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Cerno Capital has received a Suggestus 3D Award for 2017 from Asset Risk Consultants (ARC). (more…)

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Boutique wealth management firm Cerno Capital is participating in the litigation seeking damages from Volkswagen. (more…)

Cerno Capital supports UK women athletes, explorers and adventurers. (more…)

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This article was first seen on The Mixed Zone – the women’s online sport magazine (more…)

The Women’s Sport Trust #BeAGameChanger Awards 2016 are now open for nominations. (more…)

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Japanese equity, which has been a consistent allocation within our client portfolios since 2011, now stands at a twenty percent weight. Within this allocation, the precise expression has changed over time.

Our approved list provides us with the necessary toolkit to alter allocations in response to changing drivers of the Japanese stock market.

At present, half of our Japanese allocation is to the Lyxor JPX Nikkei 400 tracker.

This ETF is assembled of companies, predominantly large caps, which score favourably on a shareholder value creation ranking. The Japanese equity market is attractively valued and we anticipate further improvement in return on equity (ROE), which currently averages nine percent across the corporate universe.

With his triumvirate of ‘arrows’, Japanese Prime Minister Abe introduced measures to reform corporate governance and refocus corporate attention to the shareholder. These aim to prompt companies to allocate capital more efficiently and target returns on equity above the cost of capital, or to return cash to investors in form of higher dividends and share buybacks.

To encourage companies to adhere to these principles, the Japanese Exchange Group (JPX, world’s third largest bourse operating the Tokyo Exchange amongst others) and Nikkei have jointly created the JPX Nikkei 400 Index. This index explicitly selects companies which focus on the efficient use of capital, specifically referring to ROE, as well as those promoting good corporate governance.

It excludes companies which have been listed for less than three years, have liabilities in excess of assets during any of the past three fiscal years, those which had an operating deficit in all of the past three fiscal years and those which are designated for delisting.

Eligible companies are scored and ranked according to the following criteria:

  1. 3 year average ROE
  2. 3 year cumulative operating profit
  3. Market capitalisation on the base date for selection

Point one and two are each given a weighting of 40% and market cap is only weighted with 20%. In contrast, the TOPIX is a market cap weighted index and the Nikkei 225 is a price weighted index.

To encourage adoption of corporate governance standards, scoring based on qualitative factors is also applied and focuses on the following three items:

  1. Appointment of independent directors (with the requirement of at least 2)
  2. Adoption or scheduled adoption of International Financial Reporting Standards (IFRS)
  3. Disclosure of English earnings information via TDnet (company announcement distributions service in English)

Whilst these features are common in companies listed in the US or Europe, to the majority of Japanese companies, these are rather uncommon features to date, even for some large multinationals.

The 400 highest scoring companies are selected for the index, subject to buffering rules to minimise turnover. Constituents are reviewed once a year in August and companies can be dropped if they no longer comply with the criteria. This is consequential in a country with a shame culture, such as Japan. The index has already been dubbed the ‘Shame Index’.

To compliment this broad exposure, we are invested in two mid to small cap specialists: Polar Capital Japan and Michinori Japan Equity.

James Salter, manager of the Polar Capital Japan fund runs an all cap strategy, but typically with a mid to small cap bias. James’ experience in the Japanese equity market is long standing and he has managed the fund since inception in 2001.

To direct his research efforts, the manager first analyses strategic macro trends, both in a domestic and global context, to establish broad sectoral consequences. The bottom up stock analysis is done with a bias to value and growth characteristics.

Allocations are typically geared towards exporters, financials and cyclicals (or defensives depending on the prevailing environment). Domestic exposure is typically low.

Michinori’s fund manager, Sean Lenihan, has spent the better part of his career focusing on the local Japanese small cap market. He is based in Japan and his language fluency gives him an edge over international fund managers as many of his holdings’ management teams are not equipped to deal with international investors and few of the small cap holdings are covered by analysts.

The manager builds his portfolio entirely from a bottom up basis. He believes the Japanese equity universe offers the value investor companies with strong balance sheets, earnings growth and shareholder focus which provide higher ROE characteristics than the overall market, irrespective of macro influences.

In the recent restructuring of positions, we have split part of our active allocation between the existing Polar Capital Japan fund and the less well known Michinori Japan Equity fund. The reasoning behind this shift is Michinori’s strong domestic exposure versus both the large cap index we hold and the Polar Capital Japan fund.

To give a flavour of the portfolio, 73.5% of the revenues of Michinori’s underlying holdings are domestically derived and those that are international have very little revenue exposure to either China or the emerging markets in general. Investments are focused in companies with good visibility on the outlook for increasing expenditure by customers.

42% of the portfolio is invested in companies with a market cap of below £1.5bn. Noteworthy is the 11% of holdings of companies below £350m. Polar’s small cap exposure currently focuses on the £350m to £1.5bn range.

Commonality between our large cap index tracker, Michinori and Polar is as little as 11% and 12% respectively, as would be expected. However, the overlap between Polar and Michinori is not large either. Less than 10 names are shared in both portfolios. The latter fund has an industrial bias, a higher exposure to technology stocks and puts less weight on financials and materials on a relative basis.

Our allocations across all investments are geared toward companies with sustainable ROE growth and shareholder friendly management. We have modest exposure to consumer staples, healthcare, materials and utilities.

Portfolio construction is also a point of differentiation between the two active managers. Due to the difference in assets under management (Polar Capital Japan manages US$2.8bn and Michinori less than US$150mn), position sizes in the latter are much larger and the portfolio is much more concentrated. Sean Lenihan tends to hold around 35 positions, top ten names make up close to 50% of the portfolio. Polar holds 70 to 100 holdings depending on the prevailing opportunity set.

Having successfully managed the portfolio since 2001, Polar Capital has soft closed the strategy to retain its agility to invest across the entire market cap range. Michinori intends to close the strategy at around £600m to retain its small cap bias.

Although it was a disappointing Ashes Test for England Women at Canterbury last week, Cerno Capital hosted an event to remember on the second day of play at the Spitfire Ground.

A delayed and rainy start to proceedings saw Australia declare for 274-9 before Wallabies star Ellyse Perry took centre stage to see off several English wickets.

In the event box, Cerno were remaining positive about England’s slow start, with members of the investment team and guests celebrating the coverage of women’s Test cricket across TV screens and on the radio, via Sky Sports and Test Match Special.

Former England cricket captain Mike Gatting attended the event day, sharing his thoughts on the Test match and discussing the progress of women’s cricket on the international stage.

It presented a fantastic opportunity for all to quiz the brave batsman about his career, who played for Middlesex and toured South Africa as captain of the infamous rebel tour party of 1990.

Gatting wasn’t the only inspirational cricketer present on the day, with Isabelle Duncan, author of ‘Skirting The Boundary’ – a history of women’s cricket, a guest speaker at the event.

Duncan told stories of how she appeared on the cover of Wisden Cricket Monthly wearing an MCC jumper in 1998, during a controversial time when the MCC were voting on the admittance of women. Duncan was chosen because she was and still is a club cricketer who bats and bowls alongside men, currently captaining Albury CC (all-male apart from her) in the Surrey League.

She read from chapters in her book, which detail the history of women’s cricket and its progression from the late 18th century, right through to the 19th and 20th centuries, while also celebrating the success of the modern day stars of the game.

