Present: Charles Heenan (CH), Steve Plag (SP), Max Ward (MW), Andrew Hamilton (ANH) and Peter Forrester (PF)
By Zoom: Robbie Hunter (RH), Giles Chance (GC), Archie Hamilton (AJH).
Apologies: Alex Hammond-Chambers, Angus Tulloch and Keith Falconer.
Value v Growth?
Value & Growth defined
VALUE investing is the identification and holding of shares in companies which, given the prospects of these companies, are fundamentally undervalued by the market.
GROWTH investing is the identification of shares in companies which are likely to grow almost regardless of the company’s current Balance Sheet. Such stocks are sometimes referred to as “disrupters” or “outliers”. Recent examples of such stocks include Amazon, Facebook, Netflix, and Google, (FANG).
In his absence, ANH took Alex’s place in the chair. What follows is a truncated version of a two-hour discussion.
CH: Value investing can be interpreted in many ways. For us at Kennox, Value investing is about identifying the highest quality companies temporarily out of favour, i.e., companies whose prices have fallen because of too much bad news. If these headwinds prove to be temporary, it can be a genuine opportunity. If the headwinds prove to be permanent, run a mile. This will always be a valid investment philosophy – but Value has been through a very difficult patch.
In the next 10 years Value will come from companies operating in areas of the market where supply decreases but where demand remains same. This leads to improvement in profitability – largely absent in last 10 years. Banks have been happy to continue lending to their weakest borrowers – in some cases, they have lent them more. (“Extend and pretend”.) All backed by Government. Energy is a great example at present. Not popular with the “Environment Social & Governance” (ESG) lobby, but countries and economies are still oil dependent and that makes it ethical! (A tip – avoid companies investing in v. expensive renewable projects!)
Oil capex (capital expenditure) – has disappeared – it was too high at peak in 2014 but now is almost certainly too low having fallen more than 80%. That level of replacement is insufficient for the length of time that our society will need these vital energy sources – if nothing else to build the renewable energy sources of the future (These aren’t just going to appear magically!) This supply squeeze is a risk for all consumers, so well worthwhile investing in the stocks which will benefit.
An example is Royal Dutch Shell – doing a good job on balancing the ESG demand and shareholder returns. And the profits in a supply squeezed market for a company as well-placed as Shell, are being underestimated by the market. Better still, look at Equinor (previously Statoil – 67% state owned, proximity to Russia – offset to Middle East).
Whatever you do, avoid going from expensive growth to expensive (or risky) value!
MW – Value needs more time in the sun. I am drawn more to Growth stocks. Quality of businesses now are stupendous – timing and cost outweighed by long term benefit. Currently astounding number of good quality Initial Public Offerings (IPOs). Some are too expensive e.g., Trustpilot and Auction Technology – world’s largest auction online platform.
SP: I am agnostic on value versus growth. Value v Growth is only one of three considerations for the future of the market at the moment; the other two are the inflation v deflation debate and the real elephant in the room, the possible resurgence of a coronavirus variant that leads to more lockdowns or the emergence of a population of a sicklier people, following a vaccination strategy that might yet backfire.
I think the inflation we are seeing is mostly down to a bottleneck in supply. I doubt we will see a sustained period of above trend growth in the world economy – after the post Covid lockdown ‘bounce’ – that could be inflationary. There is simply too much personal and private debt in the system to see substantial growth in lending, the bulwark of global economic growth until 2008.
The supply chain is currently chaotic and there are some serious bottlenecks. So, yes, there are some alarming price increases, but I believe these are transitory. It looks like inflation – but it is not – it is the weakness inherent in ‘just in time supply chains’ following lockdown closure of plants, global container rates rising as the containers were in the wrong part of the world, and the fallout of the Suez Canal blockage.
On the third consideration, don’t get too complacent on the coronavirus theme as ‘Freedom Day’ approaches. We are not, as we are led to believe, ‘out of the woods’ yet. There are cognitive biases at work (availability heuristic, confirmation bias) due to very poor analysis and commentary by the media, together with a very definite attempt by the big tech companies to cancel and block any dissenting voices (e.g., learned academics and medical professionals) who raise any form of dissent to mass vaccination. An army of ‘fact checkers’ has also appeared who are often unqualified, biased (confirmation bias abounds) and who frequently make reference to each other. Perfectly reasonable and legitimate commentators are branded as ‘anti-vaxxers’ or conspiracy theorists; this creates a danger in the financial markets as the information available to the markets becomes biased and distorted. This is what we are interested in as investors – an information inefficiency in the financial markets – these can create opportunities or threats. In the case of Coronavirus – it is a very definite threat. (More of Steve’s analysis on the real threat of Covid 19 is shown in Annex 1.)
