It is an unfortunate, yet widely accepted maxim that good news doesn't sell newspapers. However, as we reflect on the end of another twelve months that leaves us wanting to see the word "unprecedented" banned from the dictionary, we find ourselves feeling optimistic. Household and corporate balance sheets are in great shape, helped along by international border closures. Australians spend $65b a year overseas, and that money is now trapped in our local economy. While we lose out on the $45b we typically bring in from tourists annually, these imported tourist dollars tend to find their way only into very targeted parts of the economy; such as, the travel, tourism, and hotel sectors. By contrast, trapped locals are spending widely across the economy and saving too: we're seeing it in record deposit levels for the banks, in booming retail spend, rebounding new car sales and record used car prices. It's becoming clear that international borders are likely to remain shut for a while yet, so we expect this strength to continue.

The economic backdrop is further supported by rising house and record iron ore prices. Put simply, the Australian economy is in the best shape it's been in years. Further, we've managed the pandemic better than other countries, yet the performance of our stock market has lagged, only recently exceeding pre-pandemic highs. As per below, in October our market was one of the worst-performing major markets, despite our economy being one of the most resilient in the world. We made the case six months ago that the Australian market looked like good value in a relative sense, and the subsequent 10% rally likely reflects that.

Source: MST Marquee

Risks to the outlook

1. Inflation

So where to now? The first potential fly in the ointment is always interest rates, given the price of money sets the price of every asset class globally. The main debate raging in markets right now is about inflation. With inflation numbers rebounding off last year's global economic decimation, the debate is over whether it is likely to be transitory (a one-off bump as supply chains normalise post-Covid) or structural (a multi-year demand unleashed and things get out of hand). We are certain that we will see an uptick in the near term in inflation; most of the companies we talk to are calling out pretty significant raw material and labour market inflation, and a desire to pass this through in terms of price increases. So it is definitely underway.

As for what happens after that - exact corollaries in history are impossible to find, but we see two possible precedents:

Is it an echo of the December quarter 2018, when the Fed was raising rates in response to a dramatic uptick in global input costs and associated inflation, only to reverse course (within a few months) as inflation faded due to the immediate demand destruction response? i.e. a short-lived blip?

OR

Is it an echo of the 1970s, when raw material spikes fed into a wage-price spiral that got out of hand for a decade?

Obviously if it is more like the latter scenario, every asset globally is overvalued. However, a few things lead us away from thinking scenario two is likely. Firstly, the 1970s was an era with a lot of directly inflation-indexed wages, which added to the feedback loops that saw raw materials spikes driving a wages/prices spiral. Secondly, debt is a very deflationary force, and the world has a lot more debt now than the 1970s. The increase in global debt levels increases the sensitivity of debt-holders (which include most homeowners) to increases in interest rates. So you get a demand response very quickly when you increase rates, which is what we saw in 2018.

In Australia, we see monetary policy settings stuck in emergency mode, when there is no (economic) emergency. Anyone who's attended an auction recently can tell you interest rates are too low. This will need to be addressed over the next few years; however, in our view, one or two rate rises would likely dampen demand enough to have the desired effect. We do not think we'll see cash rates heading back towards 3% (which would be very bad for equity markets).

So we lean towards thinking structural inflation is a tail risk for portfolios, rather than a base case. In all fairness, this has been the "consensus" view for the last six months, but we note a subtle shift is taking place, with more and more voices leaning towards scenario two. So we think the market is beginning to worry about a more extreme inflationary scenario, which could throw up opportunities.

2. China

The other tail-risk for markets is the worsening diplomatic relationship between Australia and China. We've avoided exposure to companies that generate the bulk of their revenue in the Chinese market. Where we remain vulnerable in our portfolio is through our position in resource companies such as BHP and Mineral Resources. We can't rule out trade disputes spilling into iron ore, however unlikely; mining participants warn us they believe China is willing to "shoot itself in the foot to hurt Australia". In order to mitigate this risk, we invest only in mining companies with diversified earnings (not solely iron ore), and rock solid balance sheets: Mineral Resources is net cash, and BHP should end this year with net debt of only 0.2x EBITDA.

