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The growth of passive investment strategies has been supported by a narrative that active management should be shunned in favour of the passive approaches which have disrupted the investment management landscape. We at Cerno remain ardent supporters of well-considered, properly implemented active approaches to investment. Our position is based on our own experience of investing and of our time spent observing active investment managers and the development of passive, or rules based approaches.

The potential rewards to a successfully implemented active investment strategy are significant and are perhaps best exhibited through the example of a savings plan for a new born child. Assuming the parent of a child born in 2016 is willing to make the requisite JISA and ISA contributions and that child is subsequently able to continue with contributions to the age of 65, the uplift from an active approach results in a potential doubling of income in retirement. Chart 1 demonstrates this clearly by assuming a 4% nominal annualised return from a passive approach and a 6% nominal annualised return from an actively managed approach. These assumptions compare with the average return assumption of 7.6% taken by US Public Pension Plans.

These assumptions appear reasonable and correspond with our own experiences: the 2% uplift in return assumption from active management corresponds with the aggregate (net of fees) excess return generated by the Cerno Capital list of approved third party managers while the 6% assumption closely mirrors the return since inception of our core multi-asset strategy.
Chart 1: The Power of Active – JISA to ISA
Power of Active
Source: Bloomberg

Alliance Bernstein[1] has recently observed that the introduction of cheap factor driven strategies, typically called Smart Beta, has destroyed any clear differentiation between active and passive. While this stance has some attractions, we believe that we can be clear in defining active and passive approaches as follows:

An active investor will use skill, analysis and judgement to build a portfolio of investments which are expected to deliver an attractive rate of return. The active investor will also avoid investments which are believed to offer unattractive returns or where the potential return is not understood.

Meanwhile, the passive investor defines the asset classes and sectors to invest in (the universe) and then allocates client capital to all investments in that universe. This is typically achieved by investing according to weights set in publically available indices. The passive investor makes no considered assessment of the underlying fundamentals of any individual equity or bond that is bought other than to check that it is included in the relevant index. The passive investor therefore does not care whether his client’s capital is placed in a “good” or “bad” investments in terms of expected return.

The challenge for someone wishing to invest passively is how to deal with the many investment decisions that need to be made in a diversified portfolio. For example;

Chart 2 highlights a typical challenge for the passive investor. The blue line is the FTSE 100 that might be used to track UK equities. But this index is globally facing and concentrated in Energy, Banks, Telecoms and Pharmaceuticals. What about all those great industrial businesses in the UK? Perhaps a more representative index would be the FTSE 250 which has compounded at 8.4% per annum versus 4% per annum for the FTSE 100. This is a huge differential when compounded over a long period. Thus we find two UK equity indices providing two very different investment outcomes.

Chart 2: Which Index?
100 vs 250
Source: Bloomberg

The passive investor faces similar choices in Fixed Income. The challenges of being passive within one asset class are very evident, but perhaps not insurmountable providing the investor is willing to compromise on potential return. The next challenge is to define a passive approach to allocating between asset classes. Our observation is that the typical approach is to set an allocation based on observation of historical returns and volatilities. Such a backward-looking approach seems at odds with the standard disclaimer “Past performance is not a guide to future returns”.

Our conclusion is that it is impossible to be a truly passive investor or lender as all portfolios need some human judgement. What is clear is that it is possible to be passive in individual asset classes and the exchange traded funds and passive unit trusts offered by passive fund providers form a useful part of the active investor’s toolkit, for example when a short term market opportunity is presented and a simple allocation to the broad market will capture the opportunity effectively.

Passive has gained most traction in the management of equity portfolios. This is to be expected as the earliest index tracking fund was developed to track the Dow Jones Industrials 30 Index. This was followed in 1975 by John Bogle’s Vanguard 500 Index Fund which tracks the S&P500. By 1999, this vehicle managed $100bn. It is within the field of equity portfolio management that there has been most analysis of the ability of investment managers to deliver net of fees performance in excess of a relevant benchmark.

The argument for passive goes along the lines that the majority of equity funds under perform their benchmark index. The small number that do deliver outperformance fail to do so consistently, year in year out. Therefore there is no point in trying to find the ones that do.

The academic backing for this stance is strong. Countless studies show that in most peer groups of equity funds, the average manager underperforms the index.

We would not disagree with this conclusion – if we are scientific and include all relevant data, it is a racing certainty that the average manager will underperform after costs. However, is it not odd to be interested in the average manager?  Surely we should be interested in excellent investors? When was the last time an average tennis player won Wimbledon? The more important question is first; are there any managers who deliver net of fees returns in excess of an appropriate index, and second; can we observe commonly recurring characteristics that would allow is to identify them on an ex ante basis?

We can certainly identify the managers with a high probability of producing an average or market like return by looking at their portfolios and working out how much overlap there is with the index. A high level of overlap means the portfolio is unlikely to perform very differently to the index and is therefore not interesting. The name of this measure is active share and a score above 70% is indicative of a highly active portfolio, although allowances must be made for highly concentrated markets such as the UK and Australia where values will be lower. The average score for the equity managers on the Cerno approved list is 90%.

It must be acknowledged that to perform differently to an index, a portfolio needs to be invested differently to that index. The use of active share allows us to make a naive assessment of an investors approach to portfolio construction and to observe whether it is constructed to allow it to perform. We must remember that high active share will not of itself lead to positive returns.

So, if we strip away the closet trackers, what are we left with?

A simple screen of the Morningstar database shows that of the US Equity Funds with a 20 year track record to the end of March 2016, twenty percent have delivered a compound annual return in excess of the S&P500 over the full twenty years. This figure will overstate the true number of funds that outperform given survivorship bias. This analyst’s rule of thumb for the likely opportunity set of skilled investment managers in a given peer group has always been ten percent.

While manager returns can be observed on an ex poste basis, the more important question is whether managers with a high probability of success can be observed on an ex ante basis. Our response is that they can. There are key characteristics that we see repeatedly across excellent investors. The first characteristic is one that surprises many casual observers of the investment problem. When investing in companies or buildings or lending money “active” should not imply activity. The ability to trade successfully and the ability to invest rarely reside in the same person or team. Excellent investors are patient, methodical people who think about the development of a business in terms of years rather than the development of a share price over minutes. Contrast this with the quick minded trader, taking advantage of market psychology on the demand and supply of paper assets. While the popular image of an investment floor involves Bloomberg terminals, flashing lights, phones tucked into bent necks and much shouting, the truth is that excellent investors typically operate in an environment not dissimilar to a library. A number of the great investment teams we follow boast of the absence of Bloomberg terminals on their investment floors.

The result of in depth, patient, fundamental analysis is that excellent investors tend to own companies for many years and often decades. Portfolios can be easily examined to confirm this.

There is academic evidence to support the idea that the pool of patient investors who build idiosyncratic portfolios is an attractive pool for the manager researcher to fish. In their December 2015 paper; Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently, Cremers and Pareek[2] show that a group of US equity managers selected purely on the basis of long duration of holdings and high active share outperformed the S&P by a little over two percent per annum over the twenty year measurement period.

Turnover can be used as a proxy for the patience of an investor although it is not the same thing as duration of holdings and the Cremers and Pareek study does not support its use in place of holding period. High turnover is not necessarily a bad thing, but we tend to be suspicious when we see it.

While portfolio construction (active share) and duration of holdings are quantitative metrics that help define a universe of managers with performance potential, a qualitative approach which focuses on understanding an investment approach and determining soft factors will improve the chances of selecting an investment manager with a high probability of delivering strong performance.

We have observed that investors who can articulate their investment approach clearly and succinctly have typically invested considerable effort into formulating their approach and are therefore well placed to remain committed to the approach during periods of cyclical underperformance. Of course, the manager researcher must have a reasonable understanding of the asset class to be able to determine whether or not the chosen approach is appropriate for the asset class. Moving away from investment strategy, we have observed that the operating environment in which an investor or team sits is a key determinant of success. Investment teams that own the business within which they operate are typically more aligned with clients than hired guns. These investors are also in a position to control the quantum of assets they manage to ensure weight of assets does not erode performance potential as it tends to do when a business is driven by the sales team.

The obvious route here is to direct interest toward boutique investment firms which typically focus on one core strategy in which the founders are long-in-the-tooth specialists. However, the boutique founders of tomorrow may be operating in large organisations today; hence it is important to maintain some coverage of the larger firms to be in a position to move early into boutiques. In addition, there are skilled investors who have found they operate more effectively with the infrastructure of a large organisation and have built a franchise that gives them protected status. As we assess a fund management organisation, the corporate structure adopted is relevant. For example it is easy to contrast the time horizons of the partnership with a listed business and one can observe a very different targets and incentives given to investment professionals.

Finally, we must return to the observation that active investors that do generate outperformance do not do so consistently, year after year. Once again, we must shout “of course they don’t!”

