Commentary

As 2020 draws to a close I find myself looking back and reflecting.

Despite being a year unlike any other in living memory, “Santa Baby” looks likely to deliver many investors a gift that they could not have imagined during the early stages of the crisis – profits. He has been helped by the Central Banks elves who both lowered interest rates and bought assets with freshly printed money.

The elves’ generosity means that stock market investors have received three distinct gifts:

• Low interest rates which make owning shares in a company more attractive, as the dividends they pay look increasingly appealing.
• Low interest rates which reduce a company’s cost of making debt interest payments, leaving more of their revenue in the pockets of shareholders.
• Newly printed money for bond purchases which decreased their supply and in turn left investors with fewer alternatives to owning shares.

We go into 2021 with the world’s major economies having seen record falls in GDP, yet with financial markets reaching for new highs. The three reasons above provide some of the strongest justifications for not worrying that market valuations look high with respect to history.

So, if interest rates are set to stay low, what have we got to worry about?

The financial burden of the pandemic has been shouldered by Governments, meaning they have become increasingly indebted. This is set against a backdrop of falling corporate tax rates reducing Government revenue. This is illustrated in the chart below that shows average corporate tax rates for G10 countries together with the ratio of government debt to GDP. It is a picture that speaks for itself.

The cost of stimulus cheques and job support schemes have been, and are still being, funded centrally. At the same time asset owners by-and-large are having their cake and eating it. It seems that Governments are “socialising” losses and “privatising” gains, funded by the gift of printed money. This, intuitively, troubles me. Whilst I enjoy a free lunch, like many observers, I feel that something must eventually give.

Given the current economic fallout there are many people who will go into the new year facing unemployment or frozen pay. For them, this years’ political and economic support for asset owners will seem unjust. My message for any investor fixating on this year’s gifts is that Governments might yet decide that it is not better to give than receive.

If Governments find that they cannot borrow endlessly they will be under pressure to plug their financial holes and asking asset owners to help, via increased taxes, seems like a distinct possibility. Whilst low interest rates justify higher market valuations, higher tax rates will have the exact opposite effect. I believe many investors are relying on the former whilst ignoring the latter.

What does this all mean?

For us, we proceed with caution in the belief that market valuations that look high with respect to history present a risk. Whilst there are reasons for it to persist, we see pressures building in society that could threaten the status quo. To this end we will continue to strive to own a portfolio that will be robust in a range of future scenarios.

On behalf of Neil and myself I will end by saying thank you to all our supporters. In the words of the song, I hope that Santa Baby hurries down your chimney. Even if he does not bring you a yacht, duplex, outer space convertible or deeds to a platinum mine, I hope you at least get a nice pair of socks!

‘The four most expensive words in the English language are: ‘This time it’s different.’’

Sir John Templeton.

Amid another lockdown here in the UK, we must all look for new ways of entertaining ourselves at home. In a clear sign of lack of imagination, my source of extracurricular entertainment this week was to revisit the “Nifty Fifty” stock market boom of the 1970s.

The, so called, Nifty Fifty were a group of popular “Blue Chip” companies where there was a widely held belief that their solid prospects meant that they were “one decision” investments to be bought, and held, at any price. The stock market crash of 1973 and 74 made owning these companies suddenly seem less comfortable. There has been much debate as to whether their lofty valuations were justified, or if it was a speculative bubble. Either way, many investors who purchased shares at high prices had to endure a wait of five, or more, years to recoup their losses.

The enthusiasm we currently see for large “growth” companies is, to me, eerily reminiscent of the early 1970s. This is illustrated in the chart below, that compares price earnings ratios of the Nifty Fifty companies in 1972 to the 50 largest US growth companies today.

Does this imply that these businesses are overvalued? I wish I knew. What I do know is that “value investors”, like me, avoid businesses where the purchase price requires undue optimism about the company’s future. The more expensive an investment is relative to its underlying economics, the greater the risk of future disappointment. I would suggest that this is not the right moment to make an all-in bet on this time being different and that value investors, like us, could offer some diversification if today’s Nifty Fifty were to disappoint.

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”.

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[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