Lessons from America

The authors of the content on this page from Sept 2012 to June 2017 are:
Market Commentaries: Gary Paulin, Ameet Patel, Paul Moran, Douglas Morton, Oliver Sherman, Ben Brownette, Rob Arnott, James Santo, Neil Campling
Research: Ameet Patel, Paul Moran, Douglas Morton, Oliver Sherman, Rob Arnott, Neil Campling

I have been marketing/seeing clients in the US this week. It’s always insightful, for me at least, to observe the US investor base. Given its size, it can meaningfully impact all assets globally and so it’s always interesting to get a sense of what they are thinking, how they are positioned, what they own and importantly what they don’t, which, it seems is Europe, especially her Banks. In Q1, it was China and Miners. –just saying.

Below are a few highlights of the discussion points with some of my own comments. Feel free to call me if you wish to expand on any.

On Rates – clear change in thinking

We sensed a clear change in thinking on the ‘direction’ of rates. While they don’t see the absolute levels rising much, the market is hyper-sensitive to ‘any’ movement, and so it’s the delta relative to positioning that they are most focused on. Rates may only need to move from the absurd to less absurd for correlations to fall and dispersion to rise (bring on the taper-tantrum I say!). We have been discussing this point for some weeks. The main driver is ideological, namely a change in the debate as to the appropriateness of NIRP/ZIRP. The BIS, the central bank of central banks, believes it could do more harm than good. We have seen the Japanese acknowledge, for the first time, the importance of banks to the transmission of money and are pursuing policy to steepen the curve. With similar intent (we presume) the Europeans trialled a taper-tantrum some weeks ago and the US seems almost certain to raise rates this year. Implicit in this is a re-focusing away from the balance sheet of the system, to the P&L; less about the stock of money, more its velocity which is where banks play a role. A move to fiscal spending adds support, and to us looks likely to be coming at least in the US, probably the UK and is ongoing in China. What’s more, there seems to be some implied abandonment of fiscal rectitude, even from the guardians of such, the Germans. More on this below.

On quality and yield

It seems most of our competitors are saying this is it for bonds, and by extension, the bond-like. The 35 year party in fixed returns is over because QE has reached its zero bounds and oil prices are going up. Notwithstanding the fact the broker community was saying the same in 2014, we have sympathy with the logic although we believe it’s too simplistic to just sell all QE winners (growth, quality, dividend) and buy the losers (value cyclicals). It’s just never that simple in our view. We stay balanced, avoid semantic and remember there is seldom a substitute for good stock picking. Indeed, certain compounders are making record highs (we discuss one at length below) and some value cyclicals have enough cost control they too can compound (the mathematics of which don’t end just because rates go up). To us Europe doesn’t suffer the concentration of risks like the US does (we believe there are less factor-based ETFs) and while QE may be ending, the other drivers of yield – demographics, technological disruption and regulation – haven’t disappeared overnight. Rates higher, but not by much.

On irrational markets and solvency

We think few argue with the absurdity of NIRP/ZIRP. It’s irrational, economically speaking. But as one thoughtful and experienced investor reminded me, quoting Keynes and citing Japan, “Gary, the markets can stay irrational far longer than you can remain solvent. I remember broking Japan in ’86, and we all knew it was a bubble then, and yet it lasted till the end of the decade. The Nikkei tripled”. Wise words (if you ignore what followed) and yet a part of me thinks Sanofi and Henkel recently raising debt at negative yields is the market equivalent of Tokyo’s Imperial Palace being worth more than California in ’89, just prior to the peak. Stick to equities, the bubble is in bonds we think. [Side note, the keiretsu conglomerates’ practice of cross-holding each others’ shares, reducing supply as a consequence, has some parallels with QE doesn’t it?]

On peak austerity in Germany. Can you be serious?

Germany, the guardian of fiscal rectitude and the most ardent supporter of austerity, has said there is scope to cut taxes by around €15 billion after the country’s federal election in September 2017 despite increased spending on migrants, (Wolfgang Schäuble, September 6). Not only that but they are putting through a national wage hike of 4% come Jan 1, that’s 5x the CPI increase. What on earth is going on? Oh yes, it’s an election year. Self-preservation, it seems, is a powerful tonic even for die-hard enthusiasts of austerity. Either that or they have started to read Bertrand Russel who once said, “I would never die for my belief, in case I was wrong”. We need to take another look at Hugo Boss.

On pain trades and European Banks

Earlier in the year we wondered if our bullish oil views at the time would support the last great pain trade of all – EU banks (note: we closed our China related shorts in Q1 – Oil/Miners etc. – and went long Rio, and oil stocks; Atlas Copco, Intertek etc. were already QCC names). While the real-asset part of the reflation worked, the sentiment part, banks,  did not, until recently. As we often discuss, extreme positioning combined with change, albeit subtle or even in the second derivative, can we think be enough for mean reversion to play its part and rally the things few own, aka the pain-trade. Currently we think that clearly applies to banks, and while we struggle to ‘invest’ in many save for those in consolidated markets like The Netherlands (ABN/ING) we do think tactically banks, especially the more quality franchises, might continue to rally into year end, which would be consistent with the market’s behaviour all year – to illicit maximum pain on maximum number of investors.