We have established that excellent investors have a clearly articulated investment approach to which they are committed. If these active managers are disciplined and stick to their approach they should deliver attractive returns in excess of any appropriate index over a reasonable time-frame. However, over short periods, stylistic factors come into play. In other words, the approach is either in vogue or not and when it is not, short term performance will likely lag the index. The key takeaway is that relative performance is cyclical. This cyclicality is caused by the preferences of the investment manager which can manifest themselves in sector biases, for example some managers prefer consumer facing businesses over industrials while others are drawn to asset light services businesses and ignore asset rich utilities. Cyclicality is often caused by style with periodic dispersion between value and growth being the most well observed. Chart 3 highlights the prolonged underperformance of value versus growth that began in 2007. Anyone looking at a manager with a deep value bias today should expect to find underperformance and should be wary of managers describing a deep value philosophy while presenting exceptional recent performance.
Chart 3: Style Drives Relative Return CyclicalityStyle Drives Relative Return CyclicalitySource: Bank Credit Analyst

A failure to appreciate the cyclicality of performance will result in the most common mistake made by fund allocators – buying after strong relative performance and selling after poor relative performance. The buy high, sell low phenomenon is the trap that awaits anyone using performance screens to choose managers. Never ignore the disclaimer: “Past performance is not a guide to future returns”. Historic returns data has only one use – to test the allocator’s knowledge of the investment strategy. If the track record is not understandable given knowledge of the approach, get rid of the manager regardless of whether the track record shows good or bad performance.

Chart 4 demonstrates the patience required of the clients of successful active managers. The chart plots the rolling three year annualised excess return of the IVI European Equity Fund. Over the period, the fund has delivered an attractive average three year annualised excess return of 2.4% per annum. However, to achieve this return, the client has enjoyed a period of great joy and then was perhaps tested in 2014 when the three year number declined to -3% per annum, since when the relative numbers have returned to an upward trend. The message is clear, once a good manager is identified; it pays to stick with them.

Chart 4: Relative Return Cyclicality

Relative Return Cyclicality


The debate between supporters of active and passive investment management will undoubtedly rumble on. Meanwhile, a select group of active managers will continue to deliver benchmark crushing returns for their clients and asset allocators with adhering to the principals outlined here will continue to benefit from the investment skill of this group. To recap, by constraining the search to truly active managers with a long term perspective; who are committed to their discipline and by understanding the manager’s operating environment, the asset allocator stands a better than average chance of selecting funds which can be held for prolonged periods of time and thereby compound returns to create real wealth for clients. By way of a proof statement, the results of Cerno Capital’s approved list managers are shown below. The excess return generated by our list correlated with the 2% outperformance assumed in Chart 1.

Chart 5: Cerno Capital Approved List Performance
Cerno Capital Approved List Performance
Source: Cerno Capital

[1] Alliance Bernstein, “In Defence of Active Management”, May 2016

[2] Cremers & Pareek, “Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently”, December 2015

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The potential to use investor sentiment as a gauge for future market trajectory is an appealing proposition. Sentiment is often cited as a contrarian indicator; excessive bullishness signals market exuberance poised for a reversal, whilst extreme bearishness may be the precursor to a market recovery. Such indicators are most useful when they are at extremes, and less so when the readings are neutral, which tends to be most of the time.

The reason for assessing sentiment is that, when investors are extremely bullish, they tend to be fully invested, leaving little available cash to drive asset prices higher. On the other hand, when extreme bearishness prevails, the abundance of cash sitting in portfolios can be deployed to buy cheap assets, creating the foundation for a bull market.

There are broadly two approaches to quantifying investor sentiment: attitude and activity. The former are typically surveys, gathered through proxies, of near-term expectations of active investors or market commentators. The second method maps risk appetite through trading activity, measured by asset flows, positioning and market volatility. In practice, the usefulness of these sentiment indicators for predicting stock market returns is somewhat uncertain. In this note we will examine a few of the most quoted metrics.

Starting with surveys, we look at both institutional investment advisor sentiment as well as individual investor sentiment, represented by US Investor Intelligence (II) and the American Association of Individual Investors (AAII), respectively. The US Investor Intelligence series is one of the oldest sentiment indicators, dating back to 1963, collating the opinions of over 100 newsletter writers through weekly surveys. Currently, the series is displaying extreme pessimism. The bull/bear ratio dipped below 95th percentile for the first time since 2008, or 2011, if you include the very close encounter of that year. We use percentiles instead of the usual standard deviation measure due to the skewed nature of the series (positive skew, in this case), defining extreme observations as the outermost 5% on either end of the bullish and bearish spectrum.

Exhibit 1: US Investor Intelligence Bulls/Bears RatioSentiment_1Source: Investors Intelligence

On this measure, some simple analysis shows that it does in fact have predictability, albeit rather one-sided and, somewhat surprisingly, more reliable over the longer term of 2-3 years and less useful for near-term returns of one year or under. The caveat here is the limitation of a small sample size, as this level of pessimism has only occurred a handful of times in history.

The table below shows the average forward returns of the S&P 500 index from the point which sentiments become extreme. Given this is a contrarian indicator, we would expect to find negative future returns if one invest at the point of bullish extremes, and vice versa. And indeed, we do observe visible predictability at bearish levels, whereby future returns are generally positive, and becomes more pronounced as the horizons extend. The quality of the return pattern also improves towards the longer end of the time horizon as the number of negative observations decreases drastically for 2-3 years (from 45% at 1M to 5% at 3Y), meaning you will make money most of the time, whilst in the short-term (<6M), it can be an almost 50:50 chance of getting positive or negative future returns.

Exhibit 2: Forward S&P 500 Index returns at extreme sentiment levelsSentiment_2Source: Cerno Capital

By contrast, on the extreme bullish levels, there is no emergence of a contrarian indication as the future returns tend to still be positive on average, and the quality of the result remains mixed even as time progresses. One possible explanation for this may be that the bears can be too early to call a market top, as an irrational bull market can extend for several years before it eventually crashes, as it did in the Global Financial Crisis, thereby making the reading less predictable.

The main difference between professional investors and individual investors seem to be a matter of emphasis. For example, the bullish sentiment leading up to the TMT bubble is much more pronounced on the AAII but barely registered on the II. The peak bullishness in 2015 displayed in II, on the other hand, is much more muted on AAII. On this occasion, both surveys appears to be giving a similarly extreme signal where the bears outnumber the bulls by a hefty margin, as illustrated by the AAII Bulls-Bears spread chart below.

Exhibit: 3: AAII Bulls-Bears SpreadSentiment_3Source: AAII, Bloomberg

In forecasting returns, it is also the case for AAII that extreme negative sentiment provides a better indication of future performance than positive sentiment, on both standard deviation and 5th/95th percentile basis, as we see in the table below. Although compared to Investor Intelligence, the level of mixed result remains higher even at the longer horizon of 3Y, whereas the chance of getting a negative return after 3Y is all but eliminated for II (% of negative return in 3 years: 17% vs. 5%), which means that the chance of being too bearish too early is still relatively high. The bullish side does give consistently low or negative future returns up to 2 years on average, but again, the quality of the result is questionable given the high percentage of positive readings.

Exhibit 4: Forward S&P 500 Index returns at extreme sentiment levelsSentiment_4Source: Cerno Capital

Other commonly used investor activity indicators are also trending towards extremes, including the CBOE equity put/call ratio, which records simply the total volume of equity puts traded divided by the calls traded in the options market, also a contrarian metric.

Exhibit 5: CBOE Put/Call Ratio 30-Day Moving AverageSentiment_5Source: CBOE

Flow data which measures the pace at which investors are rotating out of equity is gaining momentum, signalling that they are becoming more risk-averse, as shown in the ICI mutual fund flows data for equity funds:

Exhibit 6: ICI Mutual Fund Flows: Net New Cash Flow – All Equity Funds (USD, Millions)Sentiment_6Source: ICE

The bearish sentiment reflected in the shift out of equities is also mirrored by a rise in the price of gold, where gold is typically regarded as a safe haven asset and a good gauge for market uncertainty, having the tendency to perform well in times of stress. This trend is supportive of an increasingly uneasy investment community, with its 3 month price change the quickest gain in value just short of two standard deviations above the long-term mean.

Exhibit 7: 3M % Change in Gold PriceSentiment_7Source: Bloomberg

Finally the VIX, also known as the ‘fear indicator’, is a measure of the 30-day implied volatility of S&P 500 index options. Whilst not extreme, it has recently surpassed values last reached in 2011.

Exhibit 8: The VIX IndexSentiment_8Source: Bloomberg, CBOE

Summary & Conclusion

Such indicators are most useful when they are at extremes, and less so when the readings are neutral, which tends to be most of the time.

Each sentiment indicator measures the market from a slightly different perspective, therefore should never be used on a standalone basis, and it is advisable to monitor in conjunction with other market indicators (especially fundamental).

This is by no means a comprehensive list of all the possible sentiment metrics. Not surprisingly, those which we have surveyed are consistent in implying a growing bearishness.

