Commentary

It was the winter of 1928 when JFK’s father, Joe Kennedy, was said to have received a stock tip from a shoeshine boy – “Buy Hindenburg”. The story goes that Joe went straight to his office and sold everything, reasoning that it must be time to sell when the shoeshine boy gives you stock tips.

Markets are often characterised as being driven by fear and greed, something that is formally recognised by the field of “behavioural economics”. As the coronavirus pandemic took hold markets were indeed overcome with fear – fear that a massive economic shock would wreak havoc on investors’ portfolios. Central Banks acted swiftly to appease these fears – “injecting liquidity” – by purchasing financial assets with newly printed money. These actions to stabilise markets were, in my view, the responsible thing to do. However, can you have too much of a good thing?

We are in the middle of the worst economic shock in post-war history and yet many stock market indices are close to their all-time highs. How is this so? Bar Stool Dave is making headlines, telling his “trader bro” followers to remember that “stocks only go up”. More seasoned market commentators are reasoning “don’t fight the fed”. Whilst the most cerebral pundits tell us that low interest rates mean that future corporate cashflows are worth more in today’s money because we can look far into the future without heavily discounting them. They tell us that these high stock prices are now mathematically justified (failing to mention that this logic relies on corporate cashflows both not seeing large declines and on us correctly forecasting them into an ever more distant future).

It is not just pundits who are telling us to have no fear. The speaker of the US House of Representatives, Nancy Pelosi, went so far as to say “But let’s just go to the heart of the matter: the stock market, there is a floor there.  You know that the Fed and others are pounding away to minimize the risk in the stock market, and that’s a good thing.”

Perhaps all that is left is for the government to pass legislation to mandate that stock prices must always go up?

It is thus we are in an environment where the “fear of missing out” seems to be the dominant risk for many in the markets. This thought leaves me wanting to get my shoes shined – in the hope of having my own Joe Kennedy moment. I am yet to find a shoeshine boy (or girl) where I live in rural Oxfordshire and have not had any more luck in the streets around our Marylebone office. Perhaps the twenty first century equivalent is watching “Bar Stool Dave” on YouTube?

Am I foretelling an imminent crash in markets? I am not – that type of punditry is not for me. What I do see is that there appears to be an absence of risk aversion in markets that I believe can lull investors into a false sense of security, which increases the risk of unpleasant surprises. As a “card carrying” value investor I believe that no matter how great a business is, it will only make for a great investment at the right price and that the fear of missing out encourages people to invest at any price.

The value-growth debate is now long in the tooth. We have seen a decade of growth-style investors outperforming their value-brethren, and so proclamations from the latter “sore losers” that “the end is nye” for growth quite reasonably fall on many deaf ears.

My view is that the meaning of value investing has been hijacked by a narrow definition of buying companies based solely on a low price-to-book, or price-to-something-else, ratio. From this narrow definition it then follows that any company which is not classified as “value” must therefore be “growth”. Clearly putting 40,000 companies into one of two groups based on just a few numbers is only ever going to provide limited insight.

What value investing means to me is having an opinion about what something is worth based on its underlying economics. If you are not doing this, I believe that you are speculating, not investing. A true value investor will buy a growing business, if she believes it is worth more than she is paying for it. Expecting growth is one way that that you can justify paying more upfront.

I believe that the composition of “growth” and “value” indices increasingly now provides a window onto a popularity contest more than anything else. The widely owned “growth” companies, such as the US technology giants, clearly have business models that are robust to the current crisis and potentially benefit from longer term trends – meaning that owning them feels comfortable. By contrast “value” holdings typically have business models that are cyclical in nature and at worst are threatened by longer term trends. Owning these companies is uncomfortable by comparison. The key question is the extent to which prices reflect these concerns?

The MSCI World Growth Index now has an “off the chart” price to earnings ratio that means that its constituents look very expensive with respect to history. It is the rapidity with which this has happened that makes me believe that the “fear of missing out” has taken hold. By comparison, the Value Index has seen a more muted recovery from its crisis low point.

There are reasons to believe that the world is changing and there are arguments as to why this latest bout of market “FOMO” might not be a bubble. As the most popular companies become ever more expensive verses their economics, so I believe the risk of ownership increases. If this resonates then I suggest that the real risk of “missing out” is that of not having sufficient “value” exposure should the popularity contest reverse. Might it even be that investors are rewarded for the discomfort of owning cyclical businesses in the years ahead?

