as real estate or growth companies have already incurred noticeable losses. So to speak, stable growth stocks are "the last shoe to drop".

Germany's competitiveness and the banished risk of insufficient energy supply

The greatest threat to German companies in recent years has been the risk of insufficient energy supply. This problem has been solved for the next two to three years anyway and, in all likelihood, for this winter and next winter as well. The perception of Europe and of Germany, especially by the rest of the world, is far too negative from our point of view, even though this does not mean that all problems should be talked down. Germany's success and prosperity are by no means - contrary to what is often said - essentially dependent on cheap energy imports. And that of globally active companies is certainly not the case. Energy is very cheap in the developed economies, especially in the USA, where specific consumption is correspondingly higher because energy savings bring lower benefits. Now we can ask ourselves which of the American megacaps owe their success to cheap energy. Energy is processed and consumed locally, either directly or in many products. The number of end products that are transported around the world with a high value energy content is very moderate. In this respect, all of this only affects Germany's external competitiveness to a limited extent.

Positive outlook – despite it all

Who it will affect: It's the consumers. That's annoying, but we're talking about an order of magnitude increase in the cost of energy imports, which should ultimately amount to perhaps 40 to 60 billion euros for Germany. That's 1 - 1.5 % of national income, or roughly the annual increase in productivity. I will bet that a consistent reduction of senseless bureaucracy should bring many times that amount in savings. Now that the whole country seems to be rejoicing that liquid gas terminals can be built in ten months instead of ten years, that would be a good time to consider the latter. But again, none of these are good reasons to buy or sell stocks. The only reason that makes sense in the long term to make an investment is the attractive valuation of a stock. And here, after a year of chaos and confusion, there is plenty of choice to be had across all industries and sizes of companies. And so, despite all the recession fears, we expect 2023 to be a much better year.

Sincerely yours,

Martin Wirth

FPM-Comment Reducing the Noise by Martin Wirth: 4/2022 dated October 24th 2022

No place to hide on the financial markets – and how things could continue with a clear head and a rational approach

• Massive bulwark against share prices falling further
• Buying in a recession has proven to be the best strategy
• The role of gas prices for the German economic model
• Inflation, interest rates and Ukraine war: dealing with and the impact of the "double whammy"
• Scenarios for the financial markets

If we thought several times since the turn of the millennium that something bad had now happened that could not be topped, we have again been proven wrong in 2022. The recession of 2001 (noticeable only by falling share prices, which had previously been overpriced), the financial crisis of 2007 to 2009, the debt crisis of 2011, the distortions in international trade triggered by Donald Trump, all followed by the Covid-19 pandemic. From today's economic perspective, this caused massive damage through the lockdowns, but also through the various government interventions, which are only gradually coming to light. Keywords are the chaos in production, logistics and administration as well as a shortage of personnel in many regions, for example due to government cash gifts, especially in the USA, which ultimately caused an inflation not seen for decades. The latter, of course, was also caused by panicked central banks with extremely expansive monetary policies. And now a war in Europe, which Russia has instigated against Ukraine. Apart from anything else, this has also contributed to inflation and shortages of important goods to a considerable extent. For the time being, only the use of atomic bombs, a war between China and the many states regarded by China as rivals, and a comet impact remain as possible increments. As well as of course the climate catastrophe with its consequences.

Massive bulwark against further falling prices

As you can see, we've already come a long way, but there's worse to come. In any case, the market is not being driven by pleasing underlying conditions or excessive optimism. And negative surprises are something that no one wants to rule out anymore and will take into account in some form in their investments. After all, all of this forms a formidable bulwark against further falling prices: if you don't look at the indices and their reasonably solid performance due to a manageable number of large-cap stocks, you will see a large majority of stocks that are miles away from their highs of the last ten years.

Inflation, interest rates and the war in Ukraine are massive headwinds

Since the beginning of the year, the headwinds for the markets have been at record high levels. One was the underestimated inflation as well as the equally underestimated aggressive willingness of central banks to fight inflation, but most of all the rising long-term interest rates, which only a minority of investors could have imagined rising ten months ago. The same applies to the war in Ukraine: first, that it is taking place at all. And then, that Russia, having failed to achieve its goals, chooses the path of escalation at every point where there are several alternatives.