It is too early to call a bottom as not all of the indicators have reached extreme levels. The danger with sentiment watching is that theoretically it can always become more optimistic or pessimistic, driven primarily by price momentum.

As portfolio managers, who have a keen interest in odds (and tipping them in our favour) we monitor sentiment indicators to look for extremes. Should such an extreme be reached, our understanding of these readings will influence asset allocation.

Extracts from this article first appeared in The Daily Telegraph on 5th March 2016


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The hunt for income continued in 2015. Equity income investors who were drawn to the energy and materials sectors faced the headwind of commodity price declines. Recent dividend cuts from companies such as Anglo American highlight the risk of a singular focus on yield. The Cerno UK Equity Income Strategy had no direct exposure to these sectors during 2015 having sold a position in Royal Dutch Shell at the end of 2014. The proceeds of this sale were invested in Vodafone. Other than this purchase, portfolio activity for the year was restricted to rebalancing.

Our strategy identifies London Stock Exchange listed businesses which demonstrate a history of dividend progression along with growth, profitability and balance sheet characteristics which suggest the progression of dividends can be maintained. The strategy is concentrated in a small number of positions which are equally weighted and rebalanced routinely.

The performance of the strategy is captioned below:-


Since Inception ^


Cerno  UK Equity Income Strategy




FTSE 350 Index




FTSE 100 Index




FTSE 250 Index




^ Inception date was 12th April 2013

Note; performance represents the UK Equity Income Strategy which is run as part of a Cerno Capital client portfolio.

Index Data Source; Bloomberg

The largest contributors to performance for 2015 were Greggs and RPC Group. Both companies have been held since inception. Greggs is a UK baker with a strong position in the food-on-the-go market. When the shares were purchased, the market was concerned by the strategy for growth given a large number of retail units in existence. This was not helped by the company exploring ideas which moved away from its core competency of selling competitively priced, freshly made sausage rolls, sandwiches and apple turnovers. The company has subsequently refocused on core values and been proactive in moving retail units closer to customers, which means an increase in transport hub locations relative to high street locations. Capex was also routed to revamping outlets which had become somewhat dated. The board of Greggs has delivered a solid history of dividend growth stretching back to 1991. A period of maintenance rather than growth of dividend while the corporate strategy was reworked provided the opportunity to make our initial purchases on a yield in excess of 4%. The subsequent performance from the company has enabled the board return to growth in the dividend and this was supplemented with a special dividend of 20p per share midway through 2015 – for comparison, interim and final dividend payments for 2015 totalled 22p.

RPC Group is a manufacturer of rigid plastic packaging. The company sells various plastic packaging products to consumer goods manufacturers worldwide. The company is emerging as a consolidator in this sector and has made a number of acquisitions, the most recent of which is the purchase of Global Closure Systems (GCS). The board has delivered a growing dividend stream with average dividend growth of 7% over the last five years.

These two holdings contributed 14% to the strategy return for the year.

The strategy’s holdings in mid cap companies represent 40% of the portfolio and therefore the outperformance of the FTSE 250 versus the FTSE 100 can be viewed as a tailwind over the whole period since inception.

The strategy contains four companies which are more typically considered as income stalwarts of the large cap universe such as British American Tobacco and Vodafone. In aggregate, these have contributed 3% to the 2015 performance.

The large detractor for the year was Pearson which delivered a negative contribution of -3.8%. The company has a long history of dividend progression and this has continued. Pearson is undergoing significant corporate change as it exits from print media businesses and focuses on delivering education to children and adults via digital delivery. The challenges of monetising Pearson’s intellectual capital are increasingly evident and this resulted in significant weakness in the shares.

The portfolio received ordinary dividend receipts in 2015 that were 5.5% higher than 2014. This excludes special dividends.

The yield on the portfolio of 3.4% is currently lower than that offered by the FTSE 350 Index which is 4.1%. This lower yield is a result of the portfolio holding no exposure to the materials and energy sector where optical yields are high; however the risk of dividend cuts is also high.


Share buybacks, or the repurchase of shares by listed companies is a popular use of listed companies’ cash. Repurchased shares are initially held in treasury which means they do not qualify for dividends or voting rights. If treasury shares are subsequently retired, this provides a stronger signal on the intentions of management.  From the long term shareholder’s perspective, a buyback is viewed positively because the reduced share count increases all other shareholders’ percentage ownership of the company. Of course, the value of the company has declined by the amount of cash used to repurchase the shares.

A buyback impacts per share data. Therefore, an immediate benefit to shareholders of a buyback is the reduction in share-count which increases dividend per share assuming there is no reduction in the total amount of cash set aside for dividend distribution. The corresponding benefit to management is an increase in earnings per share; many incentives are based on earnings per share growth data, rather than aggregate earnings growth or return on invested capital metrics.

It is therefore understandable in a world of income starved investors and incentivised corporate managers that buybacks are generally welcomed. Indeed, some commentators have been tempted to add the dividend yield to the percentage of shares bought-back to come up with a dividend plus buyback yield. While this might be appropriate at the individual company level, the extension of this type of analysis to the aggregate market level should be treated with caution. A recent paper by Chris Brightman of Research Affiliates provides a more thorough analysis of the activities of companies buying back their shares in the US.

Are Buybacks an Oasis or a Mirage?

In particular, he highlights the appearance of some of the largest repurchasers of stock on the list of largest issuers. Why would a company buy back shares only to reissue? Typically, to fulfil stock compensation plans. In other words, companies may be repurchasing shares in order to give them to management – hence the need to see companies retiring equity rather than holding in treasury for use as compensation plans vest. Brightman correctly observes that it is wrong to only look at the equity component of the balance sheet; an assessment of debt issuance is also important. He notes that total debt issuance by US corporates in 2014 was US$1.2 trillion. How much of this was used to repurchase stock as opposed to funding growth in operations? Brightman points to a study by his colleague Rob Arnott that observes average dilution through aggregate net issuance of equity on the US Equity Market of 1.7% per annum since 1935. This would go a long way to wiping out the yield impact of buybacks.

This analysis backs up the view we, at Cerno Capital, hold on buybacks – they are a tool of the financial engineers at work within companies (and their advisors) and should be analysed on a case by case basis within the context of the whole capital structure of a business. Most crucially, share buybacks cannot directly alter the operating performance of a company; however, financial engineers can use them to alter the distribution of profits from operations and it is the job of the equity analyst to identify whether or not shareholders are being treated appropriately.

For a full analysis of the value created by share buybacks, we recommend the following article from the consultants at McKinsey;

The value of share buybacks

In recent weeks, China has dominated the headlines; in particular the recent stock market and currency volatility have sparked fear across global markets. Looking forward, we would highlight a less discussed market that has been concerning us in recent periods: – Turkey.

Turkey is significant, due to the size of its economy (13th largest among OECD countries) and its geographical and economic proximity to Europe, which accepts circa 55% of its exports. Turkey is in a more vulnerable position than China in several ways: it runs one of the highest current account deficits in the EM universe owing to its dependency on short-term foreign funding to support the economy. Like its EM peers, Turkey has been a beneficiary of large foreign capital inflows, manifest in the significant external leverage built by its domestic corporate sector, masking its waning economic momentum. Gross external debt has doubled from pre-crisis levels to almost US$400 billion in Q1 2015. This  represents 50% of GDP, which, as noted by financial historian Russell Napier, exceeds the threshold of 30% where historically a country is more likely to default. In comparison, while China’s debt level is much higher in absolute terms, its ability to repay is stronger with the ratio sitting at 9% of GDP.

There are some countervailing elements, however. Falling commodity prices are beneficial to Turkey, being a net importer, in stark contrast to Brazil or South Africa. This will help improve its current account deficit somewhat, if low prices are sustained for longer. Turkey is also the least exposed to China among major EM economies, with less than 1% GDP of exports to the country.

Nonetheless, the end of quantitative easing and the expectation of rate rises in the US may see a reversal of the trend of flows that have been fundamental to Turkey’s economy, signs of this are just beginning to emerge. This will make funding more expensive and debt more difficult to repay, thus making Turkey more vulnerable to capital flight, taking into consideration that almost 25% of their bonds are held by foreigners. These eventualities are often precursors to the introduction of the foreign investors nemesis – capital controls.

Flows within dedicated EM bond funds are increasingly negative. The most recent week has seen $2.5bn of outflows, the worst level since February 2014, although still significantly below the 2013 taper tantrum period.

Exhibit: Dedicated EM bond fund flows

Dedicated EM bond fund flows

Source: Barclays Capital

On average, Turkey account for 5% of hard currency and almost 10% of local currency EM bond indices, and is weighted similarly in the largest EM Bond funds with few exceptions. Given this level of exposure, coupled with the accelerating negative unwinding trend in emerging market debt, Turkey’s weak fundamentals, high debt levels, and sensitivity to capital flow volatility will yield an increased risk of capital controls being introduced as a counter measure. Should this happen, we will likely experience significant turmoil in EM debt markets and renewed focus on the lending banks.