Inflation vs Deflation
ANH: Alex sent me a message keen to remind us that inflation comes in two main guises – cyclical and structural. Cyclical Inflation is often referred to boom & bust, i.e., the economy overheats, prices rise, and the seeds of the next recession are sown. Structural Inflation, whereby Government loses control of monetary policy and the value of a unit of currency reduces not just because of increased demand (a la Thatcher in the 1980s). Structural inflation is much more difficult to control.
SP: Inflation is a misnomer. It comes in many different types, e.g., goods, assets, property, and land. Inflation in the money supply is what matters. In the past, the ability of Central Banks to create money (“power money”) has been restricted. However, last year the Fed broke their rule and extended the range of assets which it can buy in the market to corporate bonds. (For example, LQDE investment grade 4% high yield is now guaranteed by the Fed and is now up 25% since the Fed’s announcement.) And the fact is that whilst M2 creation in the US has exponentially increased, the velocity of M2 continues at rock bottom. In fact, M2 has continued to make new lows since we discussed this in 2019. This should put the Fed into panic mode, and I believe the last thing it will do is raise interest rates. In the UK, the crunch would be exacerbated if the massive ‘extend and pretend’ forbearance of bad debts was not extended. These bad debts, both in the UK and US, must be cleared before any thought of raising interest rates.
To get prices of goods and services to rise you need a wage price spiral. I believe when furlough ends there will be massive unemployment – so forget inflation. Also, the effect of working from home will also be critical as it will create arbitrage between home and office. In the past such arbitrage was ultimately a killer for the blue-collar worker as the jobs were simply transferred to countries where wages were much lower. We could see a similar fate for the white-collar worker. Working from home means you can do a job anywhere so a Council strapped for cash, for example, could save huge wage bills by offshoring its administration to India.
MW: The corollary is that hospitality jobs could be the best paid of all – if we ever get back to hospitality.
SP: So, my prediction is that there will be deflation in goods and services. And the wage crunch, rising unemployment, the rise of gig economy et al will continue to foster arbitrage.
MW: I have no record in making such judgements but buying good companies with strong brands will see you right.
PF: Stephen Roach has just written an interesting article on inflation entitled “The Ghost of Arthur Burns.” (Arthur Burns, the man in charge of the Federal Reserve in the early 70’s effectively removed 70% of goods from the basket saying that the price increases were transitory. This blew up in 1974 when oil prices doubled!) The Fed are currently engaged in similar Arthur Burns tactics, trying to massage the real increase in CPI.
MW: Many people were worried about consumer inflation in 2008 – they got that wrong! And the attitude now is that “we won’t be fooled again” – the consequence being to ignore what is actually in our best interests – which is to turn a blind eye to inflation. This is a behavioural issue.
CH: The real danger is that in the last 10 years we have dropped interest rates to impossible levels, and we will need to keep them here forever – the ‘extend and pretend’ mentality will cause us to run up debt levels from which there will be nowhere to hide. Regarding interest rates, if they rise, I just do not see how the amount of debt across the world is sustainable. Inflation seems to be the only answer.
MW: Referring back to the central banks’ ‘power’ and commercial banks’ actual’ money, where does helicopter money fit in?
SP: This is money put in your hand – i.e., real inflation: the quantum must inflate, so it has to be compounded to generate a bigger quantum next time round. A single instance without compounding will mean transitory inflation, but continuous inflation of helicopter money will eventually break sovereign bond markets and currencies. Then interest rates will have to rise.
CH: But since it is a world phenomenon, I can’t see any interest rate rises at all.
SP: For central banks, an easy win would be negative interest rates, but you cannot get this while you still have notes and coin. If you ban notes and coin and introduce digital currency you can create negative interest rates at the flick of a switch. The Bank of England, the Fed and the ECB have all produced papers on this. The pretext could be elimination of black markets and digital crime. However, negative interest rates would see savers flee to real assets and create mass market dislocations in asset prices. So negative interest rate would be a dangerous tool.
GC: The Jury’s out – we have a novel situation. This is no longer a one-off – we have an unprecedented situation with QE and now we are seeing inflation. We have had a favourable financial and investing environment for 12 years. This can’t continue forever: for example, a pullback of QE could have devastating effect. I am genuinely worried about the significant chance of a major event over the next 12-24 months.
China – will Xi snuff out capitalism?