But: under the circumstances, relevant aspects have developed better than expected

Many things developed better than expected: Ukraine's defense readiness and capability, its support from the West, but also the significant weakness of Russia. Strategically, this could represent a huge gain for mankind, even if it will entail considerable costs in the next few quarters and in purely economic terms, particularly in Europe and especially in Germany, as can be seen from the development of share prices. The good thing is: Russia, as the global schoolyard bully and role model for many other autocrats, has shown itself to be much weaker than expected by all who have had to put up with and accept its posturing for decades. The price of an improved world order is high, especially for Ukraine, of course. But it was due at some point, as we now know, and: it is probably not nearly as high as feared. Another positive aspect is the West's ability to free itself from Russian energy supplies for the foreseeable future at high cost, but without the collapse of industry and society. Germany seems to be prepared for the winter under normal circumstances, and companies have also taken a variety of measures. BASF can serve as an example: Whereas in the spring it was still said that the Ludwigshafen plant would have to be closed if capacity utilization fell below 50 %, it is now said that solid profitability already begins at 50 %. This may be at the level of the contribution margin and by focusing on higher-value products, but it is a far cry from the doomsday scenarios in the spring.

No place to hide on the financial markets

In 2022, there was hardly any place where you could safely hide your wealth. Government and corporate bonds, highly valued growth stocks, low-valued normal stocks: all of these were under pressure, and due to the special situation, especially in Germany. Valuations are a key driver of share price performance in the longer term and, unlike other drivers, are easier to assess. In the short term, however, deviations from expectations dominate. And this is where companies deteriorated throughout the year, so that there was a permanent reason to sell shares. With few exceptions (energy, agriculture, partly banks), companies were affected by deteriorating business prospects (rather the "value" stocks) or became victims of their high valuation, which suffered from rising interest rates. Combined portfolios with an equity/bond mix posted the worst results in the U.S. in the last 100 years, except for 1931 and 1937, which helps to put the proportions into perspective.

Cash was also not an option from the start: real losses in Germany equal to the inflation rate were inevitable, which in hindsight was still far better than what happened to owners of stocks and bonds. So all in all, it was a disaster that investors could hardly defend themselves against.

The question now is what happens next and how to assess the situation.

Buying in a recession has proven to be the best strategy

First of all, it's not during a recession that markets do poorly, but on the way there. During a recession, stocks tend to perform poorly when they were previously highly valued and well when they were not. After a recession, performance is dramatically positive. The trouble is, you don't know a recession has officially ended until months after it's over. To that extent, you have to bite the bullet and buy when the situation is uncertain but stocks are cheap. As already announced in the last quarterly report in July, a recession this winter is as good as a foregone conclusion. That is also the consensus now. To that extent, there is widespread clarity in this regard. The open questions are: How long will the recession last, and how will interest rates and inflation develop? Without having a pronounced opinion on this, it is obvious that the markets are now expecting aggressive action by the central banks, which is therefore also likely to be priced in. As it looks, the cycle of interest rate hikes may already be over by the end of the year. It should also be noted that rising prices, especially in Europe and Germany, will have a significant restrictive impact, which will complement the effect of the rate hikes. In that respect, this doesn't just look like a full stop, it is one.

What is crucial for the further development is how inflation rates develop in this environment, and there is not only bad news here. Various commodity prices have been falling for months, reflecting weaker demand. The enormously high inflation rates, which are currently even more prevalent in Europe than in North America, are mainly due to the distortions on the procurement side. This will probably return to normal to a large extent in the coming quarters and years. This is not possible in the very short term, and no restrictive central bank will help. How strong second-round effects will be remains to be seen. Initial wage settlements in Germany look reasonable in view of the parameters.

Even though the upcoming recession, especially in Germany, could be more severe than is usually the case, it has the advantage that it has been expected for months and will therefore not be a surprise to be prepared for. Anyone who hasn't factored that in now is probably in the wrong place.