Much ink has been spilled on the relative merits of “growth” verses “value” stocks. As there are around 90,000 public companies classifying them into one of two groups is, by necessity, always going to be a little vague! So much so, that I wonder if these labels convey as much meaning as many assume? Our ideal investment would represent both good value and have good growth prospects.

What follows is a tale of two businesses that for now I shall call “Company A” and “Company B”. We are shareholders in one of these businesses, but not the other, and the story is intended to show you what we look for in an investment. Company A makes Windows whilst Company B makes ploughs.

Company A has a history of making high profits, but with the passage of time their business has become more “asset intensive” – they need more “stuff” to turn a profit. Company B has been comparatively much less profitable but improving. Despite Company A’s magnanimous past, the companies now look to deliver similar levels of profitability from this perspective. This can be seen in the chart below that shows historic profits as a percentage of the value of assets used in each business (for anyone schooled in accounting, you will recognise this as the “return on assets” ratio).

Source: Havelock London calculations using Bloomberg data.

In recent history Company A has been increasing their borrowings, whilst Company B has reduced theirs. The falling profitability of Company A’s underlying business has, in part, been compensated for by their increased use of leverage. By the opposite token Company B has decided to decrease their leverage. This is illustrated in the next chart that shows the size of each company’s liabilities, relative to the amount of shareholder equity they employ.

Source: Havelock London calculations using Bloomberg data.

In the last decade Company A has paid out almost all their profits in dividends and share buybacks whilst funding their growing asset base with leverage. By the opposite token Company B has reinvested more than half their profits back into growing their business. Company A has seen much higher revenue growth than Company B but the same is not true of their earnings growth. (I calculated this by looking at total profits in the last ten years, relative to the ten years prior. This avoids one extreme year causing a wonky reading and smooths out the impact of earnings volatility.)

Last Ten Years	Company A	Company B
Profits Reinvested	4%	59%
Revenue Growth	115%	45%
Profits Growth[1]	95%	141%

Source: Havelock London calculations using Bloomberg data.

The final piece of the story is a chart of the price to book ratios of the two companies. Company A has commanded a distinct premium valuation in comparison to Company B. This was well justified for much of history because their underlying business was so much more profitable, as illustrated by their superior return on assets. As of 2019 the two companies have more similar levels of underlying profitability, but we have seen that Company A has leveraged these returns by making much greater use of leverage. Company B on the other hand has reduced their use of leverage.

Source: Havelock London calculations using Bloomberg data.

Company A has a price to earnings ratio of 36.4 and Company B 12.6, so simplistically A is three times as expensive to buy as B. By most accepted definitions Company A is classified as a “growth” stock, whilst Company B is classified as “value”.

Company A is a truly great business, but we would not invest in it at the current high valuation. We invested in Company B because of its respectable and improving profitability, its low leverage, and its reasonable valuation. On top of this the “value stock”, Company B, has seen as good levels of earnings growth in the last ten years as the “growth stock” that is Company A. Clearly, the shortcoming of this exercise is that I am looking at the past, not what is expected in the future. Likewise, Company B’s earnings have been more volatile. Nonetheless it gives me pause for thought on the use of “value” and “growth” labels and if this wide disparity in valuations is justified.

For anyone that has made it this far your reward is to know that Company A is called Microsoft (I told you that they made Windows). As Company B is not one of our top 10 holdings, we do not disclose its name.

I do not know if Microsoft will have higher or lower future earnings growth than the industrial company that we have invested in. That was not the point I wished to make. My message is that I believe that the labels of “growth” and “value” are a poor substitute for proper analysis and may not be as descriptive as they first appear. In this case the “tech” business looks to be as asset intensive as the industrial one, with similar levels of long-term profits growth. Furthermore, a great business, such as Microsoft, will only make for a great investment at the “right” price. The more an investment is seen as a “sure thing”, and the higher the price moves, the lower the chances of the price being “right”.

---

[1] Measured based on total profits in the last ten years, relative to total profits in the prior ten years.

The economic shutdown that we are living through is without precedent in modern history. The US unemployment rate has moved in a matter of weeks to 15.7%, the highest it has been since 1940. In the UK 27% of the nation’s workforce have been furloughed. Once the full impact of the shutdown is reflected GDP falls are expected to exceed anything that we have seen in living memory. This is set against world debt at an already high level of $253 trillion, or a surprising $33,000 for every man, woman, and child who inhabit our small planet.