Just as England were starting to find their stride through captain Charlotte Edwards, the floor was opened up for questions from the Cerno team and guests. Belinda Moore, Director of Sport at Speed Communications and wife of England rugby union legend, Brian Moore, lead the way with questions surrounding the development of the women’s game at a grassroots level.

Duncan expressed how the expansion of girls’ cricket at a schools level has improved through the charity Chance to Shine, of which she is closely linked. She also gave memorable anecdotes of the time she spends sitting on the committee for Girls on the Front Foot, an initiative which aims to attract girls to the game of cricket.

England’s Katherine Brunt stood out in the final stages of play, with an innings of 39, as Cerno and guests continued to talk about the progression of women’s cricket over tea and scones.

However, as the event day concluded, so too did England. Australia’s Megan Schutt wrapped up the innings with a dismissal of Anya Shrubsole, leaving England all out for 168.

It was further frustration for England during the final two days of the Ashes Test match at Canterbury, with Australia winning the four-day Test by 161 runs.

They are now faced with the task of winning all three remaining games of the series, in order to obtain a draw and retain the Women’s Ashes. The first of three T20 matches will be held in Chelmsford on the 26th of August, with play moving to Hove on the 28th, and Cardiff on the 31st.

Cerno Capital are wishing England Women, the very best of luck.

‘Skirting the Boundary’ – a history of women’s cricket, by Isabelle Duncan: 

James and IsabelleWomen's Cricket Cantebury 2015 Women's Cricket Cantebury 2015

Women's Ashes Cantebury

In an ideal world, an investment portfolio would deliver a total return in excess of that of the risk-free rate (e.g. Gilts) (more…)

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Written by Eleanore Kelly and added to by Natasha Mackinlay

When Cerno Capital’s James Spence met Judy Murray at the BTSport Action Woman of the Year Awards last December they instantly hit it off. So much so that when James asked Judy if she might come along and speak at an event organised by Cerno Capital, she agreed whole heartedly.

Some six months later and the team at Cerno were pleased that Judy Murray – the mother of the World No 3 Andy Murray, Wimbledon Doubles Champion Jamie Murray, captain of the British Fed Cup team and TV star – was still keen to devote a wet and windy Wednesday afternoon in Glasgow.

Weather notwithstanding, Judy graced us, 50 Glasgow and Edinburgh based IFAs, and journalists from several Scottish national newspapers with both her presence and her wisdom. Renowned sports journalist Sue Mott was present from BTSport with Maureen McGonigle also present to represent Scottish Women in Sport ( The discussion took place in the Arthouse Hotel, chaired by BTSport journalist Eleanore Kelly with opportunities for everybody present to ask questions. Interestingly most of the questions posed by guests revealed that Strictly Come Dancing is a popular TV choice in the world of finance.

The invitation was sent out to companies across Scotland and it was apparent that our somewhat unorthodox approach to networking was a success, with the vast majority of those agreeing to give up their lunch hour to meet Judy and Cerno Capital. Judy did not disappoint – entertaining and inspiring us all with tales about her sons growing up, the journey to stardom, the glamorous but cut-throat world of professional tennis, not to mention the blood, sweat and tears it took to propel them all there.

If indeed “pressure is a privilege”, to Judy pressure largely meant a lack of financial resources to support her two talented sportsmen as sons. Clearly a woman of determination, guts and tenacity Judy explained how it was not unusual to juggle three jobs at a time, borrowing money in order to pay for her sons to train with the best possible coaches to help the fulfil their potential. Her story inspired us all- a young girl in Scotland with a burning ambition to play tennis professionally- which she did despite the lack of training opportunities and resources. Later on a single mother forgoing family events and other obligations in order to do the best for her children in her role as coach, mother and the main bread-winner. Despite the pressures, Judy recounts that she never saw it as a “sacrifice or compromise” to allow her sons to fulfil their dreams of playing professional tennis. Of course, she also mentioned the pressures of overcoming her stage fright and “two left feet” to win over both the media and the British public on Strictly Come Dancing last year.

It is no secret that Judy was responsible for coaching her sons in their formative years of tennis and has she has continued her interest in developing and motivating others in the game. She has fuelled several initiatives to develop and encourage not only young female tennis players but also her fellow coaches. These include Miss-Hits ( aimed at girls between the ages of 5 and 8 and Tennis on the Road ( – where Judy and her team of coaches “drive around in a white van” introducing and developing tennis abilities for children in Scotland as well as also training coaches to deliver these skills. The decision to implicate such initiatives stemmed from Judy’s witnessing of how few girls are selected as “on track” to play professional tennis. “I decided that we need to create a legacy in tennis for Andy and Jamie” she stated.

Judy has been an influential example to many women working in all aspects of sport – as professionals, coaches and decision makers – and she campaigns tirelessly to do more. There is still a long way to go. Judy described how female coaches are outnumbered 9-1 by their male counterparts. She believes, however, that Andy’s appointment of Amelie Mauresmo has helped her cause for women. Andy’s subsequent success under Amelie has reinforced that the decision was certainly no gimmick and Judy believes that the French coach has rekindled Andy’s creativity in his play. “Amelie is getting Andy to feel the game again.” Furthermore, she believes that women often make better coaches than their male counterparts “There are some things that women do better than guys in the coaching sense and certainly in the mentoring and teaching sense. I think that egos don’t come into it as much and women are far more open to asking questions.”

“There is still sexism in the sport but there’s a lot of momentum around the whole women in sport issue at the moment. I think Andy’s appointment of Amelie has created awareness and shown that it is not about gender, it’s about the skills that you have and the personality fit” she says.

As sponsors of BTSport Action Woman, we agree with Judy, sport is not about gender. We firmly believe in the importance of encouraging women’s sporting initiatives and will continue to offer our support. Hannah Sharman of Cerno Capital commented, “We have met many extraordinary people through our sponsorship of Action Woman, an awards programme which recognises great sporting achievements. As an Ambassador to Action Woman nominees, Judy is an inspiration, having played and coached tennis at the highest level. Her ongoing commitment to engage young people to pick up a racket and play will be a legacy for future generations.”

Judy Murray

Judy Murray

Judy Murray and Violet Creams

Eleanore Kelly, Judy Murray and Hannah Sharman

Cerno with Judy Murray

Hannah Sharman, James Spence, Judy Murray and Nicholas Hornby

Those who have seen our opinions on Japan will know that our arguments on expanding equity returns in the country are predicated on the condition that Japanese corporates implement reforms, aimed at increasing shareholder value.

We like to think of long term investment as being evidential, and are therefore seekers of proof for our beliefs.

We have already seen a string of positive developments. Most recently, Fanuc, a large cap Japanese robotics manufacturing business, has announced the hiring of an investor relations team. The company was previously known for purposefully avoiding shareholder contact. This is a significant development, with a 1.2% weight in the TOPIX index, Fanuc is leading by example. Other noteworthy changes include the reduction in cross shareholdings between companies, announcement of dividend increases and share buybacks.

With the prominent launch of the JPX Nikkei 400 Index, one particular measure of shareholder value creation has been pushed into Japanese CEO’s spotlight – return on equity (‘ROE’). The index gives it a 40% weight in its selection criteria, besides operating profits (40%) and market capitalisation (20%), in arriving at its 400 constituents.