Hitting the road: observations from our travels

We have availed ourselves of reopened state borders to get back out on the road again this year, with trips to Brisbane, the Gold Coast, Melbourne and WA. These trips left us feeling enthused about the high-end, quality operations and the level of innovation being undertaken across the country. In April we travelled to Ormeau, Gold Coast to meet with Kees Weel, CEO and founder of our portfolio holding, PWR Holdings. PWR make radiators and cooling systems for motorsports (supplying every Formula 1 team), high-end original equipment manufacturers (e.g. Porsche, Aston Martin) and a number of exciting emerging applications such as electric vehicles and defence. We were blown away by the level of technical expertise and innovation in walking the factory floor, and it's always good to be hosted by a CEO who greets everyone in the factory by name. This is a true Australian success story; PWR's radiators are regarded as some of the best in the world, and PWR enjoys very healthy economics as a result (c30% EBIT margins, >40% return on invested capital).

In June we travelled to WA and met with a few mining companies. We were left feeling that the shift to a global clean energy system should create fantastic opportunities for Australia, which is rich in many of the mineral resources that are needed to facilitate this shift over the next 20 years. Further, geopolitical tensions could play in Australia's favour, with the desire for countries and OEMs to construct ex-China battery supply chains providing an opportunity for Australia to exploit its position as a low-cost supplier of critical battery materials such as lithium and nickel.

One particularly exciting opportunity is in lithium. In order to meet our Paris Agreement targets, the IEA estimates the world will require over 40x more lithium than was used in 2020, driven by a 25x increase in EV sales.

Source: IEA

Unlike other battery metals, whose demand profiles are greatly influenced by the way battery technology develops over the next few decades, lithium demand is relatively immune to the way battery chemistry ends up going.

On the supply side, the industry has just gone through its first proper boom/bust cycle. With lithium prices more than halving from their 2017 peak, many new projects were scrapped and mines put on care and maintenance. Now, with demand picking up, the industry looks set for a supply deficit emerging as early as next year. As such, we would expect further price rises.

Source: Credit Suisse

This is good news for two portfolio holdings: Mineral Resources, which operates Mt Marion and (currently mothballed) Wodgina mines, and Wesfarmers, which recently acquired Kidman Resources and is developing a lithium hydroxide plant in Kwinana, WA. For Mineral Resources, we think their lithium business has the potential to be worth >$3b, well in excess of the current c$1.2b we believe the market is valuing it at today, or $10 a share on today's $50-odd share price.

Overall, we feel the future is bright for a number of Aussie industries and businesses, and we remain happy co-investors along the way.

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Within the last 12 months the market narrative has switched from fears of deflation to concerns of inflation.

This narrative is often coupled with the forecast that "value" is likely to outperform "growth". In this article, I discuss why, rather than focusing on economic predictions, or market themes such as value or growth, we prefer to focus our efforts on a concentrated portfolio of 10-15 high quality companies whose earnings are likely to be materially higher in 5-10 years and whose current price should allow the fund to meet its long-term return objectives of returning 8-12 per cent per annum (p.a) ― regardless of what economic outcome prevails.

Let's start with the inflation/deflation question.

Those arguing that inflation is on the way like to point to the following factors - a rapidly growing money supply, artificially low interest rates, growing budget deficits, wage pressures and rising commodity prices. It makes for a pretty convincing argument.

However, when I talk to the deflationists, they like to point to ageing demographics, record debt levels and the ever-present deflationary forces coming from technology. They also note that after the global financial crisis (GFC) the same narrative that quantitative easing (QE) and high commodity prices would lead to inflation, has so far been wrong.

Those arguing for inflation will point to the Austrian economists and the experience of the 1970s, while the deflationists will point to Japan and more recently the period following the GFC.

To be honest, I find both camps make reasonable arguments. This is why, when asked by clients, my answer is quite simply "I don't know". Experience over many years has taught me that things the "experts" tell us are "obvious", often don't come to pass.

Below I list some "obvious" events that never came to be.

One. In the late 1980s it was "obvious" Japan would come to dominate the global economy, just before they entered a 30-year period of relative economic decline.

Two. The stock market crash of 1987 that would usher in what some people thought was a new "Great Depression". In reality, share indices were up in that year and the economy did not experience a recession for another three years.

Three. The GFC that would lead to a new "Great Depression" and a lost decade. In reality, the US achieved record low unemployment of 3.5 per cent in 2019 and the stock market is up over six times from its 2008 lows.

Four. The exit of Greece from the Eurozone and the impending collapse of the Euro in 2012.

Five. The collapse in oil prices by over 60 per cent in 2014, when "experts", including the Federal Reserve, said oil would remain above $100 per barrel indefinitely.

Six. Less than one third of the "expert" pollsters actually predicted Brexit.

Seven. Only two major polls predicted that Trump would win the US Presidential Election in 2016 and ― even if you got that forecast right ― who then predicted that the market would rise by 14 per cent p.a. during his Presidency? As an aside, I also remember the narrative ― very similar to now ― that Trump would spend large amounts on infrastructure and reduce the market dominance enjoyed by the large technology companies. This actually provided a very nice buying opportunity for large cap technology.