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…)

The change to China’s currency regime has potentially large consequences for global financial assets. It should prompt new thoughts. The reason why it surprised many was on account of the authorities’ insistence that they did not see the currency as a tool to promote growth,  the relative stability and strength of the currency in the past 20 years and, due to the tight way in which it is managed, the lack of volatility over recent years. The general consensus was that relative currency stability would further China’s desires for the RMB to be accepted as a transactional base currency with regards to their longer range plans for capital account opening and inclusion in the IMF’s currency basket of Special Drawing Rights.

Whereas the relationship between monetary policy and currency in, for example, the Eurozone or Japan is readily accepted, in the case of China, it comes with a heavy freight of political considerations, both within Asia and, in particular, the US. Opinion could be said to be asymmetric as it is only weakness that vexes, not RMB strength. In the past two decades, nations, both sides of the Pacific, have come to fear China’s export strength and have had to deal with the hollowing out of their own domestic industries.

The economic context of the three day weakening of the daily fix between the 11th and 13th of August was clear enough. A persistently weak run of economic data, capped off by the July export numbers (-8% yoy) in light of a persistent relative strengthening of RMB, evidenced in the below chart of real effective exchange rates.

REER relative to 10year average

Source: Bank for International Settlements

Professional investment managers had, perhaps surprisingly, not much active exposure in the RMB which is freely traded in non-deliverable offshore contracts. Investing in Chinese equity and bonds remains more a regional, specialist activity managed from Shanghai, Hong Kong or Singapore. The offshore rates differ from official onshore rates which fluctuate within a 2% band of the daily fix. The onshore rate regime sits somewhere between a fixed currency and a floating currency; an area normally referred to as a dirty float, though, perhaps in this case would be better referred to as a dirty fix.

In suggesting that the daily fix would reference the offshore rate, the officials at the Peoples Bank of China (PBoC) promulgated a powerful logic that then pushed the fix down three consecutive days before the resultant back-draft of surprise prompted them to halt the process on day three. This has not done anything for Beijing’s reputation for financial management which was undeservedly robust.

From their perspective, all subsequent decisions carry gargantuan risks and the ranks of bureaucrats are no longer peppered with international experience: none have had any education outside of China or Russia. On the one hand, further steps to weaken the currency will stimulate increased capital flight, but, if not of sufficient size, will not provide assistance to the export sector. If the new flexibility in the fixing is abandoned, China’s aim for capital account opening and international recognition of its currency is in jeopardy. There is a risk of incoherence in policy setting and adoption.

A meaningful depreciation of the RMB will set off a deflationary pulse around the world. Reduced purchasing power from China may remove an element of global corporate profit growth. This in turn crimps returns from the only remaining prospective asset class: equities.

By being short the Chinese currency, part of the negative impact of this possibility is offset.

For our own part, we hold a short RMB position in our core portfolios, including TM Cerno Select. We increased this position on August 11th. Prior to that date, it was our view that the weakness in the Chinese economy would be persistent enough that there was a moderate medium term possibility of a large currency adjustment. What has taken place is a small (-2.9% as at August 14), near-term adjustment to its currency which presages further near to medium term adjustments. To gauge a sense of magnitude, the currency would have to weaken by 23% to return to its relative 10 year average on a Real Effective Exchange Rate* basis.

*The weighted average of a country’s currency relative to a basket of other major currencies, adjusted for the effects of inflation. The weights are determined by comparing the relative trade balances, in terms of one country’s currency, with each other country within the index.

Sometimes one comes across a written piece that so succinctly expresses a held point of view that the only job in hand is to circulate it. (more…)

Value Ranking for Government Bonds

The above chart, which is sourced from the Bank Credit Analyst, depicts the deviation from mean real yields since 1980 for the world’s major government bond markets.

The picture it paints is stark: with a very few exceptions, the valuation of most bond markets stand at more than one standard deviation from long term norms. Some bond markets are approaching or have exceeded two times normal levels.

For the kind of new normal described by these valuations to prevail, something definitive and long lasting has to have taken place with regards to inflation.

We continue to be of the view that greatest risk facing markets is that either growth or inflation surprises to the upside. Bond markets, inflated by non-price sentive buyers, are now priced for only one environment: pervading disinflation.

Since mid-2014, the trade-weighted dollar index has surged 21%. If this is indeed a new bull market in the US dollar, it is not yet fully fledged. The previous two major US dollar bull markets during the open currency era traced rises of 88% and 47% between 1980-1985 and 1995-2002, respectively.

Divergent monetary policies remain the key driver, predicated on the assumption that the Fed tightens first, whilst other major blocs retain looser monetary policy, increasing interest rate differentials. Speculative long dollar bets reached a record high earlier this year with the most extended positions against the Euro and the Yen. However, since March, with the renewal of the Greek Crisis and Chinese equity volatility grabbing headlines, the dollar has traded sideways and given up some of its earlier gains.

A stronger dollar also exerts pressure on emerging market economies, who traditionally suffer under this scenario. History suggests that disruptions occur when the Fed tightens and the dollar rises in tandem. The previous two dollar bull markets proved traumatic for, respectively, the Latin American and Asian economies in the early 1980s and late 1990s, as the burden of repaying dollar-denominated debts became intolerably expensive.

This time may also be painful for countries that have borrowed extensively in US dollars during the QE phase post the Global Financial Crisis, especially those with large currency mismatches (aka. where foreign currency borrowings is not matched by foreign currency earnings). Until 2008, developed nations have led the global debt accumulation, but since then, the emerging markets have taken over the driver’s seat as capital flowed in from investors chasing after yields overseas. Data from the Bank of International Settlements (BIS) estimates that offshore US dollar lending has grown to US$9 trillion from US$6 trillion pre-2008. Emerging markets are, once again, on the receiving end of a large proportion of this credit, as seen below.

Exhibit: US dollar credit to non-banks outside the United States (in USD Trillions)

US dollar credit to non-banks outstanding stocks1US dollar credit to non-banks by counterparty country

Source: BIS

Whilst Southeast Asia learned hard lessons from 1998, China, which escaped the Asian Financial Crisis, appears to have not. It has become a fervent borrower: out of the estimated US$4 trillion that flowed into the emerging markets, it alone accounted for over US$1.1 trillion, with the majority of the credit disbursed in the form of loans. In the below chart, the other two BRIC nations, Brazil and India, pale by comparison.

Exhibit: US dollar credit to Brazil, China and India (in USD Billions)

US dollar credit to Brazil, China and India (in billions of dollars)

Source: BIS

China’s corporate debt sector currently stands at close to 200% of GDP (including financials), having doubled from 2007 levels. Its issuance of US dollar bonds is also 11 times larger than it was in January 2007, as illustrated by the chart below.

Exhibit: China foreign currency bonds outstanding by issuer (in USD Billions)

China Foreign currency bonds outstanding by issuer

Source: Asian Bonds Online

Almost 25% of aggregate Chinese corporate debt is dollar-denominated, but only 9% of Chinese corporate earnings are. The difference between these two figures defines the mismatch. The Chinese real estate sector is the worst offender, where approximately 50% of the debt is concentrated. The second biggest borrower is the utilities sector. These sectors also have the greatest currency mismatch as the majority of the revenues will be in local currency, with exposures generally unhedged.

Exhibit: China currency mismatch by debt and EBITDA

China Debt by Currency China EBITDA by Currency

Source: Morgan Stanley

However, whilst China’s aggregate debt level appears high in absolute terms, it must be noted that a large proportion of this is domestically held. The triggering factor for most major defaults is often a consequence of large external borrowings, an area where China remains relatively robust. Its overall gross external indebtedness is low at 9% of GDP as at end-2014, not a level that raises immediate concern (conventionally alarm bells ring when level reaches 35% of GDP). China has ample foreign reserves for coverage (US$3.6 trillion or 4x covered) in the event of distress. On the other hand, many other emerging nations appear vulnerable on this measure, including much of EEMEA. In emerging Asia, the weak link is Malaysia and in Latam, Chile.

Exhibit: Gross external debt as a % of GDP, Q4 2014 (in USD Billions)

Gross External Debt as a percentage of GDP Q4 2014

Source: World Bank

Outside China, the picture in emerging Asia seems more reassuring in general: on average 22% of their overall debt is dollar-denominated, balanced in large by their 21% dollar earnings. With flexible currencies, adequate FX reserves and a larger proportion of local currency denominated bonds, the Asian economies should be more resilient than during previous periods of dollar strength.

Nevertheless, pockets of vulnerabilities do exist and contagion risk is not improbable. Growth has slowed in many countries, markedly in China, but also in major borrowers including Brazil, Turkey, Russia and South Africa. These latter countries must service dollar debt using energy sector revenues, which have been exposed to recent falls in oil prices that may persist for longer with Iranian supplies back on the map. In other cases, current account deficits are funded by short-term capital inflows. Turkey, Argentina, Malaysia and Mexico all have short-term borrowings of over 50% of reserves.