GC: Unlikely. Two things make China work. (1) A dynamic commercialized, hard-working, enterprising society – this is visible in its entrepreneurial companies: and (2) a top-down, rigid but efficient system. It’s corrupt of course, but the Chinese are mostly accepting of this because they mostly believe that a top-down organized system is necessary. Xi Jinping knows Chinese entrepreneurs are the goose that lays golden eggs. If he snuffs out the entrepreneurs., it will be a catastrophe for the Chinese economy.
300 years ago, China was at the top of the pile. Then it was trodden on by various Western powers, plus Japan (Opium wars, invasions etc.). This is now China’s time. The Chinese believe that now is the big return to things as they were and should be. Chinese culture is fundamentally different. Just because it’s a different system or a different culture, is not in itself reason for thinking fail or that it’s rubbish. The Chinese have a zero record for successful democracy. China is not going to disappear in a puff of smoke, nor will it become the 51st American state. An adjustment is needed by the West which we are now at the beginning of – with or without Xi Jinping.
AJH: On a personal level, we lived in China for 14 years. It was Xi Jinping and his authoritarian inclinations that destroyed our joy in living in China. I miss the new regime not at all.
My belief is that the amazing achievements of the last decade in China are as a direct result of the expansionist and liberalizing policies of the 30 years prior. The reason that the likes of Tencent, Alibaba, Bytedance and Meituan have become such incredible global leaders in technology, logistics and innovation is because from about 2005 onwards, Chinese minds were freed and encouraged to think individualistically. This momentum has dramatically reversed under Xi, but I think he is bathing in the reflected glory of the entrepreneurial successes which have less and less to do with him or his regime. He will continue to do so, I believe.
ANH: We love Baillie Gifford for their investment style, their never-ending quest to find and stick by world beating companies. But has the primacy of Baillie Gifford been challenged too far or not far enough? Max, you used to be a partner in Baillie Gifford – can you sum up their investment style?
MW: The Baillie Gifford investment philosophy is based on simple academic research – which demonstrates that positive stock market positive performance over time comes from a tiny number of companies. Their whole effort is to find outliers has been incredibly successful up to now, and if it carries on, their position will continue to strengthen. How do you judge this? I don’t know, but the research methodology is on a very sound basis. One fundamental characteristic – and James Anderson is an extreme example of this (which makes them different to most other managers) – is that once they find an outlier, they do not sell. Avoiding the single biggest mistake of all fund managers.
ANH: Charlie, your Value proposition at Kennox is very different from BG. Can you expand?
CH: My take is that middle is disappearing; there is now no middle. So, I have a lot of time for Max’s observations on Baillie Gifford’s investment style. It’s very pure, they take strong positions. My worry is for middle part of our industry. We have heard some divergent opinions here. For example, Steve is worried about deflation and not inflation. Personally, I worry about sound money – or the lack of it – which is inherently inflationary. So, my advice, Andrew, is to build a portfolio across the range. It makes sense to buy FAANGs pioneered by Baillie Gifford. But don’t sit in the middle. There are plenty of outlier opportunities. For example,. China Mobile is a clear leader in huge market: it currently yields 7.5% and no one wants to know them at the moment. Why? I don’t know, but my hunch is that China is regarded by many as too dangerous – and unlike Apple is regarded as unsexy!!
MW: Where is China Mobile listed?
CH: Hong Kong.
ANH: I can see us all rushing for the door after this meeting!
CH: I go back to diversification. Look for example at Shell, Equinor, and Japan – real businesses with huge piles of cash. In Japan, there is Fujikon, makers of headphones. They haven’t done well in the last 5 years, but at a 20% discount to cash it is still profitable and on a 5% dividend yield. So, look around and consider everything,
GC: Angus Tulloch – when at Stewart Ivory – bought China Mobile in the 1990s and tripled his money. Interesting that this is coming round again. I wouldn’t rubbish BG. Indeed, I am a big fan, but the weather changes; Benjamin Graham, James Anderson have been (are) right in their day.
CH: Issues – will China continue to get it right, will protectionism result, do we throw sand in the economic system? These are not only considerations but worries. At company level, buy quality, strong brands with a high barrier to entry. Avoid duplication of effort and concentration of risk. Diversify, e.g., not just Baillie Gifford or the UK;
SP: Winter and coronavirus are my medium-term worries.
MW: Macro economic forecasts are not my forte. Monetary factors will keep people buying until there is an event which will cause consternation.