What is more difficult than in previous recessions is the lack of clarity about the availability of, for example, various preliminary and intermediate products. Not everything looks solved, but the situation seems far better than was feared a few months ago under the current conditions. The quantities are one thing, the other is the prices, which seems to be of only marginal interest to green politicians in particular, as became apparent in the nuclear energy debate. To put the dimensions into perspective:

Gas prices are important, but not alone decisive for the German economic model

The increased gas prices have the effect of a massive tax increase, unfortunately by foreign countries, and this time also as a tax per capita rather than geared to individual performance, which primarily affects private consumers. In the corporate sector, the dislocation varies depending on whether companies need a large or small amount of gas, have hedged their procurement costs or not, need gas for higher- or lower-value products, suppliers can continue to produce, or production can be moved to countries where much lower gas prices must be paid. According to estimates by the Ministry of Economy, the costs are €60 billion in 2022 and €100 billion in 2023, equivalent to just under 2 - 3 % of Germany's national income. By way of comparison, the EEG surcharge to finance green electricity has been between €10 and €16 billion p.a. since 2010, while the gas bill has been around €20 to €30 billion in recent years. How high the actual burden will be remains to be seen. When the new sources of supply have settled down, the annual additional burden is likely to be around €30 - 40 billion, i.e. 1 % of national income. This is really not the end of the world and usually corresponds to the productivity growth of a single year. To attribute the success of German companies to low energy prices is ridiculous. Perhaps the state will also manage to reduce the excessive bureaucracy. This could be made easier by the fact that it is visibly suffering from it itself. Then a positive result could still emerge from this and overcompensate for the higher gas bill.

The government will shoulder most of the additional burden and stretch it out over time

Two factors are uncertain:

One is the question of who will pay for all this and when the bill will come due. With the "double whammy" of up to €200 billion, or 5 % of national income, the government has decided firstly to socialize a large part of the additional burden and secondly to stretch it out over time. This means that, correctly calculated, new German debt will be roughly on a par with the usual French level, outside times of crisis, mind you. In this respect, there is no reason to get upset if one follows the usual European line of reasoning. This will considerably mitigate the expected recession, even if the distribution effect is not certain because the measures have not yet been fixed. However, the basic principle should be obvious to everyone, even if the clamor is still great due to the lack of specification. With the rising national debt thanks to the once again adopted extraordinary budget, the demand shortfall will be at least partially offset, and in purely arithmetical terms even to a large extent. The bill that is paid to Norway and other states is thus paid by the German state. For the recipient states, on the other hand, the bill looks the other way round, of course, minus the additional logistics costs compared with the earlier Russian delivery. In sum, the recession could thus be less severe than has recently been feared in some quarters.

What is also uncertain, but relevant, are the indirect effects of skyrocketing gas prices. On the one hand, there is a shortage of products that are gas-based but have low value added, from carbon dioxide for the beverage industry to fertilizers. In addition, and probably more important, are the distributional effects of distorted prices. Known and discussed everywhere are the windfall profits of power producers who benefit from the high electricity prices driven by gas. Depending on how these are handled, they will also be in the tens of billions of dollars. Regardless of where you stand on this, it leads to further increased uncertainty. On the other hand, much of this money will remain in the domestic market. This problem is also temporary. However, it will not be solved by building a lot of renewable energies, which in boundless naiveté is supposed to be the solution, but by procuring the raw materials for the controllable energies from other sources. But here we can be sure that this will happen. Even if it is not always the most tepid who understand the most, if you follow the debate about the merit order principle.

In relation to nominal national income, the additional debt is less significant

A few more figures to classify the costs of the "double whammy" and the distributional effect that the current environment has. Anyone who is now frightened by the sum of up to €200 billion should bear in mind that it is probably not the general public that will bear this damage. Assuming that Germany grows little in real terms in 2022 but will have inflation of an estimated 8 %, this will lead to an increase in nominal national income of almost €300 billion. Thus, this alone will hardly increase the debt ratio, especially if a good part of the government support falls into 2023. If we then take into account the fact that government revenues will benefit significantly from inflation, it is not impossible that the government could mathematically be on the winning side despite rising spending.