Eight. In 2008 I did not see one single economic forecast that suggested in 2021 we would have negative yielding bonds, double-digit budget deficits and people talking about modern monetary theory (MMT).

Nine. The "experts" at the Treasury who forecast that COVID-19 would see the Australian economy shrink by 20 per cent, only to see output at a new record high in Q1.

The legendary Ben Graham was not one for economic or market forecasts:

"I have never specialised in economic forecasting or market forecasting either. My own business has largely been based on the principle that if you can make your results independent of any views as to the future, you are that much better off."

Like Ben Graham, our investment process is totally devoid of any economic or market forecasts. You will not see our daily investment meetings start with an analysis of the latest musings from the Federal Reserve or the latest production numbers from China. It is not to say we don't read newspapers and have our own personal views, but we deliberately exclude projections about the economy, markets, themes or sector "bets".

Focus on quality companies

We control our overall risk through the quality of our portfolio companies. Rather than forecasting economics or markets, we simply prefer to focus on earnings power, balance sheet strength and sustainable competitive advantage.

To look forward, we always start by looking backwards, and our first point-of-call is to analyse how our businesses have fared in tough times - the GFC usually provides an excellent case study. Not one of our companies got into any form of financial difficulty, was forced to cut its dividend, or raise emergency capital.

Over the last decade, the average earnings growth of the companies in the portfolio has been 12 per cent p.a. and across the portfolio, the weighted debt/EBITDA is 0.5x.

As to sustainable competitive advantage, the operating margin across our portfolio is 25 per cent ― nearly two times the average US-listed business, and the average age of companies in the portfolio is over 80 years, with the oldest dating back to 1866. This does suggest some form of sustainable competitive advantage and resilience!

As a result, this financial resilience and earnings power allows us to be confident that our companies are well placed to weather the inevitable adverse economic events when they occur. Knowing this, we are free to spend our time looking for companies with long-term sustainable competitive advantage and earnings power, rather than trying to forecast how economies and markets will affect the short-term cyclical prospects of what we own.

Growth versus value

And as for all the talk about buying traditional, beaten down "value" stocks? For argument's sake, let's assume the "experts" crystal ball is in good order ― should we switch from "growth to value"? What does this actually mean in practice?

Well, first of all, we would be forced to sell a portfolio of competitively advantaged businesses (and pay a lot of tax and brokerage) to put together a portfolio that had exposure to banks, oils and other more cyclical businesses. This collection of businesses would have lower margins, higher balance sheet leverage and reduced long-term earnings power.

An alphabetical perspective

To take it one step further, let's assume you owned all of Alphabet (the parent company of Google) - would you really be happy to sell a business currently growing revenue at over 20 per cent, with over 90 per cent market share, a rapidly growing Cloud business and net cash of $120 billion?

Would you really be happy to buy a collection of European banks, where instead of net cash, your equity is leveraged 10+ times; you have limited visibility of the loan or derivatives books and decreasing confidence in times of stress; your profits are at the whim of Central Bank interest rate policy experiments; and where capital allocation is also determined by the same regulatory authorities, bearing in mind banks were required to suspend dividend payments by the European Central Bank during the COVID-19 pandemic.

Alternatively, would you really be happy to sell your dominant search engine monopoly to buy an oil business, whose profits are determined by a volatile commodity price input ― and in the long-term may potentially become extinct owing to new technology or inadequate reserve replacement. Any rational business owner would tell you this makes no sense at all!

To put this in terms most Australians can understand - this is like selling the Vaucluse mansion with harbour views to move to a remote suburb, as it's "better value" and could have better short-term relative performance.

Carrying on with the Google example. The company listed in 2004 at $85 a share and has since delivered a return of 22 per cent p.a. Over that period the Fed has met 136 times, which provides plenty of fodder for the economic and market prognosticators. How many of those "experts" predicted the GFC, the Euro crisis, Brexit, Trump becoming US President, COVID-19, negative yielding bonds, MMT etc?

It did not require a huge leap of faith to see the Google search business was clearly superior to any alternative, with an increasing economic moat, driven by an incredible network effect, informational advantages and capital resources to hire the best talent and maintain its technological dominance.

A long-term investor (as opposed to short-term speculator) would have generated a more predictable and healthier return by just buying what was clearly a great business and doing nothing. But no Doctor ever really achieved fame and fortune by recommending two aspirin and an early night!