ROE can be decomposed into three measures, according to an analysis first introduced by the DuPont Corporation in the 1920s. ‘Net Profit Margin’ multiplied by a company’s ‘Asset Turnover’ and finally multiplied by the ‘Leverage’ employed equals a company’s ROE. The below table defines these ratios further.

ROE factors

We have examined the three factors for the Japanese market, using the TOPIX index as proxy to assess where Japan is lagging the competition, i.e. other developed nations. In particular, we made a comparison to the S&P500.

We found a general decreasing trend in the ‘Asset Turnover Ratio’, which measures how efficiently corporates are employing their assets. This seems to have, however stabilised for the US, but is still declining in Japan. All in all, it is quite similar for both regions.

Topix - March 2015

Source: Bloomberg

Unexpectedly, leverage has been trending downwards, but is, at the moment, above the S&P 500 as US corporates have deleveraged even more significantly since 2008. Compared to Europe, however, both figures are currently at very low levels.

These two aggregate figures, of course, have to be considered in the context of the respective sector compositions underlying these indices.

The last measure, ‘Net Profit Margin’, is considerably lower for Japan. It has been so in a consistent fashion since the early 1990s, when our datasets start. This stark difference is resulting in the drag of Japanese ROEs versus the comparator countries’ corporates’ ROEs, even accounting for different sector compositions.

We believe that the greatest boost to ROEs will come from margin improvements and also from putting assets to use in a more efficient manner.

Asset turnover can be improved by shedding assets: for example, the vast amount of excess cash on balance sheets, accumulated as a result of corporates’ attempt to de-lever and to repair their balance sheets. Cash of that extent is dead weight, contributing little to profitability. Share buybacks and the increase of pay-out ratios are one example, how this can be achieved. Both are gaining popularity as course of action in Japan.

Also, the sale of non-performing legacy business units will improve the asset mix and enhance the turnover ratio as well as operating profit margins. This comes down to companies adopting more long term strategic goals, cutting unnecessary costs and therefore improving corporate profitability and ultimately shareholder value.

Another component of net profit margin that we expect to improve, besides operating profit margin, is corporates’ tax burden. The official corporate tax in Japan was over 35% at the end of 2014, compared to the official figure of 40% in the US. However, the actual figure paid by US corporates is much lower than that, whereas Japanese corporates have been paying an even higher rate than the 35%. At the end of 2014, the Japanese government agreed on a series of corporate tax cuts aimed at reducing the ultimate actual rate paid to below 30% over the next years. This will lift the tax burden and is a positive development for Japanese net profit margins.

The Japanese workforce remains highly inflexible. However, the number of part time workers is increasing and also the demographically induced structural decline of the workforce will help to reduce inefficiencies and streamline costs.

The reduction in taxes and the decline in the workforce should more than offset potential wage rises.

The last paragraphs have demonstrated that there is much room for improvement in margins and asset efficiency of Japanese corporates. We remain highly constructive and currently hold a 21.2% equity allocation to Japan in our TM Cerno Select fund, invested via one active manager and ETFs.

Last year, the Japanese Government Pension Investment Fund (GPIF) announced its intention (more…)

Throughout 2014, institutional investors have become more concentrated in their positioning. The consensus became to be underweight the euro, long the US dollar, overweight US equities and short commodity currencies. We have recently backed away from this consensus.

Last year, European equities underperformed US equities, the sixth of the last seven years in which they did so.

The negligible positive return they recorded in 2014 (+4%) reflected the lack of earnings growth.

Currently, there is a fascinating spectrum of opinions on Europe within the active management community with most gravitating to one of two opposing outlooks. Sceptics argue that  European QE is doomed to fail: ‘too little, too late’. On the other end of the spectrum we see enthusiasts cautiously hailing QE in combination with lower energy and commodity prices as the saviour of Eurozone lending and spending.

A careful analysis of active managers’ portfolios reveals that almost all exhibit a well ingrained quality bias in their holdings.

Until recently, this has been warranted as European defensives have outperformed European cyclicals (ex-financials). The relative measure of this has exceeded one standard deviation.

EEU Cyclicals Defensive Graph(click on graph to enlarge) Source: Bloomberg

As is often the case, internal equity market dynamics tend to shift before macro data. On a more granular level we have recently seen a tick up in earnings of European cyclicals. Valuations in the sector are still priced for recession and reflect little optimism toward looser monetary policy, lower commodity prices and a weaker currency.

It is interesting to note that this divergence is reversed in the US, due to polar opposite expectations with regards to economic outcomes.

US Cyclicals Defensive graph(click on graph to enlarge) Source: Bloomberg

In summary, the question to be asked right now is whether relative expectations, between the US and Europe and between defensives and cyclicals, have become too extreme and, if so, how to respond.

We believe that they have.

To our minds, the best way to invest in cyclical themes is through passive trackers. Few active managers have the stomach to consistently express entirely cyclical positions. It is too much of a roller coaster and carries with it considerable career risk. For those reasons we favour sector trackers and this is a good example of how an active allocator deploys ETFs.

Throughout 2014, institutional investors have become more concentrated in their positioning. The consensus became to be underweight the euro, long the US dollar, overweight US equities and short commodity currencies. We have recently backed away from this consensus.

Last year, European equities underperformed US equities, the sixth of the last seven years in which they did so.

The negligible positive return they recorded in 2014 (+4%) reflected the lack of earnings growth.

Currently, there is a fascinating spectrum of opinions on Europe within the active management community with most gravitating to one of two opposing outlooks. Sceptics argue that  European QE is doomed to fail: ‘too little, too late’. On the other end of the spectrum we see enthusiasts cautiously hailing QE in combination with lower energy and commodity prices as the saviour of Eurozone lending and spending.

A careful analysis of active managers’ portfolios reveals that almost all exhibit a well ingrained quality bias in their holdings.

Until recently, this has been warranted as European defensives have outperformed European cyclicals (ex-financials). The relative measure of this has exceeded one standard deviation.

“You were the guys that came into the room and said yes, we’re going to do this” was how Clare Balding welcomed us at the BT Sport Action Woman of the Year Awards in December 2014.

Our involvement with Action Woman represents a new era for Cerno Capital. The referral-based nature of our growth trajectory to date is perhaps in contrast to the visible world of sporting sponsorship. We have learned, however, from many years investing in the markets that opportunities can appear in unexpected places and as such we try to go about most things we do in a considered way.

While the commercial relevance of being involved with a project which promotes diversity and inclusion was not lost on us, there was a more profound connection. On a cultural level, the process of immersing ourselves in the world of Action Woman has been an enlightening one, in particular through driving us to extend our values beyond investment.

To us Action Woman is the recognition of talented individuals who have worked incredibly hard and achieved extraordinary things, usually against the odds. We admire their attributes – dedication, professionalism and discipline to name a few.

Cerno Capital is a small, close-knit and hard-working team operating in a competitive and performance-driven industry. We recognise the hurdles involved in breaking through.

The determination and drive of the Action Woman nominees to succeed at the very top of their game connected deeply with our own culture and values. Meeting the nominees and their ambassadors has served to strengthen the belief that these individuals are people with whom we are proud and honoured to be associated. Perhaps more importantly, they are people with whom we can work to shift perceptions across all walks of life.