Economically, the bill will ultimately be paid by nominal savers

So who pays the whole thing? The nominal saver. And in a breathtaking order of magnitude: If the real (gross) redistribution in the last years with negative interest rates and a manageable inflation was approx. €50 - 100 billion p.a., it is 2022 rather €400 (!) billion. Who may not believe this: Here comes the calculation. German financial assets, largely fixed-interest, amount to more than €5 trillion, and with interest rates of 0 % and inflation of 8 %, this results in the above-mentioned loss of real value. And this does not even include the price losses of bonds! Whoever believes that nominal interest rates of now 2 % for ten-year bonds are attractive should think about it again and not completely ignore the expected inflation rates. Or he doesn't care what investors get in real terms. At least, one can see here at first glance what is commonly understood by "financial repression": The sometimes slower, sometimes faster expropriation of savers by government action, starting with interest rate manipulation by central banks. In recent years, this has given states the opportunity to largely avoid unpleasant reforms, but instead to heartily expand bureaucracy and the welfare state. The appreciation for the latter has been limited, as can be seen in the media on a daily basis. And there may always be more: In Hesse, the number of teachers has risen by 50 % in the last 50 years, while the number of schoolchildren has fallen by 25 %. Even here possibly not apples with apples compared: One might conclude that this is a substantial improvement. Instead, there are complaints of a massive teacher shortage and warnings of the collapse of the school system. By contrast, no one has audibly warned of an expropriation of savers. This is hereby done for the readers of this report.

Last but not least, another possibility should not go unmentioned: Inflation will collapse and fall back to a level below 2 %. And even that is not completely out of the question, although probably not next year, as second- and third-round effects will still be driving prices then. And then the central bank will simply continue repression at lower levels.

Shares are real assets whose prices are temporarily depressed by the underlying conditions

This is also where it gets exciting for stocks. At the moment, the market is busy guessing and pricing in the difficulties of the next few months. This is nothing new: looking at the situation six months from now is the core competence of the stock market, seriously and without blinking an eye. It is obvious that the earnings estimates currently circulating are too high. Analysts are guided by the forecasts of companies, and these in turn have to comply with various formalities in order to adjust their official expectations, to put it simply, and this takes time. One could now say why it is not possible to anticipate this. Answer: The stock market takes care of that all by itself; the analysts' estimates merely follow reality here. That's no big deal, because analysts have much more relevant functions than publishing the ever-correct earnings estimate.

As economic expectations fell, so did share prices

As economic expectations fell and interest rates rose, stock prices fell. Unsurprising as far as that goes. On the other hand, however, the vast majority of companies have managed to pass on a large part of the cost increases to their customers. In a recession, this may be temporarily different. Nevertheless, when the general conditions stabilize, equities, as opposed to nominal investments, will have been able to compensate for inflation much better than bonds or savings deposits, which, as I said, is already becoming apparent today. So how is it that stocks are falling? Precisely because of the focus on the next six months, the short-term news situation and, perhaps strongest of all effects, the liquidity needs of many market participants. Thus, one has the chance to use one's much more devalued liquidity to buy stocks whose value, in most cases, may have fallen little in real terms and certainly not at all in nominal terms in the long run, but which have nevertheless become much cheaper. Looks like a good deal.

... and are trading today in many cases at record low valuations

German stocks today are in many cases trading at the lowest valuation levels of the last decades, measured by substance rather than volatile earnings. In this respect, the opportunity for a solvent and medium-term oriented investor is clear. What is unfortunately completely unclear is: How solvent are other market participants? If you have to liquidate, you sell, regardless of the valuation. What has happened in the bond market in recent months is of epochal proportions. The realization that most of the gains in the bond market over the last ten years were borrowed only in the form of temporary price gains and are now vanishing into thin air is difficult to assess in terms of its significance for the solvency of many investors. With many investors unable to withstand the volatility of equities for regulatory or other reasons, a valuation premium in favor of equities has built up to record levels over the past 10 to 15 years. This does not even take into account the fact that equity valuations reflect real interest rates, while bonds offer only nominal interest rates. Which, in real terms, simply vanishes into thin air.

Stocks as real assets usually suffer less than average from inflation ...