On supra-national bailouts of national banks

One could be forgiven for thinking the change in tone from the EU is a veiled attempt to prevent Deutsche Bank from being pushed into the hands of the German government (a step too far). As most agreed, DBK doesn’t have a balance sheet issue as much as a P&L one, they simply have been unable to ‘earn their way out’. With that in mind, it seems somewhat convenient that the same week DBK is on the ropes the EU launches a taper trial balloon (with the effect of lifting rates), and now there is talk of the EU softening the stable-funding rule in 2018, at least as it impacts on trading in derivatives. And who would benefit from lower funding costs for derivative transactions? Deutsche Bank. Whether this is a bail-out of sorts or simply acknowledgement that banks matter, the subtle change in rhetoric from obsessing over prevention (of another crisis) to growth (lending) is probably worth paying some attention too in our view. Many may dismiss this as hot-air, it’s the EU after-all, an institution not known for proactive or promotional policy. But as regulation has been a key reason to avoid banks these past few years, any change in direction here, however subtle, could impact even if only in the second derivative. And it’s Q4 – see below.

On Q4, beta and performance chasing

Notwithstanding that most of our US clients are very long-term in nature, Q4 performance chasing was a topic raised by some of the hedge-fund clients we met.

Q4 is the time of year most FMs consider performance, and for those that need to catch-up, they can only do so, by definition, in things likely to give ‘bang for buck’, like banks. While there are some hurdles for banks to overcome, the Italian referendum, the Deutsche Bank fines etc., should these things pass, or can you avoid these situations outright, the upside potential could attract a few desperate to improve their numbers.

On Europe

So those who have a choice choose to ignore Europe it seems to us. Indeed, European funds have seen a record 37 straight weeks of outflows, according to BoAML, making Europe and especially her banks, the biggest underweight globally. In contrast, those who have to look at it (based on our discussions), love her companies for it’s home to some of the most durable and successful businesses and brands the world has known. Think Chateau d’Yquem (owned by LVMH) which started in the 17th Century, Hermes (1827), Unilever, Reckitt and so on. Unlike the US these names are not stuffed into ETFs, so we think suffer less from a concentration of style based risks. Some US investors also seem to see huge opportunity at the stock level given capacity withdrawal from both sides of the market; and if there ever is growth then such has been the cost rationalisation that real operating leverage should drive earnings growth. That sort of optionality has a number of asset owners considering it, despite the flow-data and media rhetoric to the contrary. The issue some face however, is were they ever to deploy significant capital to the region, there are limited ways of doing so. The message here is, get your marketers on a plane.

On process

While the trends towards passive investing remain, we heard of a few owners looking to return to active management, cognisant of the limitations quant funds have to a change in drivers absent of any qualitative overlay that asks “what if…”. What’s interesting is those who are thinking like this are not interrogating performance as much as process,  to them it’s process that wins prizes. So be ready to define yours and have it available when asked. Clue: keep it simple.

On the arbitrage of time

If there is still one big arbitrage in markets, it is time in our view. Those with it sit in an enviable position to those without it. They can buy what they like from those selling what they can. US investors are happy to take 5-10 year views. Why? Because many are paid on long-term performance measures (incentives define behaviour). Indeed ‘long term’ seems to be becoming a bit of a theme; many we met in the US are looking at global markets through such a lens, at least they say they are. What this means is great companies should always have a bid for them. The key is to define a great company, one that will endure ‘change’.

On change and buying great companies

We view the two biggest drivers of change as being technology and demographics. Investors are being forced to ask what a business will look like in 10 years’ time. Will it continue to exist, and still defy the rule of mean reversion? Or will it be disrupted by technology (software is eating the world), or rendered obsolete by changing demographics (millennials want to share, not own). The experience of Novo Nordisk is putting into question a lot of this thinking, but I think it’s important not to extrapolate a general theme from a small sample size (NB: we had removed Novo from our basket some weeks prior to this warning). Our QCC basket, for example, is a portfolio of stocks we think are great companies per our definition. They fit different and diverse categories, although none is a bond proxy in a classic sense (given they all grow their cash-returns and many have pricing power). Yes, some are defensive – Unilever is there for example, so too is BATS, Orion etc. But some also serve end markets that have cyclical drivers, like Atlas Copco, Nokian and Geberit, but what they share and what should not be impacted by rising rates, is they generate cash, and have history in reinvesting that cash at high-rates of return, which compounds over time. In other words, you can find other people’s factors in great companies. We prefer to own these.

Quote of the week

Passive investing is un-American because you can’t ‘win’ with the average“.