Clare Balding’s message to Cerno Capital:

BT Sport Action Woman AwardsBT Sport Action Woman

US Equity Market Cyclically Adjusted PE Ratio, 1881-2014

We live in a world where a teenager can discount future cash flows with the aid of a financial calculator. A little screen tells him the price/value of a financial instrument to as many decimal places as takes his fancy.  This great leap forward for mankind has, however, not made the valuation of financial instruments materially easier. Indeed, the increase in the speed and ease with which man can extrapolate may have made valuing financial instruments considerably more difficult. Small tweaks in inputs have always had major impacts on present values but perhaps those tweaks were made less frequently when they were tortuous, boring, time consuming and hence expensive. Indeed, it is now possible to dispense entirely with the human element and the collapse in the cost of computing power means that intra-second, present value calculations are both possible and cheap. The rapid oscillation in price/value resulting from the interminable tweaking of our binary buddies is neither much of a spectator sport nor a game suitable for adults. Adults are interested in inputs, while machines and teenagers still marvel at the purity of the equation and the speed at which it can be solved. So what does the history of inputs to net present value calculations tell adults about current equity prices? It tells us that current equity prices/valuations are likely to produce poor long-term returns.

A simple discounting model tells us that the net present value of financial instruments rises when the discount rate falls, the growth rate of the cash flow rises or the discounting period is extended. The owners of financial assets have much to celebrate if these three amigos appear simultaneously. History shows that high valuations for equities in particular occur when just such a posse of positives rides into town. More importantly, history also shows the impossibility of such a combination having the permanency which contemporaries assume and which is thus capitalised by financial markets. Ultimately, understanding the dynamics of how such seemingly permanently bullish inputs inevitably pass is much more important for investors than celebrating their arrival. We all know that an elephant can stand on its head but the important information for those standing in close vicinity to the inverted pachyderm, is just how long can it stand on its head. Financial history has much to say on how long a low discount rate, a high growth rate of corporate cash flows and a long discounting period can co-exist. These variables can co-exist long enough for the trader to make profits and long enough for the investor to lock in poor long-term returns. So why do investors come to believe the impossible can this time be possible, and why do they stop believing?

Faith that the three amigos have come to stay usually stems from a major technological breakthrough. Investors are a sucker for the transformative power of structural change usually in the form of technology. Whether transfixed by the sight of ships sailing through the countryside (canals), iron horses rumbling across the plain (railroads), messages pulsing through wires (the telegraph), signals beaming through the air (radio), petroleum forming into household objects (petrochemicals), machines that think (computers) or phones that know where you are when you don’t (smart phones) the human mind is easily distracted by its own ingenuity.

While most technological breakthroughs are disinflationary, some are more disinflationary than others. A disinflation will very likely bring a lower discount rate, and lower interest rates also reduce interest payments and boost corporate cash flows. That same technological breakthrough can simultaneously be seen as positive for corporate cash flows if it boosts productivity. Of course, any such improvement in cash flows increases the likelihood that corporations will continue to be able to finance their liabilities and thus discounting periods may also extend. History is clear that such a confident combination of these key inputs is transient, but professional investors’ job prospects are not well served by heeding the lessons of history. So why have the inputs of a low discount rate, high cash flow growth rates and long discounting periods been transient in the past despite major technological innovations? What does that historic transience tell us about how and when faith in the current bullish combination will ebb with negative implications for prices and valuations?

This distraction of structural change driven by a new technology is fatal for investors as they simply forget that they are in the business of pricing, and price is ultimately set by just two things – supply and demand. A technological breakthrough shifts both supply and demand often in unpredictable ways; however, the mechanism of price assures that supply and demand adjust so that the three amigos of a low discount rate, a high cash flow growth rate and long discounting period are disbanded. History tells us that we should expect such disbandment when the cyclically adjusted PE for equities nears 25x. Simply put, from 1881 to 2014, despite massive structural change mainly driven by technological breakthrough, US equity valuations have only rarely exceeded a CAPE of 25x. Equity market valuations are telling us in advance that the ability of that structural change to deliver low inflation, low interest rates and high growth rates is about to come to an end. This has happened either because the growth rate was too high, resulting in inflation and higher discount rates, or because the growth rate declined taking corporate cash flows with it. In extreme circumstances cash flow declines threatened corporate solvency and discounting periods also declined markedly. In short the laws of supply and demand have always ensured that the three amigos are disbanded by either the powers of rising inflation or the powers of deflation.

When the CAPE has been at 25x times there has been no room for disappointment in any of the three key discounting variables and thus, rising inflation or outright deflation have had major impacts on valuations. To believe that this time is different is to believe that something has happened to prevent the supply/demand adjustment, which has previously made price stability in a time of high growth in corporate cash flows impossible. As at previous peaks for the CAPE in 1901, 1929, 1968 and 2000 many investors do indeed believe that this time somehow supply and demand will not adjust to shatter the combination of low discount rate, high growth rate and long discounting period.  This faith is probably based upon the fact that inflation appears to have fallen to a new low trading range since 1995 and that the growth of corporate profits has outstripped GDP growth pushing corporate profits to an all time high relative to GDP. If inflation can stay low, without becoming deflation, and corporate profits can continue to rise as a percentage of GDP, then there is no reason to believe that equity prices/valuations need ever decline.

While such a permanent combination may be possible it is also highly unlikely. The historical record suggests that the actions of central bankers are at least as likely to destroy such seeming permanency as add to it. Traders can now play the game of assessing what gains can be made before the adjustment of supply and demand drives the inflationary or deflationary outcome which will reduce the price/valuation of equities. Investors need only note the inevitability of such adjustment and thus seek to avoid equities currently trading at valuations which guarantee poor long-term returns. With the CAPE at 26x the elephant remains on its head. In my opinion, this is a good time for investors to be watching from a safe distance.

After decades of subdued growth, Japanese equity markets rallied in 2013 following Abe’s election and announcement of his triumvirate of measures. The three arrows, as his policy approach is called, consist of monetary measures, fiscal measures as well as growth oriented structural measures. The first two of these have been implemented early on and were well received by investors. Japan outperformed other developed markets returning +55% in 2013 compared to +34% for the US and +21% for Europe. However, Japanese equity returns this year have been held back by scepticism over the potential success of Abe’s third arrow. The TOPIX index is flat on the year at the time of writing, compared to +8.6% and +5.5% for the US and Europe indices respectively.

Structural measures envisioned as part of the third arrow aim to improve companies’ capital efficiency to promote economic growth. The main provisions of this program are to encourage companies to allocate their cash more efficiently and to promote corporate governance. Japanese companies have been notorious for hoarding their cash over the last few decades, a habit which gained new life following the Global Financial Crisis. In the reflationary environment that the government wishes to create, cash becomes an unprofitable asset.

Within developed, capitalist countries, companies have to manage the expectations of a range of stakeholders, namely: customers, suppliers, employees, shareholders, bondholders and lending banks. In some societies, a diffuse range of societal responsibilities are at play. Japan, being essentially a consensus culture, is one such society.

The itinerant Western investor, business schooled to respect economic value creation and growth above all other things, has tended to notice Japanese attributes that are inimical to the unbridled creation of economic value. In particular, the societal responsibility to employ people is taken very seriously and lay-offs are cataclysmic events for Japanese companies.

Asset turns in Japan are comparable with Europe and the US, however the twin effects of overstaffing and cash hoarding combined with endemically lower margins has meant that corporate Japan has lagged in terms of return on equity (ROE) or return on capital employed (ROCE) measures.