This does not mean that everything is fine on the equity side. Looking at the current performance, one can see what is deterring potential investors in the stock market. However, in the current environment, all sorts of things are being thrown into disarray. To show the potential that exists even in an inflationary environment, let's look at real estate stocks, a category we have avoided in recent years because of artificially depressed interest rates. Here, the market sees three problems at the moment: Rising interest rates are reducing the present value of future earnings, while at the same time making it more expensive to finance debt. This means, c. p., that the earnings value of companies has fallen. This can be seen in share price losses of 50 to 80 %. In addition, there is the question of how well the tenants can bear the increased operating costs. What the market completely ignores is the fact that the net asset value has risen: building apartments has become more expensive, so the existing properties are not being displaced by cheaper new buildings. At the same time, rising wages are also increasing the nominal financial strength of tenants, which means that rents will also rise over time. In addition, bond prices have fallen significantly, which means that shareholders who would buy at today's prices have gained further value from the low-interest financing.

... and should at least compensate for the discounts when the overall environment returns to normal

As you can see, it is anything but clear what the effects of inflation and rising interest rates are in the case of real assets, and these are represented by equities. We would like to refer once again to the nominal pension obligations, some of which have collapsed, and which have often enough been valued in the perception of many market participants as if they were immediately maturing financial liabilities. On balance, we believe that the shares of many companies should have held their REAL value despite the current turmoil, even if the next six to twelve months may not be particularly pleasant. Even temporary declines in earnings have little impact on sustainable value. High inflation rates will be, or already have been, passed on to customers over time; otherwise we would not have inflation. The exceptions will be those stocks that were previously trading at inflated valuations. The owners of nominal values will pay for this - and complain later that certain people are getting richer and others are stuck.

Summarizing the overall situation, we see the following picture:

- Interest rates and inflation rates have risen significantly and, with a view to falling commodity prices, will probably soon be close to their highs.

- Central banks, faced with the social implications of higher inflation rates, have reversed their direction almost in a panic and will raise interest rates very quickly, perhaps even overshooting them given the causes of inflation.

- Thanks to falling prices, valuations of many stocks are hovering at decade lows. Sentiment is poor, investor positioning is very defensive, and hedges are very high.

- In the coming months, the news will not be good. However, further price declines would require undercutting current fears. Adjustments of earnings expectations do not fall into this category: Nobody really takes today's earnings estimates seriously.

- With a not exaggerated investment horizon of one year, one should imagine what the situation may realistically look like in one year's time. Assuming the worst case is not constructive.

- However, one should keep an eye on the distortions in the bond markets, which are dominant in terms of magnitude, such as the pressure on the liquidity of relevant players, and as an investor always remain the master of one's decisions.

The war in Ukraine will drag on, but will not be relevant in the medium term as long as Russia does not ultimately escalate. The gas shortage will gradually clear up over the next few years, and the path is increasingly clear today. Again, the bigger problem may be the interest rate markets. Here, many market participants have lived for the last ten or more years on the illusion that their profits were being earned on an ongoing basis, while an increasingly large part of the return was attributable to price gains thanks to central bank purchases. Now, in just a few months, the profits of five to ten years have vanished into thin air, in contrast to companies whose real substance has risen constantly. In this respect, the question of solvency arises for many market participants, exacerbated only by derivatives that were supposed to be used to manage earnings and are suddenly no longer liquid.

Very briefly, the very large opportunities at present are matched by very large uncertainties, and vice versa. Otherwise, valuations would not be where they are. The best advice we can give is to keep a cool head and take a rational approach, to see opportunities and not just risks, and at the same time to bear in mind that not all market participants can do the same.

Sincerely yours,

Ihr Martin Wirth

FPM-Comment Reducing the Noise by Martin Wirth: 3/2022 dated July 15th 2022

Be greedy when others are fearful*

*Warren Buffett

•    A recession is hardly avoidable, but has always been a good time for investments
•    Energy supply is a more serious concern than inflation and recession
•    The "era change" will allow many weaknesses to be overcome
•    At the current valuation level, opportunities clearly outweigh risks in the medium term

First half of the year turned out to be very unpleasant on the financial market

The first half of the year was extremely unpleasant on the international financial markets, downright disastrous for many market participants. June saw a selloff that pushed most markets into bear market territory. The combination of negative influencing factors then proved too much.