Governments and central banks have acted to socialise the cost of the pandemic shutdown, shouldering much of the financial burden that would otherwise have fallen on businesses and individuals. This is analogous to the way we socialise the cost of firefighting, whereby we collectively pay for a service that will try to save your home from burning without first needing the swipe of a credit card.

It remains highly uncertain as to when the flames of the pandemic will be judged to be extinguished and what lasting economic damage there will be. I believe that until we have more scientific certainty around the characteristics of the virus and the potential for vaccines or immunity, no one can know what the immediate future looks like for the economy. State support during the pandemic has taken many forms, financed by massive increases in Government debt. Central banks have been using newly “printed” money to purchase much of this debt, alongside the debt of private companies that otherwise would have struggled to find willing lenders. The motivation of these efforts is to limit lasting economic damage.

The reaction of stock market participants in the face of this support has been for the world’s major indices to recover much of their lost ground with the prices of companies perceived to be insulated from the crisis moving back towards earlier levels. Furthermore, rock-bottom interest rates are cited as a catalyst for investors wanting to park their money in stock markets as the alternatives look distinctly unrewarding. The question that I think investors need to ask is who will likely pay the bill for fighting the pandemic?

Historically a rapid expansion of government debt is, ultimately, followed by either repayment or default. Repayment comes from a combination of raising revenue and shrinking the size of the debt via inflation (arguably repayment can be indefinitely delayed but this is a form of default). I presume that the world’s major economies are borrowing with the intent of repayment, and with low growth rates there will be pressure to either cut spending, increase taxes, or create inflation in the years ahead.

In my opinion the use of printed money to fund the bailout increases the risk of inflation as there is a historical precedent of this being the case. In recent history we have seen low inflation according to measures across baskets of goods and services, but high levels of asset price inflation. I believe that globalisation and offshoring to countries with cheap labour costs has been a major driver of this trend. If global tensions continue to rise, there is a risk that this dynamic may change.

I believe that we are already seeing the early stages of the argument over who should pay play out on the international stage. Examples of this are the spat between Germany and the ECB, as well as the rising tension between the USA and China. I think that in due course we will also see such arguments taking place within countries. I believe that the austerity measures and tax cuts that followed the last crisis will not be palatable second time around and that there will be pressure to raise taxes.

I am not a believer in making macro-economic forecasts and I do not know what the future will hold. However, I believe that investors need to be mindful of what could happen, especially where it would be a break from recent history. I want to ensure that our portfolio will be robust to a range of different possible scenarios. The narrative above is motivated to explain that I think there is an increased risk of inflation, anti-global sentiment, and rising corporate taxes.

I fear that the rapidity of the stock market “recovery” underestimates the chances of lasting economic damage, but more strongly believe that it ignores the risk that the corporate “winners” from this crisis will be called on to help pay the bill. I think that after the previous financial crisis much of society has a limited appetite for “privatised gains” and “socialised losses”. To this end I think that we will see a renewed interest in “digital taxes” on technology company profits.

What are we doing in response to these concerns?

I do not believe that there is a silver bullet answer, but I am proceeding with the assumption that we are still only seeing “Act 1” of this crisis, with the recent price falls hinting that “Act 2” might be about to begin. I am cautious about viewing the companies that are immediate “winners” of the crisis as being a sound investment at any price, especially if they “win” at the expense of other parts of the economy.

I have been spending time looking at each of the companies that we own, questioning if our original investment hypothesis has been superseded by the events of the crisis. Are there assumptions that once looked reasonable that now look optimistic? I believe that it is imperative to find the middle ground between panic and wishful thinking when evaluating a company’s prospects.

I believe that a strong balance sheet is now more important than ever and have been focusing more attention on the most highly leveraged companies in our portfolio. I have also been able to lean on our valuation models, with those companies that show up as looking very cheap or very expensive warranting more attention. The net impact of this is that we have undertaken a higher than normal level of “rotation” within our portfolio, exiting the holdings of companies where we think our investment thesis is damaged and increasing holdings where we have conviction that we see good value without undue risk.

I wish I could offer our investors more certainty at a time like this. My conviction is that remaining true to our philosophy of long-term value-oriented investing will make for the best possible chance of us doing a good job in navigating this crisis.

There is no single definition of value investing, but according to many broad definitions it has seen a long period of underperformance relative to “growth” oriented investing. There is a wealth of information available elsewhere on this topic, but I finish with a chart that shows the relative performance of “value” and “growth” factor portfolios over almost the last 90 years. Such “back tested” results need to be treated with caution, but it shows that “value” has outperformed for much of the last century but had a record under performance in the last ten years. I believe that history is on the side of the value investor and that a reversal of this recent underperformance has the potential to create a tailwind for us in the years ahead.