In summary, we believe what makes sense as a business owner, makes sense as an investor. We try not to forecast hard-to-predict events ― and even more importantly we don't sell great companies that we know intimately, to buy mediocre ones based on economic or market forecasts that are quite likely to be wrong.

As Warren Buffett so aptly puts it:

"I am a better investor because I am a businessman and a better businessman because I am an investor. Time is the friend of the great business, the enemy of the mediocre."

Apparently, Confucius didn't say "One Picture is Worth Ten Thousand Words" after all. It was an advertisement in a 1920s trade journal for the use of images in advertisements on the sides of streetcars. Even without the credibility of Confucius behind it, we think this saying has merit. Each month we share a few charts or images we consider noteworthy.

There's plenty of takeover action on the ASX at the moment as is evident from Dealogic data and Deloitte surveying. But it isn't just the listed markets - Crunchbase highlights the unprecedented pace at which VC-backed startups by other VC-backed startups. What's relatively cheap or expensive in the Internet space? Research boutique MoffettNathanson has a crack at answering. Goldman Sachs, meanwhile, upgrades its return expectations for US equities. With Sydney in lockdown for weeks now and Melbourne recently joining it, data from ANZ shows a decline in consumer transactions since May BUT data from payments company Tyro shows year-on-year growth.

ASX 200 executives expectations for the number of deals their organisation will pursue in the coming 12 months

Source: Deloitte

Australasia Targeted M&A by Quarter ($US)

Source: dealogic, WSJ

Acquisitions of VC-backed startups by other VC-backed startups

Source: Crunchbase News

Internet Sector annual forecast revenue growth relative to EV/revenue valuation

Source: FT.com, MoffettNathanson

Drivers of Goldman Sachs' return expectations for the S&P 500

Source: Goldman Sachs

Sydney weekly spending

Source: SMH, ANZ Research

Tyro's weekly transaction year-on-year growth (most recent transactions in red, prior 12 months in blue)

Source: Wilsons

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There is no doubt that the world's annual $120 trillion economy increasingly depends on just six mega-tech businesses - Facebook, Alphabet (Google), Microsoft, Amazon, Tencent and Alibaba - to function properly. You would think they would continue to all be obvious inclusions in portfolios. But investors today have a menu of reasons to avoid or even sell mega-tech investments.

After a strong 2020, many investors are worried all the "easy money has been made" - a commonly used phrase we hear in our industry (which also suffers from acute hindsight bias). They're also worried inflation will drive interest rates higher and compress the earnings multiples of higher-growth businesses. Mega-tech investments also seem boring now - a surprisingly strong criterion some investors seek to avoid. And, of course, there are the never-ending headlines pointing to regulatory pressures across the sector.

Yet our analysis shows that mega-tech stocks not only offer some of the best growth opportunities, but also offer some of the best 'value' opportunities in the market today. We see material upside in all six of these mega technology businesses. Given the combination of strong and growing advantages, enormous growth opportunities, and material undervaluation today, we believe these names should form - or continue to form - the core of any global equities portfolio.

Investors shouldn't rotate out of mega-tech to value because mega-tech are value.

At Montaka, our investment philosophy is to own long-term winning businesses operating in the world's most attractive markets, without overpaying. These mega tech businesses meet these criteria in the strongest way we've seen and they form the core of our portfolio.

 Below we look at the top 3 reasons why mega-tech stocks are some of today's best value stocks.

1.            Mega-techs have the best businesses … ever?

The first reason is that the business quality of today's mega-techs is among the highest that humans have ever created. They dominate global data, benefit from enormous ecosystems, and have superior economics and scale. The huge cash flows and profits these businesses generate can be reinvested in new business opportunities, spurring fresh rounds of growth. These mega-techs all have a vast array of high-probability growth options in enormous new TAMs (total addressable markets).

Take Facebook, for example. More than 3 billion members log in and spend significant time each month on its platforms. It is unquestionably the world's best platform for marketers to reach customers. Facebook's revenues and earnings have been largely driven by the company monetising around 10 million businesses who pay for the company's digital marketing services. But approximately 200 million businesses use Facebook today, as well as another 200 million 'creators'.

Facebook is now investing heavily in its conversion and monetisation capabilities - particularly in eCommerce and creator monetisation tools - to unlock the enormous latent revenue opportunity of these currently non-paying businesses and creators. That gives us great confidence that Facebook's future revenue and earnings power will be multiples of its current levels.

Alphabet is also leveraging its advantages in data, talent and time to become a clear global leader in artificial intelligence (AI), which will not only strengthen its existing advantages in its core advertising, cloud and productivity businesses, but will also create brand new businesses, such as Verily - which is leveraging Alphabet's data advantages to solve problems in life sciences and healthcare.