• The distribution of helicopter money, which was generously submerged almost everywhere during the Covid crisis, has largely ended.
• The disruptions caused by the Covid crisis, on the other hand, have not yet come to an end. China, in particular, excelled with senseless measures that caused shortages all over the world.
• Increased commodity prices, combined with underinvestment in recent years, drove up general prices worldwide, so that central banks were finally forced to face reality and, unfortunately, began raising interest rates into an economic slowdown.
• The pinnacle of stresses, however, in every respect, was Russia's invasion of Ukraine, which as we know is not only a human tragedy, but has and will continue to have multiple political, military, and economic implications.

In July, it immediately continued this way: Now, there is a threat of a supply shortfall of Russian gas to Europe, which, thanks to the naive policies of the last decades, would affect Germany more than most other countries.

A recession is hardly avoidable, but has always been a good time for investments

The ECB continues to expect the EU economy to grow, both this year and next. We like to be optimistic once in a while, but here we lack the imagination of how this will be achieved in view of the multiple distortions so far and in the coming months.

That's the bad news. The good news might be that recessions have always been a good time to buy stocks. The second piece of good news for investors in the real economy is that this recession will not be a nominal recession, thanks to substantially rising prices. This can already be seen in the performance of many companies, which are generating rising sales and in some cases very solid profits thanks to sharply rising prices, even outside the basic industries. It's almost funny again when it is then said that the recession is not yet visible.

The market has more or less priced in the recession. Despite lower valuations, the European markets have dropped just as much as the U.S. markets. The cause, of course, is perceived weakness in the political, military and energy sectors, which has also further depressed the euro. Fears about gas supply, especially in Germany, have become visible in recent weeks with a massive selloff in cyclical stocks. Some strategists believe that valuations are not in line with what is usual in recessions: this is primarily true at the index level, where quality stocks, which have been extremely popular in recent years, continue to have a high weighting at a high valuation. For "normal" stocks, the world looks quite different.

Energy supply is a more serious concern than inflation and recession

Where do we stand? If history is relevant, way down in many areas. As we all know, uncertainty is something that is not valued at all in the stock market, and after Covid, we are once again in "unchartered territories" here. It is not economic weakness and inflation, but energy supply that is driving investors into a state of capitulation. Whereby the first two aspects are unpleasant enough.

As for inflation, it can be noted that it is primarily driven by supply-side shortages, still pandemic-related, but now also by the Ukraine war. If these effects are factored out, core inflation excluding energy and food would still be a high, but not so absurd – 3 to 4 % instead of the overall figure of about 8 %. Here, too, effects from the Covid pandemic upheavals are probably still visible: logistics costs, confusion at airports, for example, missing personnel who are now employed elsewhere, etc. For a few weeks now, however, longer-term inflation expectations have been on a clearly declining path again, so that even the interest rate hikes by the central banks should presumably not lead to the recently feared heights. Falling share prices, uncertainties due to the geopolitical situation and collapsing consumer confidence are also having a restrictive impact on the economy and the price level, and in this respect the central banks are being relieved of some of their work.

Many stocks are trading at record low valuations...

Where do we stand at the individual share price level? A few examples, without these being buy recommendations. BASF is valued below book value. This has not happened in any crisis in the last 20 years. Normally, the valuation is between 1.5 and 3 times equity. Covestro's valuation is also below book value, in terms of corporate value including debt at a record low. Since going public, the company has halved its debt, doubled its equity, achieved returns on equity of between 10 % and 30 %, and is regularly growing in the region of 5 % p.a. Both companies have a global production network, e.g. only 25 % of Covestro's plants are located in Germany.  The remaining 75 % are located in countries that do not have a gas supply problem. In the case of BASF, investors have agreed that Wintershall has a value of zero, although a relevant part of production takes place outside Russia, business continues in Russia, and a theoretically conceivable expropriation of assets there will presumably be compensated in some way. And yes, BASF would suffer greatly from supply shortfalls of gas, but that is not a permanent problem and only affects the smaller part of the group. As I said, the uncertainty, which is hard to bear on the stock markets, means that investors prefer to assume the worst-case scenario and then put a tick on the issue.

... and increasingly use this to buy back shares

Another example is the increase in companies engaging in share buybacks, including some companies that for years adhered to the credo that share buybacks fell into the category of corporate failure. A view we do not share in any way, of course, and one that is completely illogical. However, it does show the aversion of companies to providing capital to the owners in a way other than dividends: Dividends are more likely to build a reputation. In addition, it does not carry any (rather formally relevant) price risks if the shares fall to a lower level after a buyback. For example, BMW or HeidelbergCement are worth mentioning here. There are obviously valuation levels at which things are looked at anew.