Table 1: Return on Equity as of 6 October 2014 – Japan, US, Europe



Nikkei 225



Return on Equity





Source: Bloomberg, Cerno Capital

With an ROE of only 8.2% for the Japanese equity market, compared to 15% and 11% for the US and the European markets respectively, returns for equity shareholders in Japan are lagging behind and have done so for the past twenty years as the graph below demonstrates.

Graph 1: Historical Returns on Equity – US, Europe, Japan

Historical Returns on Equity – US, Europe, Japan

Source: Bloomberg, Cerno Capital

ROE is a function of companies’ profit margins, leverage used as well as asset turnover. Asset turnover measures with what efficiency assets are being deployed. We can infer that Japanese companies’ focus has not been on increasing shareholder value, but rather that they haven’t been in control of their costs and capital has been allocated inefficiently; the focus has been on pleasing employees, suppliers and customers. The latter two very much so due to the significant cross shareholding between firms which is typical for the Japanese equity market. This has led to a lack of risk taking of corporates and short termism, i.e. focusing on quarterly earnings rather than having a long term strategic plan in place that will deliver sustainable shareholder returns over time. It has also made companies reluctant to engage in business restructuring and to divest unprofitable parts of their businesses. These inefficient investments along with the enormous cash holdings have depressed firms’ ROEs.

Abe’s structural reform aims to refocus corporates’ attention to the shareholder. He is looking to prompt companies to allocate capital more efficiently and target returns on equity above their cost of capital, or to return cash to investors in form of higher dividends and share buybacks.

Dividend yields have been low in Japan, even compared to the US.

Table 2: Dividend Yields as of 6 October 2014 – Japan, US, Europe



Nikkei 225



Dividend Yield





Source: Bloomberg, Cerno Capital

One regulation already implemented aims to change the cross holding ownership. The below graph shows that for the first time the ownership of firms and banks is below that of the equity ownership of investment management firms, individuals and foreign investors.

Graph 2: Transition of Shareholder Composition in Japan %

Transition of Share holder Composition in Japan

Source: TSE Shareowner Survey 2013, Cerno Capital

However, not all measures can be implemented via regulations. Corporate governance and stewardship codes are only principle based guidelines, which companies can subscribe to, or not.

To encourage companies to adhere to these principles, the Japanese Exchange Group (JPX, world’s third largest bourse operating the Tokyo Exchange amongst others) and Nikkei have jointly created a new index, called the JPX Nikkei 400 Index, which launched at the beginning of this year. This new index explicitly selects companies which focus on the efficient use of capital, specifically referring to ROE, as well as those promoting good corporate governance.

The index excludes companies that have been listed for less than three years, have liabilities in excess of assets during any of the past three fiscal years, those which had an operating deficit in all of the past three fiscal years and those which are designated for delisting.

Eligible companies are scored and ranked according to the following criteria:

  1. 3 year average ROE
  2. 3 year cumulative operating profit
  3. Market capitalisation on the base date for selection

Point one and two are each given a weighting of 40% and market cap is only weighted with 20%. In contrast, the TOPIX is a market cap weighted index and the Nikkei 225 a price weighted index.

To encourage adoption of corporate governance standards, scoring based on qualitative factors is also applied and focuses on the following three items:

  1. Appointment of independent directors (with the requirement of at least 2)
  2. Adoption or scheduled adoption of International Financial Reporting Standards (IFRS)
  3. Disclosure of English earnings information via TDnet (company announcement distributions service in English)

One would expect the above three from companies listed in the US or Europe as minimum standards, however to the majority of Japanese companies, these are rather uncommon features to date. The scoring of these criteria is determined so that around 10 names are different from those if only quantitative criteria were applied.

The overall 400 highest scoring companies are selected for the index, subject to buffering rules to minimise turnover.

Constituents are reviewed once a year in August. This year’s first review saw 31 in and 31 out, with Sony being one of the companies dropped. This is consequential in a shame culture, such as Japan’s, and the index was already dubbed the ‘Shame Index’.

Public endorsement for the adoption of this index was given by Japan’s Government Pension Investment Fund (GPIF) which currently manages around US$1.2trillion. Historically, the GPIF is very conservatively positioned but is expected to slowly shift more money towards a higher equity allocation. It has identified the JPX Nikkei 400 as one of its equity benchmark indices. Given the size of the GPIF and its influence on other pension funds, this should be regarded as significant support for Abe’s structural reform program.

What does this mean for investors? First of all, we can expect that better ratings and higher share prices as a result of inclusion will induce companies to modify their behaviour and spark competition to grow ROEs and an alignment with global governance standards. This in effect should contribute to asset price inflation, with the hope that is matched by wage growth to contribute to Abe’s 2% inflation target.

Critics argue that this index is little more than another smart beta offering and investors buying high ROE stocks will be disproportionately exposed to cyclical companies at the top of their cycles. They argue that by simply buying the index, not enough attention is given to the consideration of value versus quality.

Clearly, companies included in the index will tend to have higher ROEs. This is demonstrated in the below table 3 which lists the average of the most recent (August 2014) inclusions and exclusions of the index. However, we otherwise do not concede to this argument. We consider the growth in ROE to be the most critical factor and expect that via improvements in capital efficiency, Japanese ROEs will continue to improve and align with other developed markets. As they are starting from a low base, a plausible strategy is to invest in both index constituents as well as those expected to join the index.

Table 3: JPX Nikkei 400 – Inclusions & Exclusions August 2014



3 Year Av. ROE

5 Year ROE Growth

Inclusions (Av.)




Exclusions (Av.)




Table 4 below illustrates that the combined ROE of the new index, the JPX Nikkei 400, is only marginally higher than that of the TOPIX and Nikkei 225 and well below that of the S&P500 and the MSCI Europe.

Table 4: Valuations as of 6October 2014 – Japan, US, Europe


JPX Nikkei 400


Nikkei 225



Return on Equity






Dividend Yield












Source: Bloomberg, Cerno Capital

To date, two ETF providers have launched an ETF on the JPX Nikkei 400 for European domiciled investors. One of these is an improved investment for clients of Cerno Capital.

We have substantial balances at work in Japan and the advent of JPX Nikkei 400 trackers provide the opportunity to structure low cost exposure around the main themes at work in that market.

If you would like to find out more about how we access the Japan opportunity, please contact Hannah Sharman (

This aritcle was written by Will Grahame-Clarke and first appeared in thewealthnet on 29th September 2014

Cerno Capital’s James Spence believes interest rate normalisation should start in the US sooner than markets expect.

Mr Spence, lead manager of the Cerno Capital’s flagship multi asset portfolio TM Cerno Select, argues the progress of returning to normal inflation rates has been delayed for too long and the actual policy itself has not reached the parts it was intended to reach.

He is currently most bullish on Japan which he says is finally emerging from its bear run dating back to the 1980s. Mr Spence, like fellow Cerno Capital founder Nicholas Hornby, is well acquainted with Asian equities. Between 1991 and 2004 he worked as an equity analyst, head of research, and then as equity strategist at various firms based in Hong Kong, Singapore and Jakarta.

Asia is an area which has more exposure than most to the Federal Reserve’s interest rate decisions.

“Central banks have been reluctant to decisively signal when the price of money is going to change,” Mr Spence told thewealthnet.

“Normalisation now would make it easier for businesses to read the runes so they could more easily make decisions about investing and acquisitions. It now seems to be going on for too long.

