Matthew Beddall

As a nation the British like to borrow. In the thirty years prior to 2008, companies and households steadily took on more debt, punctuated by a “credit crisis” that called into question the ability for it to be repaid. Since then, and despite “austerity” measures, the baton passed to the Government. The result is that total borrowing in the UK, excluding financial institutions, has been on a steady rise for 40 years – moving from around one times GDP to almost three.

Alongside this increase in debt, interest rates have fallen, such that we have not actually had to spend more to service the enlarged debt. This, of course, is because the Bank of England has justified low interest rates as a response to low levels of price inflation.

That brings us to the present day. The recent jump in inflation means it has reached levels not seen since the 1970s, leading many commentators to draw a comparison to these times. Stories of strike activity and wage disputes, together with an energy price shock, further justify the comparison. Where the comparison falls short, is with respect to both the amount of debt in the economy and the level of interest rates. This is made clear in the chart below:

With total debt in the UK of three times GDP, a 1% increase in interest rates would require an additional 3% of GDP to be spent on interest payments. Through this multiplier effect, a quite plausible scenario of a 3% rate rise would require an additional 9% of GDP to be spent servicing debts. Clearly it would need a high level of underlying growth to both cover such an additional cost and see overall GDP growth. This is a very different situation to the 1970s.

Although this narrative creates an uncomfortable picture for the UK, it is almost identical to the US, where debt accumulation has followed a strikingly similar path. It follows that the build-up of debt in the UK economy does not, on its own, justify this year’s large fall in the value of the Pound against the US Dollar.  Clearly the risk that this debt impacts future economic growth is much the same in both countries.

We do not make investment decisions based on macro-economic forecasts and so what is my interest in this data? It is because we want to own a portfolio that is robust to what the future could reasonably hold, and these insights makes me cautious about extrapolating recent experience. We want to allow for the risk that the investing climate moves into a new and unfamiliar paradigm. Could this be the end of a debt “super-cycle”, the eponymous Minsky[1] moment?

Based on the shadow that debt now casts over the world’s major economies, low interest rates and increased amounts of leverage have not only benefited corporate profit margins but have also supported high asset prices. With all else being equal, higher interest rates will put this into reverse. This comes at a time when profit margins are already under pressure from high commodity prices, rising wage pressure and a less friendly global stage for doing business.

Specific to the UK, this year’s circa 15% fall in the Pound against the US Dollar has shielded many investors from the full force of asset price falls abroad. This comes on the heels of a prolonged period of strong performance for US equity markets. I am under no illusions that the UK faces challenges ahead, but I believe that it is not alone in this regard. There is a risk that as attention moves to problems elsewhere in the World, a reversal of the exchange rate and premium on US equity markets will create a headwind for many investors.

Despite these concerns I see reasons for optimism, as I believe the current environment is creating opportunities for discerning investors. Based on valuations, among other observations, I believe that there is a lot of herd behaviour in markets – investors moving their capital based more on emotions than analytical insights. We see examples of companies with valuations close to 40-year lows, where we believe the challenges they face have had an exaggerated impact on prices, as investors “run scared” at the slightest sign of bad news.

Clearly, I do not know what the next chapter of this story will look like. However, as students of market history, I know that knowledge of the past can only make whatever happens next seem less surprising!

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[1] https://en.wikipedia.org/wiki/Minsky_moment

After a sharp rally in July that saw many previous stock market darlings recover some of their earlier falls, investors could be tempted to ‘think it’s all over’.  The 10-year chart below shows that the price earnings multiple of the MSCI World Index had fallen to levels last seen in the depths of the COVID pandemic and suggests that many recent buyers might have been motivated to grab a bargain.

There is a joke amongst statisticians that the man who lays with his head in an oven and feet in a freezer is, on average, comfortable. The message is that statistics can often be misleading. In the chart above, summarising all 1,600 companies that are in the index with a single statistic really is not telling the whole story. MSCI produce ‘growth’ and ‘value’ indices that crudely divide these companies into one of the two classifications and despite being far from perfect, these indices tell a very different story to the chart above.

The chart of the price earnings ratio of the MSCI World Growth Index below shows that despite a significant fall, the index still stands at a 28x multiple., which hardly makes it look to be in bargain territory.

Conversely, the price earnings ratio of the MSCI World Value Index, below, shows that it has fallen to its lowest level in the last decade.

The first chart suggested that many excessive valuations, apparent at the start of the year, had moved to more sensible levels.  However, when going only slightly deeper the data suggests that many companies in the MSCI World Growth Index could still be exposed to significant valuation risk. In comparison the MSCI World Value Index looks cheap on this measure. 

Our approach to investment analysis runs much deeper than looking at simple valuation metrics, but despite the short comings of this analysis it hints at the opportunities we are finding. We believe that not all the companies that have seen large valuation falls are yesterday’s ‘has-beens’ and through patient analysis we believe there are now many more quality businesses available to buy at attractive prices.