Now we could write about 30 to 100 other companies with a similar tenor. The essential thing is: many shares are now valued at a discount to fair value of between 30 % and 60 %. If I want that discount, I have to buy at those prices. Whether they will get any cheaper: No one can say. But what we can say is this: Most people just don't buy when stocks are cheap, but when they feel good about it. The stupid thing about this strategy is that it can inevitably lead to no more than average results, if at all.

The justifications for the low prices are partly contradictory or often enough detached from the facts

There are many absurd comments that are due to the uncertainty in the markets. As for inflation: it is expected to remain high for years to come. Supply-induced price increases are now to be followed by a wage-price spiral to compensate for the increased cost of living. At the same time, due to the expectation of falling prices for companies, which are profiting particularly from the increased prices, profits are expected to fall significantly in the next few years. So the instantaneous profits are seen as unsustainable. That can happen. But if wages rise but prices don't, purchasing power would increase significantly. Which would mean something quite different for the economy than the lean years now supposedly ahead, in which consumption suffers from high rates of price increases because consumers cannot compensate for inflation rates. In the end, this says more about sentiment (everything is bad, and once it isn't, it gets bad, even if the assumptions were to be self-contradictory) than about reality. For once, we're not committing to much there, except to take advantage of the opportunities that arise from these contradictions. Because in the end, the contradictions are simply taken as given or blamed without reflection if one does not dare to take advantage of low valuations for shares.

I would also like to comment on a fairy tale that is making the rounds: Germany owes its prosperity only to external factors, and the preconditions for this have now disappeared. Prosperity is in great danger. Cheap energy from Russia, exports to China and security from the USA: Everybody is repeating after everybody else. Gas from Russia cost a few billion € less than gas from other countries, this difference was not the decisive factor for the German economic system, even if it was of some additional benefit. For a country that can spend €1 billion per month on allegedly medically questionable Covid tests, not quite a big deal. Either way, the price of gas will be a very different burden in the coming quarters. But that has to do with the Ukraine war and not with the German economic model, which is then no longer supposed to work. And will not remain this expensive in the long term. The price disadvantage of gas from other countries compared to Russia is well below 1 % of GNP – once you have the infrastructure to deliver it. China is indeed a huge sales market, and that for the entire world. But that German companies would have been naive and better off staying at home from today's perspective is nonsense of the first degree. Companies are now so big in China that they can finance even massive investments in the Chinese market internally, either from their own profits or with financing from Chinese investors. The alleged deglobalization is also due to the fact that companies are now becoming more local: For example, German automakers are setting up more and more production facilities in China, including a local supply industry (again, often the usual German companies), which lowers costs, the risk of trade wars, of tariffs, or rising logistics costs. Is this de-globalization? Moreover, if a growing part of value creation takes place in other countries, the consequence is that foreign markets become more and more important for companies, but the opposite is true for the German domestic economy. In this respect, it is becoming less and less possible to draw conclusions about German companies from the German economy. See Covestro: one quarter of capacity in Germany, largest site Shanghai. Since this causes additional work for the top-down strategist, this view is also gladly avoided once in a while, otherwise the statements would perhaps also no longer be so snappy. But perhaps closer to reality. And to the last argument, that security was outsourced to the US: While this is true, it was not due to the German defense budget, which is one of the highest in the world, but due to a completely neglected political leadership (and this does not even concern the Ministry of Defense in the first place) as well as administrative structures that obviously far exceed the usual shortcomings in Germany. If the Bundeswehr is to be strengthened, political leadership and the willingness to do so are ultimately more decisive for success than transferring more money. In this respect, one should not be fooled by commentators with strong attitudes and little interest in facts, who often come from the political camp that considers government action to be more promising than what companies deliver. All in all, the defeatism of such statements is completely unproductive, especially if these statements should be the basic assumption when investing.