Any readers who have made it this far may still be left asking what a root fire is?

“A root fire is a fire that burns underground along the root system of a tree. It’s a very dangerous form of fire because the fire can smoulder for months underground, long after the surface part of the fire has been extinguished.”

Given the threat of subsequent virus peaks we thought it an apt title!

In the meantime, I hope you and your families remain in good health.

Matthew Beddall

References:

UK Furlough https://www.ons.gov.uk/employmentandlabourmarket/peopleinwork/employmentandemployeetypes/articles/furloughingofworkersacrossukbusinesses/23march2020to5april2020

US Unemployment https://www.bls.gov/web/empsit/cpseea10.htm https://www.thebalance.com/unemployment-rate-by-year-3305506

Global debt https://www.iif.com/Portals/0/Files/content/Global%20Debt%20Monitor_January2020_vf.pdf

The COVID-19 pandemic poses a clear threat to human life and the global economy. The leaders of countries across the globe are having to act rapidly to fight both threats, with measures that are unheard of in living memory. One-by-one countries have been closing borders and forcing citizens to stay at home, leading to an overnight halt in economic activity.

This has, of course, led to a rapid change of sentiment in financial markets, as participants struggle to comprehend the implications and become fearful of losing money. This will, undoubtedly, be viewed as a major turning point in economic history. Such changes of sentiment are, in my opinion, rarely predictable, but the fact that they will occur is to be expected. In the investor update I wrote in January I said:

I believe that the actions of very many investors are guided by how real the fear of losing money appears, and that this fear will be the most likely catalyst of falling asset prices in the future. Put simply, I do not think low central bank interest rates, alone, provide a guarantee that asset prices must keep moving higher. If the fear of losing money becomes more real for investors, I believe that it will become a more powerful force in markets than the actions of central bankers.

I could not have foreseen just how prescient these words would appear. So far, the actions of central banks have struggled to stem the tide of negative sentiment that is ripping through markets. This is, not least, because cuts in interest rates do nothing to protect their citizens’ health. I wrote this paragraph because, as a valuation-driven investor, I believed that markets were “priced for perfection”. It is from this starting point that the elephants have been stampeding for the exits of financial markets.

What is an investor to do next?

At times like these I believe that the interests of a long-term investor are best served by holding your nerve and not succumbing to panic. Furthermore, I believe that the panic of others creates the seed of opportunity for those investors who can be calmly analytical in their decision making.

Our approach to being analytical is to estimate what we think companies are worth based on their ability to generate future profits and the assets that they currently own (after taking account of all liabilities). This places us firmly in the school of “value investing”. It means that we look to avoid “jam tomorrow” opportunities, where a high price relative to the economics of a business is only justified on an expectation of a rosy future.

Although we do not attempt to predict when a company will have a bad year, our valuations are absolutely based on an expectation that they will periodically occur. Right now, I believe that the biggest threat will come to those companies that have weak balance sheets, where the burden of high debts leaves less room to cope with short term surprises.

It is almost certain that all the companies that we invest in will, in the short term, see a fall in their earnings as a result of the pandemic. But our rationale for owning them means the prospect of a bad year does not cause us immediate concern. For those companies that we judged to be most threatened by current events, we instigated reviews to content ourselves that they have the balance sheet strength to weather a protracted storm, and still be around for the long-term.

We entered 2020 with substantial holdings of cash and fixed income in the fund, both to provide dry powder and to offset the risk from a number of our holdings that we believed to have a higher-than-average sensitivity to fall in price during a general panic. This has allowed us to act as a “fire sale” buyer travelling in the opposite direction to the herd, albeit making sure not to act too eagerly in what may prove to be a multi-year depression in stock prices.

I do not know what will happen in markets in the coming weeks and months as the reality of the coronavirus pandemic unfolds. However, I believe that the virus is unlikely to meaningfully impact the long-term ability of the companies that we invest in to generate profits.

Governments around the world look set to increase their borrowings, financed in part by central banks “printing money”. For this reason, I believe that the apparent safe harbour of holding cash may prove to be an illusion over the longer term. I am not an economist, but history suggests that when the money printing presses are running over-time, the cash in your pocket will buy less owing to an increase in inflation. I believe, that owning a slice of the “real economy” via part-shares of well-run businesses, provides protection against this threat.

