Dear Partners,
During 2021, Delphi Global generated a net return of 18.07%. This is a respectable annual return without exceptional volatility, with positive returns recorded in 10 out of 12 months. On the surface, the year seemed to progress smoothly. In reality, the opposite is true. It was a year full of events with many economic implications. We want to emphasize that the events described in this review do not materially affect the companies in which we invest, neither their profitability nor their long-term growth potential. However, these events are very important when choosing our investments. As we will describe throughout the review, we aim to invest in companies that are less exposed to external influences such as the coronavirus, oil prices, or interest rates.
These companies, together with unsatisfactory business performance, helped us avoid investments of this type.
The China Casino – Not Just Macau
It is common to think of investing as giving up money now in order to receive more money in the future. For example, when betting on ‘red’ in a casino, you give up money now in the hope of doubling it soon. However, this cannot be considered investing, certainly not wise investing. The certainty of receiving the future payment is not high, especially if we need to play the game more than once. The more we play, the lower the probability of receiving the future return becomes, and the higher the chance of losing all our money. Therefore, investing, unlike gambling, is an action that guarantees as high a level of certainty as possible regarding future returns.
Regarding China, which we have covered in previous updates, we will mention briefly here: a country where CEOs, Olympic tennis players, and others can simply disappear one day, where a company can be suddenly prohibited from making profits, or where the rules of the game can change completely without prior warning. In such a country, it is impossible to say there is sufficient certainty about future returns. Risks sometimes materialize and sometimes wait to do so in the future. We prefer to avoid this type of uncertainty as much as possible, and therefore our portfolio is concentrated in countries with relatively clear rule of law and regulation. It is true that stock prices in China are currently lower than in the past, but due to frequent changes affecting companies and business sectors there, we believe it is impossible to achieve a sufficient level of certainty about future profitability for many companies, and therefore we avoid investing in China out of conservatism.
Still Covid
Another major risk the global economy faced in 2021 and will continue to face in 2022 is the coronavirus. Since we have no way of knowing with sufficient certainty how this reality will develop and what responses governments around the world will take, the principle of certainty requires that we invest in companies that can continue to make money and even grow, whether the spread of the pandemic stops, accelerates, or remains in a kind of long-term status quo.
To illustrate, the following chart published by the Financial Times shows how much the conference and exhibition industry was harmed last year. The presence of the virus definitely affects the business reality worldwide and still poses a material risk to fields such as this.
Risks That Did Not Materialize
The two sectors with the best stock price performance in 2021 within the U.S. S&P 500 index were real estate and energy. Both sectors are very sensitive to any scenario of worsening the pandemic or measures taken against it. We do not need to look far back to understand how vulnerable they are; just one year back to 2020 is enough to understand the size of the risk. Our assessment was that the stock prices did not sufficiently reflect this risk, so we avoided investing in these sectors.
Looking Ahead to 2022
One of the notable economic effects of the coronavirus crisis is inflation, mainly due to logistical challenges stemming from increased deliveries (compared to physical purchases) and work stoppages in factories or ports following local outbreaks. Another phenomenon contributing to inflation is reduced investments in carbon-based energy sources, due to reliance on green energy sources that did not meet expectations because of climate conditions that damaged electricity output from green sources. Regarding the companies in which we invest, we have not identified any significant effect on their business, profitability, or growth in this context.
Generally, we prefer to avoid investing in companies that are particularly sensitive to sharp changes in energy prices or inflation rates.
Another topic to watch closely is the U.S. central bank’s policy, which has been very accommodative since the beginning of the coronavirus crisis. Alongside implementing near-zero interest rates, the central bank purchased large amounts of bonds in the market, supporting asset prices and easing companies’ fundraising. We have written extensively in the past that despite the effectiveness of these measures in preventing a severe economic crisis, they also create distortions in asset pricing, allowing low-profitability companies to continue operating with cheap loans.
In 2022, this situation is expected to change. In the coming months, the central bank is expected to gradually reduce the amount of bonds it purchases, up to a complete halt. After the purchase stop, interest rates are expected to rise and possibly the bank will sell some of the assets it bought since the start of the crisis. This reality will make it harder for companies relying on debt to finance their operations and is expected to affect stock prices of companies with excessively high valuations.
In summary, most of our investments are concentrated in profitable companies with reasonable growth rates and no debt, so we estimate that these companies will be able to cope with rising interest rates and an inflationary economic environment. That said, such events may create volatility in financial asset prices. If we witness some correction in stock prices of companies meeting our criteria, we hope to take advantage of it by investing at more attractive prices.
On a personal note, we look forward to seeing you in personal meetings and hope for a fruitful and successful investment year.