Exhibit: EM external liabilities by currency composition

EM external liabilities by currency composition

Source: UBS, Haver

As a large proportion of emerging market debt is held by foreign investors, many will be quick to retract their capital should sentiment deteriorate materially over any signs of distress. Once the cycle begins, EM companies will find it incrementally more difficult to roll-over dollar denominated loans, which form a large percentage of their external liabilities as exhibited above. This will, in turn, drive a demand for the US dollar, causing it to appreciate in value, push up the local currency value of the debt, thus making it more burdensome to service, generating a self-reinforcing downward spiral. Foreign holders of local currency denominated debt may also want to exchange it for US dollars, further driving demand.

Capital outflows in emerging markets have begun to build since the ‘taper tantrum’ in May 2013, as illustrated by the EM debt fund flows chart below. Capital flows in China have also turned negative for four consecutive quarters, recording a capital and financial account deficit of US$78bn in the first quarter of 2015, the largest since 1998, despite the small absolute value. This is partially due to a slowing Chinese economy and the result of a rising US dollar coinciding with declining Chinese interest rates. With the Fed holding on to their expectation of a 0.5% interest rate rise this year, the tendency is for these trends to accelerate.

Exhibit: EM debt fund flows (in USD Billions)

EM debt fund flows

Source: Morningstar

Exhibit: China Capital Flows (in USD Hundred Millions)

China Capital Flows (in hundred million US dollars)

Source: Trading Economics

The argument for a stronger dollar rests on the relative strength in the US economy versus other major economies, met by interest rate rises against a background of some vulnerability in emerging markets. Now that the uncertainties brought by Greece and Chinese equities have somewhat abated, for the time being, the dollar has resumed its upward trend as focus is reverted back to the Fed’s interest rate policies.

Exhibit: Trade-weighted US dollar index (DXY) since 1970

Trade-weighted US dollar index (DXY) since 1970

Source: Bloomberg

A strong dollar creates countervailing pressures, particularly through the import of deflation and a depressant effect on US corporate earnings. Standard & Poors estimates that approximately 46% of sales of S&P 500 companies are derived internationally, thus, a strengthening dollar will directly affect US multinationals’ corporate earnings. Further, US inflation was more shielded to exchange rate fluctuations during the 1990s, and US import prices were much less volatile, as Barclays Research suggests.

Exhibit: US dollar on PPP (top) and REER (bottom) measures against a basket of DM currencies

US dollar on PPP US Dollar REER

Source: ValuTrac, Bloomberg

On valuation grounds, the US dollar is not overly expensive relative to its previous peaks on REER and PPP basis, against a basket of DM currencies, as exhibited above. Although worryingly, investor positioning remains at somewhat elevated levels: two standard deviations above the long-term average despite some moderation since the trade-weighted dollar index backtracked from its recent high in March.

Exhibit: Net speculative positions on the US dollar

Net speculative positions on the US dollar

Source: Morgan Stanley

We tend to think that there is less potential for steep dollar appreciation this time round due to better EM fundamentals than during the previous dollar bull markets, in particular emerging Asia, and also due to the possible negative implications of a strong dollar for the US economy. We, therefore, expect the dollar to resume a milder climb onward, with more volatility in tow.

“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” –  John D. Rockefeller

A discussion of dividends or income can lead to glazed eyes of some equity market participants. Hot-handed momentum traders care only for the greater fool who will pay a higher price for their slice of equity. Long-term growth investors may well be invested in companies at the pre-profitability stage and hence dividends are not on the agenda. Alternatively, some investors believe in the capital allocation credentials of their management teams to the extent they entrust management to reallocate all profits on their behalf.

Meanwhile, the income investor knows exactly when his or her companies go ex-dividend, and feels Rockefeller’s embrace when the pay date comes and the dividend shows up on the daily cash sheet.

In truth, an interest in dividends is a hall mark of the equity investor. Equity is nothing more than the sliver of hope that separates assets from liabilities. The owner of common equity is entitled to nothing other than any dividend that might be declared by the board of directors.

Of course, the knowledge that dividends are important is no guarantee of success. The greatest risk is being blinded by the light emanating from a company with an exceptionally high current yield (most recent 12 month dividend divided by current price). This light should be treated as emanating from a light-house. Purchasing these equities can be a perilous exercise akin to an attempt to shortcut a headland by sailing over skerry infested waters. Dividend cuts can sink a portfolio.

It is not the yield at time of purchase that dictates the success of an equity investment, rather, the growth of that dividend over the holding period. To demonstrate this, the chart below shows the development of portfolio valuation from four different dividend growth scenarios:

The Impact of Dividend Growth on a £100 Investment

Source: Cerno Capital

In each case, the starting yield on the portfolio is 3%. We have assumed dividends are reinvested and taken the analysis out for twenty years. We have also assumed no valuation change in the pricing of the investments. The message is very clear: if an investor has a long time horizon, for example, someone in their forties looking to make investments that will provide income beyond retirement, the rate of dividend growth is the key determinant of investment success. The growth in dividends (the G in D from our title) will substantially account for the price appreciation of the asset.

To emphasise this point, an investor in a no dividend growth portfolio might receive £5.41 in year twenty. Meanwhile, an investor in a 10% dividend growth portfolio will receive a dividend cheque of £103 in year twenty.

If we give the zero dividend growth portfolio a head start of an initial yield of 5% and assume the dividend survives, the 10% dividend growth portfolio has overtaken the no dividend growth portfolio by year ten and by year twenty is producing seven times the dividends of the former.

At this juncture, it is tempting to suggest a strategy which looks for those companies that have high historic dividend growth rates. Such a strategy has some merit. However, it would be backward looking and would completely miss the point that high dividend growth is the product of a successful business that is run by management which acknowledges the interests of shareholders. Growing dividends can only be produced by companies which generate cash rather than paper profits and which have a dominant industry position that allows them to maintain their profit margins over a prolonged period of time.

These are the types of companies targeted by the Cerno Global Leaders Strategy. Our selection criteria are tightly defined and forward looking. The level of dividend or its history is not one of our criteria. However, the companies we own today have an average five year dividend growth rate of 11.3%. Our intention is to hold these companies for a very long time.

We look forward to counting our dividends.

For further information about the Cerno Global Leaders, invested as part of our core investment strategy, please refer to the TM Cerno Select Fund webpage.

writing man

Hugh Sloane of Sloane Robinson (SR), one of Cerno Capital’s Investment Advisory Board Members, (more…)

We all know that the UK and US stock markets have risen over the past 50 years. (more…)

On the 10th of June Cerno Capital hosted a round table discussion with Douglas Brodie, (more…)

For the unconstrained global investor, Australia is a prospective hunting ground for profit. Any comprehensive analysis of the main trade and capital trends at work in the world find their conflux in Australia’s capital markets. Predicated on China’s fixed asset investment boom over the past quarter century, Australia’s economy has been substantially driven by demand for its ores and minerals. It relates uneasily, it seems at times, on account of deep cultural differences, to the rest of Asia, in particular Indonesia.

Australia is an affluent, urbanised society. It is, above all, a consumerised population that is, in economic jargon, fully financially included. It has an independent central bank and currency.

On account of these features, backed by disciplined capital markets and secure laws, Australia’s equities, government bonds and currency have been a destination for macro investors of all stripes, including hedge funds.

We measure recent opportunities by looking at 12 month rolling returns of its currency, benchmark bond and main equity index.

12M Rolling Returns - Australian Equity, Bond & Currency

Source: Morningstar/Bloomberg

When the currency is weakening, returns from key asset classes are crimped, as can be seen in the below chart.

12M Rolling Returns - Astralian Equity, Bond & Currency

Source: Morningstar/Bloomberg

The tricky thing with macro investing, prosecuted via Australian instruments, is the various counter influences at work. We list these as follows:

– Shorting the AUD is intrinsically expensive on account of the yield differential between AUD and its obvious corollaries. For example, the yield differential between AUD and USD, based on 1Y rates has averaged 304bps over the past 5 years.

– Outright investments in the sovereign bond market have delivered returns in AUD based on the general fall in rates accompanied by some flattening of the curve. However, for a non-domestic investor, these gains have been crimped by AUD weakness. Longer range, strategic investments in the bonds require the adoption of significant currency risk. Against them are lined up the yield hunters and persistently positive capital flows of new immigrants from China and elsewhere.

– Many macro commentators have long predicted the demise of the economy as they surmised that that falling commodity prices would spur some form of recession that could include a property down cycle. This has tempted some funds to go short Australian equities and the banking sector, in particular, has been targeted. To their frustration, the Australian equity market has remained peachy, supported by Australia’s superannuation schemes (government mandated pensions), with the banks especially valued for their income stream.

– To cap these, the various identified trends have been subject to reversal. In particular the currency which fell 20.1% between July 2014 and April 2015 has strengthened by 6.7% from 2nd April 2015 to the time of writing.

Cerno Capital’s core strategy ran a short Australian dollar position profitably until it was closed on 16th February 2015. We currently hold no specific exposures to Australia directly.