*Note: The dotted lines in each of the charts shows the latest value.

The question that many investors appear to be asking themselves right now is if we will see a recession – prompted by concerns that higher interest rates will undermine economic growth.

I do not know if there will be a recession in the world’s major economies this year or next, and our approach to investing is not based on trying to second guess this. What I do know is that there have always been periods of economic contraction in history. I think of it like waiting at a bus stop with no timetable – you may have absolutely no idea when the next bus will arrive, but you shouldn’t be surprised when one does appear.

For the companies that we follow I take a casual interest in broker research and, of late, I have seen many “target prices” revised down by amounts as large as 25% or more. One way, or another, these revisions are blamed on the fear of a recession causing lower earnings. I struggle to see the justification for such large changes, as surely any reasonable judgement of valuation would look far enough into the future to anticipate one or two bad years.

Moving on from bus-stop analogies, the noise of financial punditry reminds me of the sirens from Greek mythology, who lured sailors to their death with their alluring songs. The mythical Greek hero Odysseus avoided this fate by strapping himself to the mast of his boat and plugging his sailors’ ears with beeswax. I wouldn’t advocate going this far to ignore the financial news, but I do think that it requires determination not to get drawn into the short-term narrative of markets. We certainly want to be alert to changes in our environment, but do not believe that success will come from trying to make timing calls about a recession.

What were we thinking?

So far this year the performance of the fund has been helped by two distinct views that I have previously written about. I thought it was worth recapping them.

In my first quarter 2021 investor letter I wrote about our growing concern that the amount of money that central banks and governments were injecting into their economies would cause higher inflation.

While we do not make investment decisions based on macro-economic forecasts, we do want to own a portfolio that will be robust to perceived threats. In this case we made efforts to consider the impact of higher levels of inflation on our holdings, and those companies engaged in the primary production of energy, food and gold have “held up” as we had hoped, as the threat became a reality.

In my year end 2020 letter I set out the case for financial markets being in a bubble, having shared our analysis in my Q3 2020 letter on the evidence for much of the outperformance of “growth” over “value” being driven by price earnings multiple expansion.

There have been two distinct types of “growth” company that investors have been pursuing. The first are companies, with no profits, where the value placed on them is based on a belief about the distant future. The second being companies that are highly profitable, but where investors have paid ever higher premiums to own them. In broad terms both types of growth company have seen price falls this year, with the former being impacted more than the latter.  Our valuation driven approach has helped us avoid the worst of this excess.

Before I start to sound too clever, we know full well that our abilities as investors can only reasonably be judged based on our long-term track record. Nonetheless it is gratifying to feel that our analytical investment views have been shown to have merit.

Matthew Beddall, CEO and Fund Manager

As of writing the Nasdaq index of “growth” stocks has fallen by 27% in the year to date*. Why has it fallen by so much and does it mean there are some bargains to be had?

The popular narrative for why we have seen heavy price falls in many “growth” stocks is that it was caused by investors changing their expectations about the path of future interest rates. I will (reluctantly) explain this for those readers who have been living in a cave and not heard it before. The logic is that investors were prepared to pay high prices for high growth businesses, because low interest rates meant they earnt less from more certain near-term investments, and so profits in the distant future became more appealing.

The appeal of this narrative is that it involves maths and things called “discounted cash flows” – all of which helps make it sound clever and objective. Were lots of investors really sat around their pocket calculators, carefully figuring out the impact of low interest rates on company profits in the distant future? I think not.

As an explanation it requires investors to have been confident about (a) companies continuing to grow profits and (b) interest rates remaining low. It follows that this popular narrative is really just saying that people were buying stocks based on speculative views about the future. The clever sounding maths provides a veneer of respectability that I don’t think is deserved.

I, personally, prefer the narrative that the large falls in growth stocks that we have witnessed are the result of investors being now driven more by the fear of losing money than the greed of making it. Admittedly, my narrative involves animal spirits and not maths, and so is perhaps less palatable to many end clients of the investment industry.

The important question going forward is if the price falls in growth stocks mean that there are bargains to be had. This also conveniently provides me with the opportunity to use some maths and prove that I am not a complete luddite!

I made use of the MSCI World Growth and Value indices, that crudely divide companies into one of these two classifications. I calculated the price earnings (PE) ratio for each of the two groups of companies, where the earnings are the average of the last five years. The chart below shows this data, with the two horizontal lines showing the average (median) PE ratios for the entire period.

What does this chart tell us?

Based on price earnings ratios, the growth companies have been historically more expensive, but the extent to which this is true increased massively in the last three years. This means that despite the MSCI Growth index having already fallen by 27% this year*, it would require a further 24% drop for its price earnings ratio to be at its historic average.  By the same token the value index is already at its historic average level.