On passive vs active investing

There was a lot of discussion on this topic. Aside from the quote above, an interesting anecdotal comment was that over 30% of the market is passive, another 30% or so are closet trackers, leaving only 40% of the market actively managed in a true alpha-capture sense. Of that 40% there are quite a lot who are outperforming, some are suggesting over half (c.20% of total) meaning if that continues for a time, and rate volatility goes up torpedoing the sleepy low-vol factor based models well owned by retail, the media may need to change their tune and stop bashing the active management industry. Some managers, it seems, are doing what they say on the tin. We need to change the narrative. Wouldn’t that be nice?

On our Autonomous Vehicle primer

With a view to the longer-term, our AV primer received a lot of attention. Many US investors were fascinated by the idea that Google could be about to do to OEMs what Android did to Nokia/Blackberry and open-source their IP. And should a solution be provided to retrofit the current fleet of cars with autonomous features, the car-ownership model could be destroyed much quicker than most envisage. In time, as Doc (Paul Moran) will tell you, the cost of transport could be subsidised by advertising revenues. Note then, Google is discussing this very thing and over the weekend we learned of a Marc Andreessen backed company called Comma.ai which is trying to launch a product to retrofit semi-autonomous features onto certain Honda models. While the regulator requires more testing before its launch, the future has clearly arrived we think. Software is eating the world, and it’s about to eat the auto industry. Stay long the disruptors and the supply chain thereof, the best of which for now is silicon and sensors.

Even STM is up +18% since Neil Campling turned a buyer and added it to his AV Basket. And in our view STM is far from the quality of an Infineon, or a Melexis. NXPI was in the basket, so too ARM. They have both since been taken out. In their absence, buy more STM, IFX, IMG and MELE.

On Novo Nordisk – a cautionary tale

This is what happens when quality goes wrong. It’s fair to say Novo received a fair amount of discussion with investors. It was hotly debated when we last updated the QCC basket in May (a signal all was not right at the time). After further debate (and a warning) we decided to remove it from the basket after a seven year love affair. Lucky we did for it fell another 20% (at one point) last week. But we are angry at ourselves, we should have acted sooner as the warning signs were there. Generally we have been quite good at identifying change, helped no less by Ameet Patel’s Dashboard product which flags where cash and reported returns, for example, are diverging. Without a good explanation for such, the resulting outcomes can be quite dramatic. Over the years this process has (or could have) helped uncover Elekta, Swatch, Pearson, Aryzta, Tesco and more recently Capita, Travis Perkins and Essilor. While we apologise for our lack of process on Novo, we do think the Dashboard can offer a different lens on a business, even one you may know well. If little else, it might help you avoid some of these landmines. Let us know if you would like to see any specific company snapshots, or a even copy of the tool to play with yourself.

On The Netherlands, look through the average to the outliers

We met an investor who had just bought a place in a nice commuter village outside of Amsterdam , paid using 10yr money at 1.6%. Now you probably have to be an EU resident to apply, but assuming you are you can loan up to 80% of the value and in the current market rent it out for c.€5k per month. Do the math. That’s a mouth-watering prospect, with a positive cost to carry an asset that still trades below its peak in 2009 with a free option on Brexit (think returning expats, bankers etc.). Or, you could just buy the banks which have consolidated over the years, ABN/ING. We would also buy NN Group. We think you will hear soon on Delta Lloyd, and should they get it below €6/share, we believe the stock will rally hard.

On scarcity and buying cable assets

With the proliferation of data-intensive content, most US investors agree with our contention that the scarcity value in the chain from content to consumption is the pipe into the home. For us the best, with fastest download speeds, is cable (and note quite a few had never heard of DOCSIS 3.1). Cable assets have historically been good investments in the US, as they put up prices every year and the stocks, at least those still independent, have performed well. But what happens when someone like Drahi comes in and improves service quality, ups pricing AND cuts costs – we think you will want to own Altice, which may ultimately end up as a separate US listing, and so showing commitment now will do you no harm. We would buy more of Telenet as well. These are two of the best non-correlated stock ideas out there, we believe.

And finally, on Partners Group

A €75 billion German pension scheme BVK is shifting its investment mix and strategy to avoid locking in years of negative gains from government bonds (source: FT). Amongst other things will be an increased allocation to private equity and infrastructure, which are viewed as a scarce route to boosting longer term returns and narrowing deficits. It is this kind of thinking from large investors struggling against an unprecedented and skewed investment backdrop that we think will continue to drive institutional flows to illiquid alternatives – a structural tailwind for Partners Group.

Partners Group shares don’t appear to exhibit significant correlation to major style factors – and stock certainly doesn’t seem to behave as a bond proxy (as QCC names often seem to be confused for). What we view as genuinely idiosyncratic industry/stock-specific drivers have led to genuine alpha – and we don’t see those drivers changing any time soon. Exceptional H1 performance reported last month included a significant pick up in performance fee revenues, which management indicated should continue for the near term at least. Given they have said in the past that management fee revenues are sufficient to fund and grow the business and so performance fees can be used for distributions, there is a possibility of a special pay-out on the back of this. And even if not, we are happy to remain buyers at a 3.5% 12M forward FCF yield given the quality of the business and underlying drivers (cf. its domestic government bonds trading at negative yields out to 30 years).