“It is as if we are being treated like children that we can’t cope with a higher price of money.

“We would welcome more clarity and we don’t see normalisation as necessarily upsetting asset class returns. If you look around the world in many places, while they are not springily robust, they are OK.”

Mr Spence says there are several reasons for this delay: “It is possible that one reason for this delay is handing responsibility for the employment figures to the central bankers. In the US we are never going to see three percent employment. The definition of full employment needs to be looked at and I think that is part of it.

“There is also a problem in the investment world where today’s indicated return after inflation is not great relative to historic averages. One effect is a prolonged bull run in core bond markets which has driven allocation into fringe bond markets which are not particularly liquid.”

Mr Spence’s stance on bonds is distinctive of the unconstrained and benchmark agnostic nature of Cerno’s proposition alongside its long term three year investment perspective.

“We remain absent from bonds across all our portfolios because we don’t see value in core bond markets and we don’t see the liquidity in corporate and high yield bonds.

“We are completely unconstrained. As such we don’t need to hold any asset class just for the sake of it. We have been out of bonds for some time.”

It is a long view that protected Cerno Capital’s clients during the 2008 crisis: “That flexibility worked for our investors because we had a lot of cash, a strong currency expression, investments with macro managers and long on volatility.”

However, since that moment Cerno have been constructive on risk assets.

The flagship TM Cerno Select Fund’s largest allocation is in equity strategies. The supposition was that US equities, being the first country into the crisis would the first out has worked well. Today, US expressions are more tiled to late cycle themes: arbitrage specialists on the basis of increased M&A activity and US banking shares: strategies that will not be upset by higher interest rates .

Cerno had also been “quite constructive” on Europe even during the Greece and Cyprus crises. But Mr Spence says Europe now doesn’t offer meaningful value from a global perspective with the exception of the UK. As such, direct exposure to European equities across the core Cerno funds has been removed.

“Our favourite market right now is Japan. Early last Autumn Japanese stocks went down to book value or just below. There is something spiritual about book value – it is the simplest way to think about value in a company. It marked the end of the bear market.

“We now want to see increasing wages, consumption activity and increasing corporate profits and these things are starting to happen.”

Mr Spence’s career familiarity with Asia is he says more likely to give him awareness of the region’s faults as it is opportunities.

“We are not taken by the rest of Asia; earnings valuations look rather flattering and much less so once you exclude Chinese banks and regional energy companies. We are bearish on Chinese property but its decline will stop short of being a global deflationary event.”

Mr Spence argues that the flexibility of TM Cerno Select is its strength, avoiding the pitfall of having to have a doctrinaire view on either inflation or deflation.

“It is better to invest with an aspect to one outcome with a portfolio that is constructive but flexible,” he concludes.

Mr Spence is managing partner at Cerno Capital and lead manages two collective investment funds TM Cerno Select and EF Unconstrained. He is a member of the Chartered Institute for Securities & Investment.

Cerno Capital has also recently recruited Hannah Sharman to represent the firm’s multi-asset strategies to the investment market place. She is responsible for the investment relationships between Cerno Capital and regulated firms and intermediaries throughout the UK and Europe. She joined Cerno Capital from BlackRock.

It has long been observed by eminent practitioners that the market really represents nothing more than a pendulum that swings back and forth through the median line of rationality spending little time at the point of rationality and most of the time on one side or the other.

In August last year we wrote that emerging market debt and currencies appeared overvalued and had further downside in aggregate. We identified vulnerable countries as those having both a poor external funding position along with low reserves. Market prices have adjusted downwards in emerging market debt and currencies over the last few quarters making this a sensible time to examine current conditions. An historic darling of EM, Brazil illustrates the weakness: the Real has fallen by about 10 percent versus the USD since last summer and the 10 year bond has fallen by about 20 percent in price terms.

We prefer a disaggregated approach when examining emerging markets, but for the purposes of this paper we consider the asset class more broadly. We conclude that while prices appear fair today, we have not yet observed capitulation. There is still no margin of safety in the context of our base case of rising US real rates.

We constructed a composite basket of emerging market bonds comprising twelve countries from the three regions of Eastern Europe, Asia and Latam. We then compared the real yield offered in the marketplace against our theoretical real yield. We calculated the theoretical real yield by the summation of US real rates plus a credit risk premium for each emerging market country in the composite. Credit risk premium was observed by the credit default spread and inflation comprised the average CPI over the last three years, given the general absence of inflation linked bond markets to reference inflation in emerging countries.

Our conclusion on examining the data from 2002 is that there is a reasonable correlation between the theoretical and actual price offered in the market. There have been periods when the yields offered by the market are above those that our theory would suggest and periods when the opposite is true.  Presently emerging market bond yields trade at almost the same level as our simple theoretical model would suggest. There is no margin of safety being presented in emerging debt at current pricing, particularly in consideration of our expectations for increasing real rates in the US over coming quarters. However, there is dispersion in the results and our analysis uncovered countries where the market rate exceeds the theoretical price.


 Composite of Emerging Market Countries


A significant attribution of local currency debt comes from the currency exposure. Dislocations often occur with a sharp rise in volatility offering tremendous opportunity for those still not invested.  We examined 1 month and 12 month implied FX volatility for a number of emerging market countries. There is dispersion in the results. For example, India is close to one standard deviation above its mean volatility and Columbia is more than one standard deviation below its mean volatility. The composite reveals that implied volatility is close to the mean value. Viewed solely from a volatility perspective, we do not appear to have had a dislocation event and volatility, in the composite, is not at any extreme value.


Implied Volatility Ranking 

Table Implied Volatility Ranking

In aggregate, implied volatility does not suggest that we are at a point of extreme. However, as with the debt analysis, individually some countries appear at extremes. We conclude again that there are some opportunities when examined in our preferred disaggregated approach.

Our sample flow analysis for local market debt suggests that assets have dropped by 38 percentage points from the peak of cumulative inflows (since 2004) in May 2013 to the end of January 2014. This would appear significant but we need to place the data in context. Surprisingly, allocations into local markets since QE1 began have not even halved yet which could suggest there is more unwinding ahead. The prime beneficiaries of QE including EM debt could be expected to also suffer the most on the withdrawal of QE.

We conclude that on both measures employed – theoretical yields versus actual yields offered and implied currency volatility we might be at fair value. We do not yet perceive a margin of safety. The flow data also lends some support to this conclusion.

For a more detailed discussion on our disaggregated study, please contact Cerno Capital.

A variety of factors have held back returns from event driven strategies since the 2008 financial crisis. We believe that the underlying forces which determine corporate merger and arbitrage (M&A) activity are beginning to align very well and the consequences of a return of enthusiasm will boost the performance of such strategies.

Cerno Capital is allocating 8% of portfolio assets to global specialists who invest around announced corporate events and acquisitions.

Event driven investing encompasses a variety of strategies that all have one theme in common: organisational change. This can be in form of special situations, such as spin-offs, breakups and industry consolidations; arbitrage, evoked by mergers, exchange and tender offers to name some examples; and distressed situations such as bankruptcies, liquidations and restructurings. An event driven manager considers the fundamentals of businesses and industries to anticipate, provoke and take advantage of such situations by investing across the whole capital structure. Position size tends to hinge on a probability based analysis of various pay-offs under all possible scenarios.