GC: The risks are high, the inherent risk in the American system is high. Despite low velocity there is inflation in system. Don’t know where it will flare up. Target income-based equities which pay dividends and have pricing power. For example, funeral homes which were the favourite investment of Peter Lynch of Fidelity!
SP: You would think that with markets at these heady heights, a collapse could be a real possibility. But the central banks simply will not allow a collapse. Central banks can buy anything they want with power money. So, you cannot be too scared of risk. You have the backing of the Fed. Look at the Fed buying high yield bond ETFs, bailing out some very foolish investors. They also bought investment grade bond ETFs including a favorite of mine with the ticker LQDE.
And the power money floodgates have been opened to markets since coronavirus. I am not promoting conspiracy theories but consider Event 201, in 2019, an exercise run by the John Hopkins University, The World Economic Forum (WEF) and the B&M Gates Foundation: all major governments took part. Event 201 was a scenario in which a coronavirus pandemic occurred, and a playbook was developed on how to manage and how to handle the consequences.
And look at the WEF Head Claus Schwab – promoter of the ‘Great Reset’ a principal policy of WEF which runs the annual Davos meeting for the great and the good. In the Great Reset policy, you will hear phrases such as ‘levelling up’, ‘coming back better’ trip off the tongue. Heard that somewhere before? Yes, from just about every leading politician in the world! Is this how we get out of the massive debts incurred by individuals, corporations, and governments?
MW: Leaves the meeting.
ANH: At Hamilton Financial we will only accept investors cash from investors with a 5-year time horizon, so by and large we don’t manage the cash that clients want to keep for emergencies. With the cash that we accept, we avoid trying to time a client’s entry into the market. (I agree with Terry Smith of Fundsmith who says that market timing is nigh on impossible, so avoid it. “Market Timing divides investors into two groups – those who can’t and those who know they can’t!”) Are we right to avoid market timing?
SP: Yes, don’t try and be too clever and stay invested. Markets are correlated – we saw that in 2008 when everything went down simultaneously including gold. Incidentally, I have changed my mind on the risks of a major negative impact on a portfolio after seeing what the Fed was prepared to do by bailing out bond investors. So, I am less worried than I was. Having said that, it might be interesting to make contrarian investments into areas that might do well if Coronavirus comes back hard.
CH: Andrew, you are spot on. Avoid trying to be too cute. But do warn clients that we are in unprecedented times and markets can go down as well as up! Try to make sure that in a crisis, your clients have sufficient reserves to cope.
ANH: Thanks to you all and see you again in 6 months’ time.
STEVE PLAG ON COVID-19
Consider data showing that the vaccination program is working to alleviate deaths (never looked for or demonstrated in any of the clinical studies undertaken for regulatory purposes). Compare for yourself the gradient of the declines in death rate as we entered summer last year with no vaccine against the decline, we see this year after the vaccination programme began (there was actually an increase in deaths as the vaccine programme began); the gradients are essentially the same – the decline in death may be attributable to no more than a seasonal waning of the virus. This will be tested over the winter months.
Also at stake to be tested over the winter is the issue of antibody dependent enhancement (ADE) – a phenomenon whereby vaccination can actually make you more prone to being seriously ill if you encounter a variant that can escape neutralization by the antibodies elicited by the jabs.
The jabs are not traditional vaccines – a vaccine is designed to introduce a whole dead or inactive bug into your body – so you have no exposure to the disease. Your immune system can see the whole bug and so elicit a suite of antibodies and T cells against a range of components of the bug.
The ‘vaccines’ being used against coronavirus do not work in this way. They are actually pieces of genetic material that hijack part of your cellular machinery to make you produce the spike protein of the virus. The literature points to the spike protein being very biologically active and so we see the range of higher than normal and some very unusual adverse events and side effects.
Importantly the spike protein your cells are forced to produce is not the same as the ‘natural’ spike protein – the have been engineered to make them more resistant to breakdown and to be ‘stiffer’ than the natural viral spike.
So, for investors we must be wary of overconfidence that Coronavirus is behind us – as still out there are these key issues – will the vaccines work under the stress test of the expected winter surge to prevent deaths? Will they neutralize sufficiently – new strains to prevent antibody dependent enhancement and will there be any medium to long-term consequences of the vaccine itself on the workforce’s health? An adverse outcome from these could have a very deleterious impact on the financial markets.
The Hamilton Financial Team
The Hamilton Financial Advisory Board
The information contained in this document is for guidance only and does not constitute advice which should be sought before taking any action or inaction. The value of investments can fall as well as rise. You may not get back what you invest.
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