And, of course, one of the biggest areas of future mega-tech growth is the cloud. Amazon, Microsoft and Alphabet, along with Alibaba and Tencent in China, dominate the cloud. Microsoft CEO, Satya Nadella, estimates there will be approximately $8 trillion in incremental IT spend each year globally by 2030, of which cloud-based services and applications will no doubt claim the lion's share. For the leading cloud providers, their advantages in scale, data and customer captivity will only continue to strengthen over time. Said another way, this is a space for which enormous growth is largely assured and for which the winners have already been defined today. This means that the future revenues and earnings power of these businesses will also be multiple of their current levels.

2.            Inflation concerns are overdone

The second reason mega-tech provides fantastic value is that investors are too worried about inflation and what that could mean for interest rates and valuations. Over the first six months of this year, equities in the technology sector have underperformed the broader market largely because investors feared rising rates would slash tech valuations.

But those fears - and the sell-off - we believe are overdone. While we note the same strong headline inflation numbers as everyone else, we struggle to see an extended acceleration in core inflation.

For a start, over the short-term, there remains significant slack in the labor markets relative to pre-pandemic levels, which should limit the acceleration in wage growth. Secondly, our analysis of Chinese credit growth shows a clear and substantial slowing, which is a strong leading indicator for cooling global commodities demand growth over the next 6-12 months. We also expect structural disinflationary forces - such as aging populations, labor-disrupting automation technologies and global corporate and government indebtedness - to persist for decades.

But something that has not yet been tested in any meaningful way is the pricing power of our mega-tech businesses. Should these businesses find it easy to increase their prices in an inflationary environment, then this goes some way to insulating investors from the negative effects of inflation. We believe the latent pricing power in these businesses is likely very strong - and in some cases, extraordinarily so. Take Microsoft 365, for example - arguably one of the most mission-critical software packages upon which many hundreds of millions of employees are reliant each day. This costs just US$32/month, vastly below any reasonable estimate for the value it adds, strongly supporting our latent pricing power hypothesis.

3.            Current valuations are way too conservative

The final reason that mega-tech stocks are great value is their attractive valuations. Our analysis shows that the expectations baked into the current stock prices of our big-tech names are far too conservative.

• In the case of three dominant US cloud providers, Amazon, Microsoft and Alphabet, for example, their implied collective annual cloud revenues by 2030 are in the order of just $650 billion higher than current levels, according to consensus estimates. This is a tiny fraction of the $8 trillion increment that Microsoft CEO Nadella expects to accrue to the tech space over the next decade. If Nadella's forecast above is even remotely accurate, then these cloud providers will see much higher revenues (and earnings) in 2030 than what is currently being implied by consensus estimates.

• Next, consider Tencent and Alibaba, the latter of which has of course suffered greatly from the Jack Ma saga, with the billionaire Alibaba founder's fintech Ant Group IPO pulled at the last minute and with Ma reportedly under serious pressure from Chinese regulators and Government. In both cases, despite owning some of the most valuable data ecosystems in China and South-East Asia - including being the two dominant cloud providers on the Mainland - their respective stock prices imply very conservative sets of expectations. Said another way, if revenue growth for these businesses were to fall from healthy-double-digits, to just single-digits by 2025, an investor today would still make money, based on Montaka's analysis.

• And finally, in the biggest head-scratcher of them all is Facebook, which is priced at a forward earnings multiple of just 14x. Some of the businesses trading at a higher multiple than this today include Australia's Wesfarmers, Scentre Group, and plumbing parts supplier, Reece. At the current stock price, the market is effectively giving investors all of the upside from eCommerce, the monetisation of the creator economy, WhatsApp, Messenger and Reels, as well as Facebook's growth in VR/AR for free!

Spectacular potential

As the global economy grows, we are all becoming even more dependent on the highest-quality mega-tech winners.

Today, the collective revenues of these six businesses account for just one percent of global GDP. By 2030, global GDP will probably be around $160 trillion per annum, and these businesses will account for a much larger share than today.

When you combine a growing share of a growing economy, the future upside of these mega-techs is spectacular. Yet the market is underestimating that.

For the patient investor who can look through the short-term noise, the rewards will be substantial, and we believe these businesses are very strong candidates to form the core of any global equities portfolio today.

At Montaka, we will continue to own these businesses in size while their prices make sense. Patiently owning the winning businesses in the world's most attractive industries without overpaying is the way Montaka believes in safely compounding capital over the long-term.