Within global equity markets, April saw value style indices outperform growth style indices. The relative return of one style versus the other would not typically be a significant event and the relative outperformance was just 1% according to the Russell Global Style Indices. However, the prolonged period of underperformance of the value style versus growth (a 5% difference over the last year and a 37% difference since 2005) and the associated headwind for equity investors with pronounced value style bias means that observers are in a mood to call for a change in trend.

Can we observe a similar pattern in active manager universe data? For reliable style universe data we look to the Morningstar US large cap value and growth peer groups. The median value manager has underperformed the value and broad market indices over the last five years while outperforming over one and three months. Meanwhile the median growth manager has lagged the growth and broad market indices over the last month after a prolonged period of outperformance over the broad index (the median growth manager rarely outpaces the growth index).

So perhaps we are onto something? It is important to remember that a value style index is a naively implemented strategy which will typically have high allocations to companies which are optically cheap on asset and earnings multiples. There is also a tendency for value style indices to hold high weights in cyclical industries when trailing multiples suggest value, because the equity market discounts a cyclical decline in earnings. We must therefore look to the underlying composition of the style indices.

When we do this, the picture becomes clearer. The largest sectors in the Russell Global Value Index are Financial Services and Energy – two beleaguered sectors which performed strongly in April.

So it appears that we are really looking at a sector effect. Peering further into the data can provide some support for this stance. The outperformance of value over growth in Latin America, again according to the Russell Indices was 9%, a much greater differential driven by the significant weighting in extractive industries within the Latam area. The picture is murkier in Asia ex Japan, a region with a much lower weight to Energy, but a high weight in Financials, particularly in China which rallied hard in April. The headline style indices suggest value also outperformed in April. However, the style team at UBS performs a much more granular assessment of style returns than the major index providers and they found that value styles continued to fare poorly across Asia.

Does any of this help us in managing our equity allocation? Emphasising value over growth is very different to implementing a valuation discipline – we would always argue in favour of the latter. Given the driver of style returns appears to continue to be sector, it makes more sense to spend time making sure stock and sector exposures are supported by a sound investment thesis. cheap hotels . With regards to manager selection, deep value managers with an unconstrained approach to sectors are the group with the most to gain from sector reversals – just be certain they are not holding value-traps enjoying a dead cat bounce.

This article first appeared in Wealth Manager magazine.

There is a sea change in corporate behaviour in Japan that is leading to a focus on capital efficiency, (more…)

The Cerno Global Leaders Programme seeks to identify and invest in a group of companies worldwide which possess leadership attributes with a view to holding them for the long term.

What constitutes leadership capacity?

There are a small group of enterprises within the global equity universe that persistently exhibit above average growth, profitability and investment returns over the long-term. These companies often operate in oligopolistic industries and possess qualities that contribute to their competitive advantage and economic moats, ranging from:-

This method of understanding industries has been shaped by the work of Harvard professor Michael Porter. Porter coined five archetypal attributes: pricing power, bargaining power, threat of new entrants and substitutes, and competitive industry structure.

From a quantatively screened universe, the investment group selects stocks based on seven main criteria that were developed from Porter’s five forces:

  1. Strong and defensible competitive position or business franchise
  2. Management with a high level of integrity
  3. Above sector average growth prospects
  4. Cash returns delivered at significant excess to their cost of capital
  5. Operating in multiple markets or in the process of extending a strong domestic position internationally
  6. Companies with a robust balance sheet and low leverage
  7. Quality company at the right price

Complimentary to these, we observe that technological prowess and innovation are relevant factors in the sustenance of positive economic value in many of our candidates. In a world whose trajectory of travel is progressively technologically oriented, the strength of a firm’s intellectual property is crucial to their ability to sustain market leading positions and preserve barriers to entry, thereby protecting higher profits and margins over long time frames.

InfoTech, healthcare and automotive industries are well recognised leaders in innovation. Companies in these sectors regularly post R&D spending in excess of 10% of sales and hold a large portfolio of patents to protect their intellectual property. According to figures from Strategy&, a consultancy under PwC, Volkswagen, Samsung and Intel were the Top 3 investors in R&D worldwide in 2014, spending US$13.5bn, US$13.4bn and US$10.6bn in absolute US dollar terms, respectively. Furthermore, the top 20 R&D spenders illustrated in Exhibit 1 are comprised solely from the three sectors mentioned above.

Exhibit 1: Top 20 firms ranked by R&D expenditure in 2014 (US$ billions)

Company Geography Industry R&D
Spend ($Bn)
1 1 Volkswagen Germany Automotive 13.5
2 2 Samsung South Korea Computing and electronics 13.4
3 4 Intel United States Computing and electronics 10.6
4 5 Microsoft United States Software and internet 10.4
5 3 Roche Switzerland Healthcare 10.0
6 7 Novartis Switzerland Healthcare 9.9
7 6 Toyota Japan Automotive 9.1
8 10 Johnson & Johnson United States Healthcare 8.2
9 12 Google United States Software and internet 8.0
10 8 Merck United States Healthcare 7.5
11 11 GM United States Automotive 7.2
12 14 Daimler Germany Automotive 7.0
13 9 Pfizer United States Healthcare 6.7
14 N/A Amazon United States Software and internet 6.6
15 N/A Ford United States Automotive 6.4
16 15 Sanofi-Aventis France Healthcare 6.3
17 13 Honda Japan Automotive 6.3
18 16 IBM United States Computing and electronics 6.2
19 17 GlaxoSmithKline United Kingdom Healthcare 6.1
20 N/A Cisco United States Computing and electronics 5.9

* R&D spend data is based on the most recent full-year figures reported prior to July 1st.

Volkswagen has been the largest private sector R&D investor for 3 straight years. The Group employs over 40,000 research personnel working to expand the Group’s model range with a particular focus on the reduction of CO2 emissions. The automotive industry is undergoing a generational transformation, with Tesla leading the way in electronic cars, hybrids increasingly gaining traction, and new players like Google and Apple entering the market with driverless technologies. All of these are highly disruptive for an industry, whose power source has been fundamentally unchanged since the internal combustion engine replaced steam boilers 100 years ago. R&D investments are therefore critical for Volkswagen to sustain an edge over competition and adapt quickly to a changing industry landscape.

In the Tech space, Samsung has more than doubled their R&D spending over the past six years, as illustrated in the chart below. This is not surprising, given the cut-throat competition in two of Samsung’s major revenue generating businesses, smartphones and semiconductors. In the smartphone segment, threats from both established entities (Apple) and new low cost entrants (Lenovo, Huawei, Xiaomi) keep Samsung on its feet as switching costs in handsets is next to zero for its customers. And for semiconductors, competition is also intensifying among the largest manufactures including Intel, TSMC and Qualcomm.

Exhibit 2: Top 3 Enterprise by R&D Expenditure 2009-2014 (US$ Billions)

Top 3 Enterprise by R&D Expenditure 2009-2014 (US$ Billions)

Source: Strategy&

But even companies that are traditionally perceived to be relatively mundane can offer surprisingly innovative initiatives. In a constantly changing macro environment, these companies are either forced to innovate themselves, or alternatively, buy into new technologies to differentiate and gain an edge over their competitors. Research and development is increasingly critical to drive their success. Here we give three examples of such companies, drawn from our approved list and which span across the consumer, industrials and materials sectors.

Givaudan, a leading provider of flavours (for the food and beverage industry) and fragrances (perfumes, personal care, consumer products), at first glance, seems far from technological. The company however, spends 10% of their sales on R&D to develop new molecules (that are patented), proprietary solutions or improve existing formulation that will create value for their customers (e.g. more use of natural ingredients, cost reduction through alternative or substitutes among others). Their products form 3-5% of their customers’ cost base, but taste and smell are highly influential factors when consumers make a decision to purchase an end product. Therefore Givaudan’s customers (for example, Nestle), are less willing to switch to a cheaper provider at risk of reputational damage should the cheaper alternatives not live up to their standard.

Assa Abloy is a leading manufacturer of security locks and automatic doors. In a highly fragmented market, the company must innovate to differentiate themselves from their peers, holding over 500 patents with another 300 applications pending. They have a robust product pipeline, in which new products developed in the last 3 years constitute 32% of sales. What makes them more interesting is their lesser known division that operates in secure solutions, embracing existing technologies including NFC, biometrics and RFID for uses in credential management, secure IDs (i.e. US green card, e-passport, drivers’ licences), asset tracking and logistics, and healthcare (RFID tags).

PPG Industries, a paint manufacturer (a more recognisable subsidiary perhaps being Dulux), also puts substantial efforts into R&D. Their industrial/specialty coatings business, in particular, requires them to adhere to universal or industry specific demands. Depending on circumstances, products must be corrosion proof, weather proof, scratch resistant, insect repellent (architectural), health conscious (for food packaging coatings). They need to think about environmental impacts, adhesion properties (to different surfaces) and application methods (e.g. electro-coat, pre-treatment, powder or liquid). Other innovations are cost or sustainability driven. For example, coatings on aeroplanes needs to be specially designed to achieve cost-savings for the client through reduction in weight/quantity without altering the finish, thereby reducing the fuel cost per flight.

