Ophir stockpicker Andrew Mitchell warns of profit downgrades until inflation is tamed

A fresh bout of selling has hit equity markets as the global economy confronts the spectre of a recession that even Australia may not escape.

Andrew Mitchell, portfolio manager for Ophir Asset Management: ‘The global economy is slowing and inflation is stubbornly high. It would take a brave person to say the sharemarket is out of the woods at the moment.’ Picture: Adam Yip.

A fresh bout of selling has hit equity markets as the global economy confronts the spectre of a recession that even Australia may not escape.

As central banks push the knife in further, the next act in this downturn will be a spate of earnings downgrades, according to Ophir Asset Management director Andrew Mitchell.

Speaking to The Australian, the Sydney-based stockpicker, whose flagship Opportunities Fund has returned 22 per cent per annum, net of fees, over a 10-year period, warned that any substantial recovery in markets would prove elusive until inflation is under control and earnings expectations are reset.

“The global economy is slowing and inflation is stubbornly high. It would take a brave person to say the sharemarket is out of the woods at the moment,” Mr Mitchell cautioned. “Although some indicators suggest market sentiment is almost as pessimistic as mid-June, we’re seeing increased signs of economic stress, including the jump in UK government bond yields on Friday and the spike in spreads on US junk bonds.”

While Mr Mitchell said he would not be surprised to see another bear market rally with the sell-off, he cautioned: “There isn’t sufficient evidence to suggest we’re there just yet.”

The biggest challenge facing markets was central bank action on inflation, with it now “very likely” that the US was headed for recession, he said.

“The market is focused on core inflation. How much does the Fed need to lift rates before they are satisfied that aggregate demand will slow? We are all hopeful for a Fed pivot, but with their credibility on the line they may talk tough for longer than everyone expects,” Mr Mitchell predicted.

“We think it is very likely the US will end in recession. The Federal Reserve’s reputation is on the line and Jerome Powell is most likely to overcorrect and go too tight on monetary policy, which will have damaging effects on the global economy.”

No Fed chair wanted to be remembered for letting the inflation genie out of the bottle, but the lead time on higher interest rates and their effect on the economy was the issue, he warned.

“The Fed has the unenviable task of lifting rates and wondering, is that enough? We think they will err on the side of caution and likely go too far.

“Powell has said inflation is his number one priority, growth is a far second and the sharemarket … well who cares. In some respects if the sharemarket is rallying like it did in August, the Fed has a problem that the market isn’t quite getting it.”

Mr Mitchell and fellow fundie Steven Ng set up Ophir a decade ago, after working together for some years at Paradise Investment Management.

The pair’s first backers were family and friends, but Ophir now manages well over $1bn in assets. Its clients now include pension funds, financial advisers, wealth managers and high net worths, with staff all putting their own money into the fund too.

The Ophir Opportunities Fund has outperformed over both the short and long term: it returned 22.1 per cent a year, net of fees, for the 10 years to August 31, versus its benchmark’s 6.5 per cent. It is down 11 per cent over 12 months but is still beating the benchmark’s negative 15 per cent return over the same period.

The fund was focused on companies with good management that would grow no matter what, Mr Mitchell said.

A further point of focus was companies making acquisitions in this market, he noted.

“Historically, times like this are the best for making money. You just need nerves of steel. We’re focused on companies that are making great acquisitions now that the market won’t acknowledge because it’s obsessed with only the most defensive businesses.

“We run a portfolio of companies from most sectors, so we’re looking for companies that have been sold off mercilessly, while their peers have been less harshly dealt with.”

At the same time, the stockpicker is avoiding businesses with little pricing power as well as companies with a lot of debt.

If past bear markets are anything to go by, the next step will be earnings downgrades, he warned. A recovery, meanwhile, won’t be in prospect until inflation is well under control.

“We are very cautious on consumer discretionary companies, companies leveraged to the housing market or financials. We feel they are the most vulnerable to an earnings downgrade cycle.”

“(On a recovery), firstly we need to see evidence of not only peak inflation, but sub-2 per cent inflation being in reach. Second, we need to see a reset of corporate earnings expectations reflecting where we are in the cycle.

“We have looked at the last 16 bear markets and on average the sharemarket bottoms six months before corporate earnings do.”

Mr Mitchell’s advice for investors in this market? Choose cash-generating businesses.

“Investors need to focus on picking good businesses that generate cash. The best businesses will emerge from this slowdown stronger than they ever have been as weaker competitors get chopped at the knees.”