Commentary

There continued to be a buoyant mood in markets in Q4 – helped by the positive clinical results, and subsequent approval, of several vaccines for COVID-19. This was despite many northern hemisphere countries facing substantial “second waves” of infections.

Following the announcement of the Pfizer vaccine trials on 9^th November many companies perceived to be most impacted by the pandemic saw large share price gains. By way of example one of our portfolio companies, Host Hotels, saw its share price increase by 30% in a single day. I believe that the link between company share prices and their underlying business conditions is often “fuzzy”, and market moves such as this only serve to reinforce this belief. Whilst the vaccine news is undoubtedly positive, for many such companies I thought the size of the reaction was disproportionate. It felt that many market participants were rushing “from one side of the boat to the other” to buy up companies that would benefit from a return to normality.

Observing markets in the last year has, more generally, served to strengthen my belief that short-term price movements are dominated by emotion more than detailed analysis. It has felt that the link between “Wall Street” and “Main Street” has become particularly stretched (not that the history books suggest they have ever moved in lockstep).

My conviction that there is a risk of an asset price bubble has strengthened over the last three months. I believe that this bubble is particularly focused in the US on companies that are perceived to be “high growth” or have dominant technology franchises.

What is the case for us witnessing a bubble?

• The total value of all public US companies relative to US GDP is “off the charts” with a ratio of 1.9x. During the “dot com bubble” this ratio peaked at 1.4x[1]. This is a metric favoured by the famed investor, Warren Buffett, and is at the highest it has been in 50 years. The extent to which this ratio has “spiked” in the last two years gives me cause for concern.

• There has been a frenzy of companies raising capital on the public markets. Much of this activity has been via “Special Purpose Acquisition Companies” (SPACs) – which are a way of raising money from investors with less scrutiny than a traditional Initial Public Offering (IPO). It is the first year in history that US companies have raised more than $100Bn in IPOs, with more companies having been made public than at any point in the last 20 years.[1]
• From a “bottom-up” vantage point the valuation of companies such as Tesla or Nikola look, to my eyes, hard to justify. The ascent in Tesla’s share price has been so rapid that it appears, to me, to have the hallmarks of a speculative mania. The company has a market share of global car sales of circa 0.7%, but it is now worth more than the combined value of its eight largest competitors[2]. For a discussion of Nikola see my last quarterly letter.
• There exists a compelling “this time it is different” story. The cornerstone of this is low interest rates and very “accommodative” monetary policy, that pushes investors to justify paying higher prices for assets in the search for yield. There appears to be an acceptance that interest rates will be low for a long time into the future, that Central Banks will support asset prices and that this can be achieved without any other adverse economic consequences.
• There appears to be a growing public euphoria for share trading. Google Trends data[3] for North America shows that google searches for “share” during 2020 have been higher than at any point since 2004 when the data begins. Bubbles are always accompanied by stories of making “easy money” that stoke up a “fear of missing out”. I believe that podcasts, YouTube channels and such like are providing the means to disseminate these stories and encourage retail speculators.
• Whilst more difficult to quantify, it appears that sentiment in the markets is not being impacted by bad news in the way that might be expected. A bad unemployment number or surge in virus cases seems to be taken as a sign that there will be more stimulus – which will be good for markets. By the opposite token good news that is positive for the economy is also taken as good for markets. I do not see how this can continue and am concerned that many investors are being lulled into a false sense of security by the “heads I win, tails you lose” environment.

What about the opposing view?

For each of my points above there is an opposing view.

• There is no fixed law governing the overall size of the US stock market relative to the general economy.
• The frenzy of IPOs could be rationalised by the continued move to a digital economy creating many new worthwhile investment opportunities.
• Companies, such as Tesla, could be argued to have such strong technological advantages that they offer sufficiently high long term future growth to justify their current valuations.
• Low interest rates could remain for many years and, despite the massive monetary expansion, may be accompanied by economic stability – for reasons that may not be obvious.
• The public enthusiasm for stock markets could turn out to be not such a big deal, or perhaps a rational consequence of more individual pension saving or even a lack of any other worthwhile investment options in their view.
• We could be at the cusp of a continued disruptive technological revolution, meaning that the prospects for the future are great irrespective of the minutiae of 2020.

I think it will be clear which side of the debate I lean towards. When I look at the evidence collectively, I believe that there is a real risk that we are seeing a bubble in some asset prices.

What are you going to do about it?

Our approach to protecting our client’s money from this threat is two-fold:

• We look to own relatively lowly-leveraged public companies, where valuations do not rely on an undue level of optimism. Our approach keeps us away from owning companies where high valuations can only be justified by forecasts of their businesses seeing high growth for a long time into the future.
• We currently hold a fraction of the fund in cash, both as a form of risk control, limiting the fund’s exposure to falling equity prices, and a source of dry powder that can be quickly deployed when risk aversion increases in markets.

It is my belief that forcing yourself to be fully invested in equities is like tying one hand behind your back when it comes to managing the risk of financial loss. It means that your risk of losing money is entirely determined by your choice of investments, without any other way to make this risk stable through time. We believe that if our risk of financial loss is consistent through time it will in turn help increase our long-term compound return.

Our investment mantra is that we wish to own a portfolio that will be robust in a range of scenarios. This is because there are many factors in financial markets that we cannot realistically expect to forecast. This balanced approach has served us well since we launched the fund, but risks making us, at times, look needlessly cautious. In the scenario that financial markets are not adequately reflecting the economic impact of the pandemic, I think this caution will be justified.

Despite my concerns of an asset price bubble, I see evidence that there are many companies that do not require optimistic forecasts to justify their current prices. Increases in market prices have not been unilateral for all companies. For this reason, I believe that a valuation focused approach to investing offers both an opportunity for profits and a way of side-stepping the most egregious speculative excess.

---

[1] https://www.bakermckenzie.com/en/newsroom/2020/12/ipo-report-2020

[2] https://wolfstreet.com/2021/01/02/tesla-finally-almost-hit-500000-deliveries-2-years-behind-its-2016-promise-for-a-global-market-share-of-0-7/

[3] https://trends.google.com/trends/explore?date=all&geo=US&q=shares

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”.

---

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