We look for companies that can identify the direction of global industry trends and are flexible enough to take advantage of a changing ecosystem.

Renishaw, a £2 billion market cap, UK industrial company, has a longstanding history of innovation in metrology products with wide applications in many end-markets, including automotive, aerospace, energy, power generation, construction, agriculture, medical and consumer products. The company is a beneficiary of ongoing trends in industrial automation and demands for high precision measurement, calibration, sensory, gauging and probing tools. The company invests heavily in R&D in excess of 15% of sales, which is the highest among peers, and holds a portfolio of 1,500+ patents. More recently, they have added a 3D printing business and a healthcare portfolio leveraging Raman spectroscopy technologies, recognising the wide application potential of the two businesses across multiple industries.

In the Cerno Global Leaders Programme, we place great emphasis on finding companies that can deliver and sustain technological advantage over the long-term, driving a defensible competitive position. R&D activity provides evidence of this commitment. We deploy a wider definition for the term ‘leader’ that also includes the explicitly and implicitly technology inclined companies such as the names mentioned in the examples above.  Exhibit 3 below displays the Top 10 firms in the Global Leaders Programme with the greatest commitment to research and development.

Exhibit 3: Top 10 firms in the Cerno Global Leaders Programme by R&D expenditure (US$ billions)

Company Geography Industry R&D
Spend (US$Bn)
R&D (as % of sales)
Volkswagen Germany Automotive 4.5 6.0%
Samsung South Korea Computing and electronics 8.0 6.9%
Johnson & Johnson United States Healthcare 6.6 11.4%
Novo Nordisk Denmark Healthcare 13.4 15.5%
Nestle Switzerland Consumer Staples 0.2 1.8%
PPG Industries United States Materials 1.7 3.2%
Givaudan Switzerland Materials 4.8 9.2%
Reckitt Benckiser United Kingdom Consumer Staples 10.4 1.6%
Assa Abloy Sweden Industrials 6.2 2.6%
Zimmer Holdings United States Healthcare 2.0 4.0%

Source: Bloomberg

One final point to take note is, however, R&D spending does not automatically translate to innovation. In other words, quantity does not always equate quality. When selecting companies, it is important to understand where their R&D focuses lie, and to assess the impact on the company itself and how influential it is on the industry as a whole. Exhibit 4 below shows the Top 10 most innovative companies globally, and it is clear that the constituents have changed somewhat compared to Exhibit 1. While Apple, Google and Amazon spend less on R&D, what they have achieved is regarded to be more influential across multiple industries that are not restricted to the one they belong to and have wider implications for the global communities.

Exhibit 4: Top 10 most innovative firms of 2014


2013 Rank

Company Geography Industry

R&D Spend ($Bn)*

R&D Spend (% of sales)




United States

Computing and electronics






United States

Software and internet






United States

Software and internet






South Korea

Computing and electronics





Tesla Motors

United States







United States






General Electric

United States







United States

Software and internet






United States

Computing and electronics





Procter & Gamble

United States




* R&D spend data is based on the most recent full-year figures reported prior to July 1st.

Source: Strategy&

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.

Through the first 8 years of the noughties, global healthcare stocks were notable underperformers. (more…)

One of our larger accounts rang me this week to ask what we thought of the geopolitical situation and how we were positioning for this.

Where? I asked.

Well, there’s the Ukraine, we really need to let them fight it out, he replied. What a desperate situation. And then there’s Greece: that’s an intractable one isn’t it? And then ISIS and that conflagration.

Our investor warmed to his topics but, after he had finished speaking I told him I was worried about other things.


My two biggest concerns are lack of depth in markets and concentrated positioning.

What do you mean?

Well, on the first point, one of the consequences of the Global Financial Crisis was to place much stricter limits on banks’ activities and capital ratios applied to each activity. The sum consequence of these measures is to drive banks out of proprietary trading and to severely restrict their market making activity. Fund managers talk obsessively about liquidity but, in truth, liquidity in many markets is a mirage. Last year we witnessed a bizarre phenomenon in the US Treasury market that was termed the “fall fall” by FT columnist #James Mackintosh. The UST gapped down in a way no participant could remember having ever happened before. For a period of time there was no other side to the market. If that doesn’t give you the heebies nothing will.

The consequence of this is that market corrections will be violent.

On the second point, there are a number of interlocking themes that have played very well in the past two years but are now quite crowded.

For instance?

Almost everybody is bullish on the US dollar, bearish on the euro, European growth, Emerging Markets, China and the mining sector. Positioning is about as extreme as I’ve ever seen it.

Sometimes fund managers’ greatest risks are to themselves and this is one of those times.

Note: This week, Cerno Capital portfolio managers have materially reduced US dollar positioning and eliminated bearish positions in Emerging Markets and Industrial Metals and the Australian dollar. New positions in European cyclicals have been introduced to portfolios.

The cyclically-adjusted price earnings ratio (CAPE), also known as Shiller’s P/E, continues to fascinate stock market watchers. The ratio, developed by the Nobel laureate Professor Robert Shiller of Yale University, and further popularised by market commentators such as John Authers, Andrew Smithers and Russell Napier, quantifies the relationship between the price of the stock market and its average 10 year real earnings. The CAPE has become widely used to gauge how over or undervalued a market is relative to its own history. It is often cited as a more useful metric than the conventional P/E ratio, based on a single year’s earnings, as the longer data essentially smooth out the volatilities over one business cycle.

Exhibit 1

US Equity Market Cyclically -  Adjusted PE Ratio

Source: Dr Robert Shiller, Yale University

According to data published by Dr Shiller[1], current CAPE at 26.5x is 61%, or 1.5 standard deviations, above its long-term mean of 16.6x, which does appear overvalued relative to its own history. The last time it reached this height was in October 2007, where it peaked at 27.5x before the market’s subsequent crash.

Cerno Capital studied this subject in some detail back in 2012, with a particular focus on the US market. We concluded that there is an inverse relationship between CAPE levels and future stock market returns, but that this is only significant over long horizons of 10 years and beyond. Comparing CAPE against forward market returns for short (1Y) and long (20Y) time horizons in Exhibit 2, the one year returns produce much more volatility and noise, while a clear trend is observable in the twenty year returns.

Exhibit 2

Short Horizon 1 year graph Long Horizon 20 year graph

Source: Cerno Capital

The scatter diagrams in Exhibit 3 illustrate this as well. As the time horizon stretches outward, the negative correlation becomes more evident with a tightening of returns dispersions.

Exhibit 3

Forward 1Y graph Forward 10Y graph Forward 20 year graph

Source: Cerno Capital

To test the level of significance, we mapped out the correlations between CAPE and future returns for different time horizons. In the short to medium term (1-5 years) correlations lays between a weak -0.15 to -0.35. The relationship strengthens as the years increase. Long term returns of over 10 years become more interesting as correlations rise to -0.5 and eventually tail off at -0.66 by the 20th year, a far more significant reading.

Exhibit 4

Correlation of CAPE vs. Rolling Year Returns graph

Source: Cerno Capital

So what does the current level tell us? We assessed the probability of losing capital associated with different levels of CAPE using past 100 years data. Buying into the stock market at current levels of 26x makes the future look rather bleak with over 60% chance of losing money over the next 10 years.

Exhibit 5: Probability of loss at different levels of CAPE over different time horizons


Forward  12M

Forward 3Y

Forward 5Y

Forward 10Y

Forward 20Y

< 7.9x






7.9x – 12.7x






12.7x – 20.6x






20.6x – 28.4x






28.4x – 36.3x











Source: Cerno Capital

The next biggest question, however, is much more difficult to answer.  And that is when will it happen?

The major caveat with CAPE is the fact that it has very limited, if any, use as a market timing tool.  Previously, it correctly signalled that the US market was overpriced prior to the dotcom bubble, and levels stayed stubbornly high for the first half of the previous decade leading up to the 2008 financial crisis. However, had investors exited too early pre-2002 or stayed out of the market between 2002-2007, they would have also missed out on fine opportunities to make money. It is difficult to foresee how long an over-exuberant market will continue its upward trajectory or how long bearish sentiments will last before mean reversion finally kicks in.

There has been increasing debate in the financial world in recent years scrutinising the statistical details of CAPE, making adjustment for changes in tax regimes and/or accounting practices. Critics of the metric argue that CAPE has not signalled cheapness in a long time, and often cite earnings as the main source for error (e.g. reported earnings are too high). Jeremy Siegel, a Professor at Wharton Business School, proposed alternatives such as using National Income and Product Accounts (NIPA) for the US series. The exhibit below shows that NIPA CAPE had always been less bearish than the standard method, and in particular the past few years display the largest discrepancy between the two measures. Indeed, on this measure, the valuation does not appear stretched.