As an investing strategy, merger arbitrage performs best within expanding economies with healthy corporate activity. Since 2008, global corporations have delivered and accumulated great amounts of cash on their balance sheets. Despite this, corporate activity has been relatively mute. No doubt this was partly caused by residual distrust of the US economic recovery, combined with out and out scepticism toward European fundamentals and solvency. The equity rally of last year has helped engender greater belief in economic recovery.

In the lower growth world in which we live, organic growth will be harder to achieve. This will drive corporates to look for other types of growth through identifying synergies and economies of scale, or simply buying revenue streams. Therefore, we expect that many such acquisitions, restructurings, consolidations that have been on boards’ agendas for the past few years, will now materialise, at progressively higher prices.

M&A activity has already begun to pick up in some key sectors, notably healthcare, media and telecoms. Seven US$10bn+ M&A deals were announced in the global telecom sector in 2013 which compares to just one deal in 2012, 2013 representing the highest level of activity since 2005 according to Dealogic.

For event driven funds, increased activity means a broader opportunity set and potentially increased returns. A higher quantum of deals will tend to widen spreads, as will higher interest rates. Furthermore, the complexity of transactions will rise with a higher deal count, which can present more asymmetric pay-off profiles as only the most skilled managers will be able to take advantage of these opportunities.

We believe we have identified those capable managers, who have the skill-set to assess the most complex deals and the experience to identify opportunities across the whole capital structure to deliver attractive absolute returns.



Recent analysis conducted at Cerno Capital reveals a positive correlation between the event driven hedge fund universe and the excess returns of smaller companies over larger companies. At the time of writing, we have observed meaningful outperformance of smaller capitalisation shares globally and some suggestions of an uplift in the fundamentals for event driven managers.

Event driven strategies exploit the informational inefficiencies resulting from corporate transactions. The term ‘event driven’ comprises a variety of strategies including merger arbitrage, special situations, restructurings and distressed events. As some managers seek to invest in a market neutral manner, in order for returns to be driven by corporate events rather than general market beta, it is said that event driven strategies exhibit a low correlation to equity and bond markets.

We have questioned this assumption. The environment most suitable to this strategy is that of economic stability and healthy corporate balance sheets, which inevitably leads to increased corporate activity as we have seen of late. Such an environment is also conducive to the performance of stocks in general. In particular, smaller companies may be benefitting more from exceptionally low interest rate policy and economic recovery.

Smaller business conditions have proven a reliable indicator for growth in the US and other developed markets. The impetus for our analysis was derived from the strong performance of smaller companies in the UK in 2013 and the backlog of IPOs of such firms. Many of them were not able to list during the financial crisis, but are now increasingly testing the market. More generally, smaller companies are attractive targets for larger companies. Organic top line growth might be difficult to achieve for those going forward, but this can be helped through strategic acquisitions; smaller companies are often the source of innovative technologies and products and offer the intellectual capital for larger companies to achieve faster growth.

To approximate returns from the wider event driven universe, we used the HFRX Event Driven index, mindful of its limitations due to survivorship bias; we compared the total returns achieved against the outperformance of smaller companies over larger companies on a global and regional basis over rolling 12 and 36 month periods.

Our analysis revealed that on available data since 1998, the correlation of the HFRX Event Driven index with the outperformance of the MSCI World Small index over the MSCI World Large index has been positive, at 0.39 over the period. The graph below illustrates the positive three year rolling correlation as the blue shaded area. The green lines are the three year annualised HFRX Event Driven returns and the three year annualised MSCI World Small over Large cap excess returns respectively. Over the past ten years, those have moved, more or less, in tandem.

Exhibit 1: 3 Year Rolling Correlation of the Global Event Driven Universe with the Excess Returns of Global Small Companies over Large Companies

chart 1a
Source: Cerno Capital, Bloomberg, HFRX

It would be a mistake to infer a stable relationship from such a short time series; however what strikes us is not only the positive correlation, but also the similarity of event driven and excess returns, on a global and regional basis, as illustrated below.

Exhibit 2: 12 Month Rolling Event Driven Returns and Regional Small Cap Excess Returns

Source: Cerno Capital, Bloomberg, HFRX

Ex ante, it is difficult to conclude whether, on this basis, it would be better to invest in event driven strategies or simply invest in a regional or global small cap ETF and selling a large cap ETF to extract the indicated excess returns. We can, however, conclude that event driven strategies on an aggregate basis have moved directionally, more or less, in tandem with smaller companies over the past ten years; however, the volatility of smaller companies has been higher both on the up and downside by approximately as much as the return achieved by event driven managers. This has interesting implications for multi asset investing and manager selection as this analysis has led us to seek managers who, we believe, have the ability to outperform the small cap premium.


We remain of the view that investment returns from gold will disappoint.

It is a widely held belief that gold is an inflation hedge. We challenged this view in a recent piece entitled Inflation protection is a noble aim, but not a reliable strategy (see What normalisation means for investors elsewhere on this website

The “Golden Constant,” was coined by Roy Jastram (1978) in which he observed that historically gold has been a poor hedge of inflation in the short run but a good hedge of inflation in the long run. The real price of gold maintained its purchasing power over long periods of time and gold’s long-run average real return is zero.  If we assume this long term relationship to be true, then plotting the gold price against CPI would reveal if current gold prices are above or below CPI. Historical data from 1875 shows that the gold price today is significantly above CPI, or put differently, to revert to the long term trend of zero real return, gold should continue its downward path and stands currently 70% above the price suggested by the CPI trend line.  Gold is often referred to as possessing insurance attributes but at today’s prices it is an expensive inflation hedge.

Another approach to understanding the price fluctuations of gold in shorter time periods is to consider real interest rates. Real rates in the US can be observed through inflation linked bonds (TIPS). The measured correlation between 10-year TIPS real yield and the real price of gold is -0.82 (from 1997 and the present day). When real rates rise, the gold price tends to fall and when real rates fall then gold rises. We might assume causality based on the opportunity cost of holding gold. This data goes back only 16 years to when TIPS were first introduced in 1997. We have created a synthetic real yield for the US with the help of Jan Groen and Menno Middeldorp from Bank of New York Fed/Liberty Street Economics for the synthetic series and examined the data from 1971 (when gold was no longer fixed) to reveal a similar result: the correlation between the real yield and the real price of gold was -0.64 which again is significant.

Chart: Historical gold price vs. US 10Y real yield (1971-2013)

Gold Graph

Source: Federal Reserve Bank of New York, Bloomberg, Cerno Capital

It is still necessary to make assumptions about real yields in order to forecast the price of gold. Over a three year horizon, if we assume normalisation of interest rates and that inflation will be relatively stable in that time period, this would suggest higher real rates. Assuming stable correlations, the implication is for a lower price of gold.


If it takes a theory to beat a theory, then there may finally be an alternative to the Efficient Market Hypothesis (EMH) first proposed by Eugene Fama in the 1960s. Paul Woolley, formerly of GMO and the founder of The Paul Woolley Centre for the Study of Capital Market Dysfunctionality at the LSE has offered a model for financial markets which seems to fit better with the real world.

The two fundamental tenets of the EMH, in its hard form, are:

(1) Public information gets reflected in asset prices without delay

(2) In an efficient market, no arbitrage opportunities exist

If markets are efficient, then logically it follows that there are no bargains. Investors who believe in the EMH do not pay fund managers a fee to pick good stocks, because they do not think fund managers can find value.