It follows that I do not see evidence that this year’s price falls mean that yesterday’s stock market darlings, have automatically become no-brainer bargains. But I do see signs that the price falls are creating opportunity.

Our “quality value” approach to investing rests on the idea that a crude classification of companies as either growth or value is too simplistic. On a bottom-up basis, we see many companies that we judge as high quality now available to purchase at valuations that look undemanding versus history. Put simply I believe that there is a rich opportunity set, but that it is naive to think that everything that has fallen in price must be a bargain.

I will end by saying that despite my cynicism, narratives clearly do matter. They help us to understand the world around us and provide us with a sense of order and certainty in amongst the disorder and chaos. More than this, narratives help us to make decisions in the face of uncertainty, and nowhere is this truer than in investing. The problem with narratives though, is that we rarely get to find out if they are true. For this reason, I believe that the best investors remain humble about the extent to which they understand the world.

*Source: Bloomberg as at 20th May 2022

As an active investment manager, we put ourselves forward as being able to deliver better than average performance for our clients. This is a tall order. To believe it is possible requires either hubris or a belief that we have an edge over other investors.

Setting out to manage other people’s money based on excessive self-confidence alone is not a great plan. Despite this, the investment industry can often encourage such behaviour. In the short-term you can get lucky, whereas it takes years to demonstrate true skill. Narratives are often crafted retrospectively, which can draw both investment manager and client into a belief that everything the former touches turns to gold.

Real investors understand the importance of remaining humble.

So, what then, do I think is our edge? I see three distinct sources, one that is transient and two that are permanent.

A Value Investing Tail Wind

The “growth” style of investing has had a prolonged period of outperforming “value”, such that there are many more proponents of the former than the latter. As I have written about before, the evidence suggests that this out-performance was driven much more by the price investors are willing to pay to own a high growth company than by actual growth in earnings.

In the long run we believe that the returns from owning a company will mirror the underlying earnings from their business and I think many investors are proceeding in the belief that this is not so.

Relative to history the optimism pessimism “gap” between “growth” and “value” styles looks extreme (as measured by the price-earnings multiples of indices on the two cohorts). As a value investor I believe this means we are fishing in a pond with less future success “baked” into the share price of companies at a moment in time when there is less competition to land these catches. It is this that I think could provide us with a transient edge.

Time horizon

If you can think like a long-term investor, I believe it conveys an advantage. It is however easier said than done.

One of the companies that we are a part owner of recently experienced a bump in the road. The company shut down a new initiative, at great expense and much embarrassment, because they believed it would never deliver an acceptable return. The company’s share price fell in response to this news, as many investors decided to walk away.

A recent broker research note on the company shared their latest valuation, with a base-case of £26 per share and an optimistic-case of £33. At the time the note was written the share price was around £19. With a potential 30% upside, you would have thought the brokerage house would be tripping over themselves to recommend buying the shares. However, their outlook was “neutral” because the “path and timing of the potential value crystallization remains unclear”.

This story is typical of the unhealthy focus on the short-term that I see in markets. In the case of this company we may, or may not, be right and we certainly do not know what the catalyst for a share price increase will be. What I do believe is that attempting to “time” a purchase or sales based on second guessing what the short-term will hold leads you down a path of missed opportunity. Being a long-term investor requires patience, often in the face of discomfort, which is a virtue I do not see being widely practiced.

Ignoring the noise

We live in an age where we receive a virtual firehose of information on a 24/7 basis. This leads to the stereotype of the investment professional sat in front of banks of screens full of scrolling news and flashing numbers. As you get drawn into this world, the nuggets of information give our brains little dopamine hits and draw you into thinking they have an exaggerated importance.  

My formal training (many years ago) was in statistics. This taught me the importance of looking beyond the noise that we are confronted with in so many aspects of life. I see this skill as related to, but distinct from, being a long-term investor. All investors have limited bandwidth – which means that time is your most valuable commodity. Even a long-term investor can squander their time with distractions that are ultimately not important.

When we make an investment decision, it is based on a thesis, which sets out why we think it will be successful. In my opinion a good investment thesis normally depends on one or two “big” things, rather than many “small” ones – being able to see the “wood for the trees”. I think that the human brain is wired to be distracted by “noise”, and if you can overcome this it will help to make better investment decisions.

Alignment of interest

My savings are invested in our fund, which provides an alignment of interest with our customers that seems surprisingly rare in an industry where you are not expected to eat your own cooking. Furthermore, Neil and I are owner-operators of our business, which I think means that our decisions are less clouded by career risk than is often the case.

I believe that being a large investor in the fund, and part-owner of the management company, helps reinforce the edges that I describe above. I believe it makes me more able to focus on long term investment decisions and less distracted by short-term noise.

I do not know the extent to which these advantages will help us deliver on our goal of delivering good long term compound returns. What I hope you are reassured by is that we are not proceeding based on hubris. In the land of the blind, the one-eyed man is king!