As the largest single investor in the fund I shall be standing shoulder-to-shoulder with our investors. If market prices continue their fall, then we will use it as an opportunity to deploy the fund’s stash of dry powder, cautiously increasing holdings of public companies. This forms part of a core belief that to be a superior investor you must often travel in the opposite (and uncomfortable) direction of the crowd.

In the meantime, I wish that you, and your families, keep healthy in the face of the very real human threat that is posed by COVID-19.

It is with great pride that I look back on the first year of the LF Havelock Global Select Fund’s life. In this time there have been two distinct phases of performance. Firstly, a wave of negative sentiment sent a chill through equity markets in the autumn of 2018, with falling prices leading to negative performance. These concerns melted away during 2019, with a buoyant mood driving equity prices higher and helping the fund recover its losses and make new highs.

The fund was well placed to weather the storms at the end of last year, owing to the amount of dry powder it held in the form of cash and government bonds. This was determined by us having conservatively set the “volume control” which drives how capital is invested into company shares. We made this decision because market valuations were high relative to history, and in the belief that our opportunities for investment were likely to improve. The combination of prices generally falling, and us completing further new investment research, led us to increase the volume control, which increased the fund’s holdings of equities in time to benefit from the general uplift in markets.

The US economy has experienced its longest period of economic expansion on record. A widespread belief that central banks will support markets if the world’s major economies contract, has led many investors to be complacent about the risk of financial loss and helped push stock markets to new highs. This rising tide lifted all ships, and so contributed to the fund’s positive performance in the first half of 2019.

The chart below shows the Shiller PE ratio, which is the ratio of prices to average earnings in the last 10 years for companies in the S&P 500 index. This metric has been widely touted as evidence for why valuations are at worryingly high levels, with current low interest rates forming the major defence of why such high valuations can be sustained.

Our own analysis suggests that valuations have become even more stretched for the most expensive stocks. To rank as one of the ten percent of most expensive US companies it currently requires a price earnings ratio above 60. At no point during our 60-year study, including during the dot-com boom, was this higher. It follows that many market participants are willing to pay a hefty premium for high quality or high revenue “growth” companies, in the belief that future profits will give them “jam tomorrow”. This bears some resemblance to the so-called Nifty-Fifty stock market boom of the late 1960s and early 1970s, where a bubble emerged amongst a small and concentrated group of large companies.

The narratives used to justify current high valuations both generally and with respect to high growth and high-quality companies have hallmarks of “this time it is different” about them. The risk to asset owners is that the world cannot sustain a low-interest rate, low-inflation and high profit growth environment, and that something must “give”. Furthermore, the Nifty-Fifty stock market boom provides some cautionary lessons on the risk of investors’ believing that valuations cease to matter for the “best” companies.

In the short-term the fund’s performance will be impacted by the sentiment of others in the markets, but in the longer term we believe that it will be driven by the performance of the businesses that we choose to buy. Our twin lines of defence against the current risks we see is to continue to hold some dry-powder, and only own stakes in sound businesses where undue optimism is not required to justify their purchase price. With hindsight an all-out bet on high-growth companies would have been more profitable than our own cautious stance so far in 2019, but our resolve to maintain our approach is, nonetheless, unchanged.

We believe that the current high tide is unlikely to never recede, but we cannot predict when it might turn or how far out it might travel. We move forward into the remainder of the year in the belief that our investment approach will leave our ship well placed to weather future storms.

Footnotes

[1] Data courtesy of Prof Robert Shiller (http://www.econ.yale.edu/~shiller)

Important information

Please ensure you have read this important information. The value of investments in LF Havelock Global Select may fall as well as rise. Investors may not get back the amount they originally invested. Investments will also be affected by currency fluctuations if made from a currency other than the fund’s base currency. Past performance is not a reliable indicator of future results. Potential investors should not use this website as the basis of an investment decision. Decisions to invest in LF Havelock Global Select should be informed only by the fund’s Key Investor Information Document (KIID) and prospectus. Potential investors should carefully consider the risks described in those documents and, if required, consult a financial adviser before deciding to invest. LF Havelock Global Select can invest more than 35% of its value in securities issued or guaranteed by an EEA state listed in the prospectus. The KIID and prospectus are available in English from this website and from Link Fund Solutions.

This website is not intended for any person in the United States. None of Havelock London’s services or related funds is registered under the US Investment Company Act of 1940 or the US Securities Act of 1933. This material is not an offer to sell or solicitation of offers to buy securities or investment services to or from any US person.