Criticism of the EMH has been predominantly based on the real world experience of momentum and mispricing. Over short holding periods, there is some evidence of momentum in the stock market, while for longer holding periods mean reversion appears to be present.

Woolley’s contribution to the debate is to recognise that investors (“principals”) tend not to invest directly in securities but through “agents,” such as fund managers. It is the delegation by the Principals to the Agents that explains the mispricing in markets. Delegation creates an incentive problem insofar as Agents have more and better information than their Principals. Moreover, the interests and objectives of Agents frequently differ from those of their Principals. Principals cannot be certain of the competence or diligence of the Agents.

In his view, this model better explains real world observations. Rational profit-seeking by agents and the investors who appoint them gives rise to mispricing and volatility. Once momentum becomes embedded in markets, agents then logically respond by adopting strategies that are likely to reinforce the trends. This leads to under-and-over valuation of asset prices.

Woolley’s theory addresses the fact that markets are not always efficient and will exhibit mispricing. It is a small step further to argue that active managers can take advantage of periodic mispricing.


Returns from government bonds have matched that of equities in the past thirty years. Their risk adjusted returns are therefore superior. Bonds have been the stand out asset class during the Age of Disinflation that lasted from 1982 to 2012. We do not know whether we are arriving at an age of inflation but the ante-room to the next era is a period of normalisation. Part of the hallmark of that period will be a rise in bond yields.

We believe that core government bonds are overvalued at current yields. What measurements should an investor use that give a) a clear result b) are intuitively appealing and c) simple to grasp and use?

As we do not believe in the Fed Model which posits that there is some statistical or valuation linkage between bond yields and equity values, we need a way to think about absolute valuations. We have two ready reckoners to guide us.

The bond risk premium or BRP simply measures the term premium that holders of long term bonds receive over holders of short term bonds. Most readings over the past 30 years place this at between 0.5% and 1.0% but BRP is currently negative. As QE sought to flatten the yield curve, we would expect the winding back of QE to establish higher term premia, all other things being equal.

The rate of 10 year Treasuries corresponds to nominal GDP growth in the long run. On this basis a 10 year yield of 2.6% understates the long run growth rate and a yield of 3% would, in our opinion, be more appropriate.

On a bonds versus equities run-off, equities win based on expected total returns.

Infrastructure can be defined as the essential services, facilities and structures which societies and economies depend upon. A rising middle class throughout the world and the shift towards urban living has made infrastructure spending a priority for many emerging and developed market economies. For investors it offers the opportunity for long term, inflation protected cash flows and attractive yields.

Infrastructure assets are typically characterised by a number of features –  their long asset life, the ability to protect against inflation through concession agreements or other long term contractual arrangements, low correlation to other asset classes, their monopolistic nature, stable cash flows and inelasticity of demand and therefore resistance to economic cycles.

The two broad categories of infrastructure investment are distinguished by the stage at which market participants enter the space; greenfield investments are made in the riskier, early stages of development and brownfield refers to investments made in already operational facilities. Within these categories, there are different ways to gain exposure; either through direct investment, pooled funds (listed and unlisted), listed equity or debt instruments, each providing differing levels of control and liquidity, resources required for achieving diversification and correlation to the general stock market.

Direct investments typically offer the highest level of control and the lowest correlation, however substantial resources are required to avoid concentration risk. At the other end of the spectrum are direct investments in the equity of listed companies which are highly liquid, but more influenced by general stock market activity. Listed and unlisted funds lie somewhere in-between. Infrastructure debt is rising in prominence due to low observed default rates and high default recovery, low-risk, steady income streams and a long dated liability profile.  To mitigate potential political, regulatory, legal and construction risk a balance between regulated and non-regulated assets should be sought.

When investors fail to secure sufficient compensation for bearing illiquidity, they almost always come to regret it. The summer reaction of certain asset classes to the Fed’s suggestion that it was considering reducing the pace of its bond purchases exposed vulnerabilities for the future. list of domains . The US-centred bond market sell-off in June caused notable stress in emerging markets. This stress was most visible in ETFs that invest in emerging market debt where some banks and intermediaries were unable to meet immediate redemptions from their clients.

Emerging Market Local Currency debt is a good illustration of  just how tight pricing has become. Local currency bonds typically offer a positive spread over developed markets and this spread is a function of a number of factors including credit risk and illiquidity premium. Market participants often underestimate the illiquidity premium component in earning their yields. The traditional appeal of Local Currency bonds is their traditionally higher yields, price increases with improved credit quality, diversification in a global portfolio and the potential for currency appreciation. The illiquidity of these instruments and return for this illiquidity that investors must demand has been all but forgotten.

We expect to see more attractive levels for emerging markets over the coming quarters for three reasons. First, emerging markets will face strong headwinds as this period of quantitative easing slowly comes to an end. A further re-pricing of the US risk free rate is unlikely to be a smooth and ordered process for emerging markets and the liquidity premium is likely to rise. Second, valuations for emerging market stocks and bonds do not appear to be especially attractive at these levels by historical standards. Finally, although there has been some capitulation in the asset class we do not appear to have had a proper capitulation from slower money. This final capitulation would ordinarily suggest a bottom may have been reached. The optimal expression for us is to hedge by being long the USD against an EM currency basket consisting of five emerging countries selected for having the lowest ranking on current accounts and purchasing power parity.




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This website has been published by CERNO CAPITAL which is authorised and regulated in the UK by the Financial Conduct Authority.

CERNO CAPITAL is a registered limited liability partnership in England and Wales (Incorporation Number OC326579), registered office: 34 Sackville Street, London, W1S 3ED.
By clicking on the “Submit” button you are stating that you are eligible to access this site and that you agree to be bound by all terms and conditions set out above, and you acknowledge that all the above information has been brought to your attention. The information contained in this website is offered to you conditional on your acceptance without modification of the terms, conditions and notices contained herein. If you do not agree with these, please do not access this website.



The Endowment Fund (hereafter “the Fund”) is an Unregulated Collective Investment Scheme (“UCIS”) for the purposes of the Financial Services and Markets Act 2000 of the United Kingdom (the ‘Act’) and as a consequence its promotion in the UK is restricted by law.

Interests in the Fund will be offered for sale only pursuant to the prospectus (offering memorandum) of the Fund and investment into the Fund may be made solely on the basis of the information contained therein.

Access to information about the Fund is intended solely for distribution to professional clients, eligible counterparties and those persons to whom the promotion of UCIS is permitted under the Financial Services and Markets Act 2000 (Promotion of Collective Investment Schemes) (Exemptions) Order 2001 and COBS 4.12 of the Financial Conduct Authority’s Handbook. Investors may not have the benefit of the Financial Services Compensation Scheme and other protections afforded by the Act or any of the rules and regulations made there under. If you are unsure on whether you are eligible to access this section of the website, please contact our compliance officer.

There is not an active secondary market for shares in the fund. As such the only method of obtaining a return of capital may be via redemption. There may be notice periods, redemption penalties or other impediments to liquidity. In addition, some of the underlying investments contain gate clauses that prevent more than a certain percentage of investors redeeming at any one time.

By submitting your email address below you are stating that you are eligible to access this website and that you agree to be bound by all terms and conditions set out above, and you acknowledge that all the above information has been brought to your attention. The information contained in this website is offered to you conditional on your acceptance without modification of the terms, conditions and notices contained herein. If you do not agree with these, please do not access this web site.

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