The "turn of the times" will allow many weaknesses to be overcome

None of this is intended to trivialize the current situation. It is not only a recession that is imminent, it is also the frequently mentioned turning point in time. How things will develop in the next few years is an open question. With the exception of an expanding war, from which Russia would certainly not expect anything positive and which is therefore very unlikely, there are also substantial opportunities. Many things that have been dragging on for years, obstructed by laws and authorities, blocked with masses of court cases, can be handled quite differently under the current pressure. Thus, many measures required for the energy turnaround can now be implemented. The weaknesses of the German authorities were already evident during the Covid pandemic. With the hopefully corresponding pressure for change. In addition, as mentioned, the Bundeswehr, structures in the EU and a more active foreign policy that does not just leave the stage to autocrats.

The question of gas supply is serious, but not hopeless

How the question of gas supply will be solved is open. Many paths can be taken. What is clear is that there would be a gap in the next few quarters if Russia stops supplying gas. However, depending on countermeasures, this gap is likely to be somewhere in the range of 5 to 20 % of gas demand. One should not be misled by Russia's 50 % share of total German gas purchases, even though the presumably much lower figure would still be unpleasant. From the point of view of a company's shareholder, the decisive question would first be how companies would be affected by this mixed situation. And here, as things stand today, the answer is clear: Under normal circumstances, production losses resulting from the gas shortage would be far from a loss, but would reduce profits to a varying extent. And to the extent of perhaps 20 to 40 % in the case of the chemical industry, roughly speaking, although individual companies might be more severely affected. And without the assumption of passing on the higher prices to customers, which might not be entirely realistic either. It could be, of course, that gas will continue to be supplied as normal: Russia used to receive about €10 billion p.a. from Germany for gas deliveries; today, at current forward prices, it's more like €30 billion to €40 billion. So for trying to pressure the Europeans, Russia would be giving up €100 billion in the case of Germany over the next few years, plus another €100 to €200 billion from other EU states: That could be the price Russia stakes in the hope of getting rid of Western sanctions. War-decisive, on the other hand, rather not. In addition, Russia would then have less money to compensate, for example, the victims of Western sanctions. Plus possible damage payments, plus the technical difficulties to resume gas production in the future: This does not suggest that it is imperative for Russia to stop deliveries. One will see.

Stability and security have built up enormous premiums again

Current events on the capital market show a reversal of the price movements since the beginning of the year. In recent weeks, commodity prices, cyclical stocks and interest rates have fallen, while the old favorites, especially quality stocks, have risen. Safety is paramount. We believe that, as far as equities are concerned, this is a move against the trend. Valuation discrepancies have widened again. These discrepancies are simply too large in the long run. Contributing to this movement has probably been the realization that a recession in the next few quarters is more likely than no recession. However, the unwinding of some aggressive speculative positions also appears to be playing a role. For example, the fact that wheat prices have now fallen back below pre-Ukraine war levels in the face of expected food shortages in the next few quarters is otherwise hard to explain. The same applies to other commodities. Here, too, we will see which interpretation was the correct one. In the first place, we see the closing of the "inflation-scarcity positions" and the switch to the familiar "quality-stability positions" in the face of the looming recession, regardless of any valuation benchmarks.

At current valuation levels, the opportunities clearly outweigh the downside in the medium term ...

On the other hand, due to the massive valuation discrepancies, we continue to stick to the strategy of investing in low-valued companies with a clearly identifiable risk profile, most of whose valuations are at a lower level than they have been for many years. And not just measured in terms of possibly fluctuating earnings, but in terms of sustainable substance. There are some new opportunities here. In this situation, one can always remain flexible and, when they arise, take advantage of even greater opportunities that may arise over time. We don't think the full impact of interest rate hikes on the darlings of recent years will be visible; valuations simply don't allow for that.

... which can be most easily exploited by remaining invested even at the low point

We believe that it is clearly too late to focus on risk reduction per se in one's risk management now: That would have been something for the time when there was no alternative to equities. Today, we are obviously closer to the bottom than to the top. And trying to hit the bottom exactly by increasing an investment level from 0 to 100 %: We checked off that naive notion a long time ago. And the effect of lowering the cash ratio from 5 % to 4 % near the low, wherever that may be: you'll have to look for that with a magnifying glass. For more, however, the desperate search for the low is usually not enough. So we'll just leave it at that and be happy about the cheap stocks in our portfolios.

Sincerely yours,

Martin Wirth