Exhibit 6

Cape vs NIPA CAPE graph

Source: GMO, Shiller, WorldBeta

Advocates of CAPE such as James Montier from GMO on the other hand, rebuffed this argument in his paper ‘A CAPE Crusader ─ A Defence Against the Dark Arts’ earlier this year. He constructed a long-term series of 7 year predicted returns by mean reverting CAPE towards the average over the next 7 years, adding a constant growth factor (6%) to reflect growth and income. Comparing the actual realised returns with the predicted returns side by side (as shown below), he demonstrated that CAPE has done a reasonable job of capturing realised returns over the long run, countering that if anything, it over- rather than underestimates returns.

Exhibit 7

Shiller PE Predicted Returns graph

Source: GMO, Global Financial Data

Once again, this brings us to the conclusion that CAPE is still a sensible valuation metric, but only for long horizons. There are reasons to suggest that the UK and Europe, whose performances have lagged of late, will trail the trajectory of the US in terms of valuations. However, for other markets such as Japan, due to the lack of long-term data, and because valuations are wildly distorted by the 1980s bubble where levels reached over 100x, it makes no sense to suggest that at current levels of 21x the CAPE will mean revert back to the 54x average.

Exhibit 8

Japan Equity Market Cyclically Adjusted PE Ratio 1979-2014 graph

Source: MSCI

Our view remains that CAPE is a useful indicator for investors who are truly long term where the long term is defined as being periods of over 10 years or more. Over that time frame, US equity market equity returns could well disappoint. We find the inherent probabilities sufficiently convincing to have already trimmed our broad S&P exposures. On other markets, CAPE cannot be relied on to any degree as the data series are not long enough to store any trust in the average ratings.

The election-inspired excitement of Narendra Modi’s landslide victory in May has subsided and investors are beginning to question whether the Modi government can actually deliver on their promised reforms. The macro story in India is very powerful, with inflation falling, interest rates dropping and the currency strengthening. All this at time of weakening commodity prices, especially oil, improving India’s external position and further helping to bring inflation down. We view India as one of the better top down investment opportunities globally; while the market has performed well over the last year, the longer term opportunities are considerable.

While the Prime Minister has been busy on the international stage in Japan, China and the U.S. securing major investments into the country, there has also been significant progress to change the way that business is conducted by the bureaucrats within the government. Corruption is one of the key areas under attack. The internet and electronic platforms are being used to allow a far swifter approval process rather than the old system of paper forms needing to be filled out and actioned. In this way the system is not being radically changed, but the mind set and work ethic of key functionaries is changing at all levels. These changes have already led to a doubling of new investment projects to Rs2.2tn July-September 2014 from Rs1.1tr in the same period last year. However, there is little evidence that the economy is doing more than bump along the bottom and expectations for a significant pick up are muted.

India Consumer Price Indices graph

The falling oil price is helpful to India and has facilitated the dismantling of the diesel subsidy. Diesel was the largest contributor to the fuel subsidy, costing the government US$10bn last year. From now on the price of diesel will be linked to the market price. Oil is a major contributor to India’s current account deficit, which has fallen from US$88bn to US$44bn over the last twelve months. At the current level of oil prices the deficit could fall further to the US$30bn level. Inflation has fallen from a peak of 11% a year ago to 5.5% in October. However, inflation expectations remain stubbornly high at around 13.5%, which is a long way from the stated central bank inflation target of 4% +/-2% over the long term. Bond yields are around 8.5% currently and these could fall further to around 6% over the next year. The current governor of the central bank, the BRI, has the support of the markets and is expected to hold interest rates at current level, which would help to squeeze inflationary expectations out of the system, allowing for lower inflation over the long term.

India 10Y Government Bond Yield graph

The role and the use of information technology are going to be transformational in terms of enabling the India growth story. Prime Minister Modi has stated that every Indian should have a bank account by 2016. The success of the electronic identity card held by over 700m Indians, up from 200m in mid-2012, makes this a real possibility. This financial inclusion is coming at a time when access to the internet through smartphones is forecast to grow from 190m now to 500m in four years’ time. This enables businesses to access the rural market in India often for the first time ever. Currently there are 930m mobile subscribers and only 20m fixed telephone lines, illustrating the potential to enfranchise a population into a world of financial services. The very large numbers of young people in India to embrace this technological revolution makes it all the more exciting.

BSE Sensex graph

Valuations for the Indian markets are 15x-16x on a forward PE basis, which is higher than many other Emerging Markets as well as much of Europe at a time when the BSE is up 38% this year, making it one of the best performing markets. However, there are very few other places in the world that offer the potential for such structural growth and at a time when the investment cycle in India should be turning up any time soon.

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.

Global Oil and Gas stocks have been rerated to levels not seen since 2000. Exhibit 1 (below) maps their relative decline in Price to Book Value (PBV) terms. In this respect, they are experiencing the mirror image phenomenon to that of Tech and Internet stocks, whose valuations have been rising. Energy companies are also asset heavy whereas Tech and Internet is often asset light.

Relative Price to Book Ratio Oil and Gas

Source: Cerno Capital, Bloomberg

Within the sector, Integrated Oil & Gas majors appear particularly cheap, trading on 1.2x book value on average (as recently as 2008, they were trading at multiples of 2-2.5x) a circa 40-50% discount to their peak valuations due to a combination of stagnant commodity prices and rising costs that have squeezed margins. Relative to the western groups, emerging National Oil Companies have fallen out of favour even more despite having greater access to resources and government support as investors are wary of a misalignment of interests between the shareholders and the government. The combined market value of state-controlled national oil companies fell 15% in 2013, while the value of the large western groups rose in aggregate by 9%, according to the analysis group IHS.

The Oilfield Services industry, on the other hand, has fared much better in general, having benefitted from the high capex of the big oil groups over the past few years. However, going forward we anticipate a reversal in industry trends as major integrated oil groups are under greater pressure from shareholders to curb spending and improve capital returns after years of heavy capex engaging in increasingly challenging environments as companies pursue opportunities in high cost ventures (e.g. ask seek knock . deep-water, arctic, oil-sands) and acquisitions. Many, independents and NOCs alike, have trimmed their capex projections in recent months and announced divestment programmes to dispose non-core operations (downstream and mature upstream) to re-emerging as leaner, more efficient businesses geared towards higher quality growth.

Price to Book vs ROE Oil and Gas

Source: Cerno Capital, Bloomberg

Aside from the attractive valuations, this sector offers a superior dividend yield and a low debt to equity ratio, on average. The trade-off between return on equity and book value is compelling on both absolute and relative terms, as displayed in Exhibit 2, in which a basket of equally-weighted global integrated O&G majors (red) sits at the bottom of the spectrum against other MSCI sectors in terms of book value with an above trend ROE.

Rather than take on the clearly high level of company specific risk entailed by stock picking in a sector with heavy government and regulatory overhang, a basket approach makes sense.

Table 1 features a putative basket of companies from Bloomberg’s global O&G universe. The criteria in this case were 1) attractive valuation 2) commanding asset position (exemplified through high proven reserves relative to market capitalisation) 3) high reserve replacement ratio from existing claims and 4) favourable cost structures. The resulting basket incorporates a mix of independent and quasi state owned majors from both developed and emerging economies, which helps to achieve diversification benefits, thereby minimising the impact of any company-specific risk.

a putative basket of  oil and gas companies

Source: Cerno Capital, Bloomberg

Global Oil & Gas companies have low growth implied in their current share prices. They have bona fide value credentials.Global Oil and Gas stocks have been rerated to levels not seen since 2000. Exhibit 1 (below) maps their relative decline in Price to Book Value (PBV) terms. In this respect, they are experiencing the mirror image phenomenon to that of Tech and Internet stocks, whose valuations have been rising. Energy companies are also asset heavy whereas Tech and Internet is often asset light.

Relative Price to Book Ratio Oil and Gas

Source: Cerno Capital, Bloomberg

Within the sector, Integrated Oil & Gas majors appear particularly cheap, trading on 1.2x book value on average (as recently as 2008, they were trading at multiples of 2-2.5x) a circa 40-50% discount to their peak valuations due to a combination of stagnant commodity prices and rising costs that have squeezed margins. Relative to the western groups, emerging National Oil Companies have fallen out of favour even more despite having greater access to resources and government support as investors are wary of a misalignment of interests between the shareholders and the government. The combined market value of state-controlled national oil companies fell 15% in 2013, while the value of the large western groups rose in aggregate by 9%, according to the analysis group IHS.

The Oilfield Services industry, on the other hand, has fared much better in general, having benefitted from the high capex of the big oil groups over the past few years. However, going forward we anticipate a reversal in industry trends as major integrated oil groups are under greater pressure from shareholders to curb spending and improve capital returns after years of heavy capex engaging in increasingly challenging environments as companies pursue opportunities in high cost ventures (e.g. ask seek knock . deep-water, arctic, oil-sands) and acquisitions. Many, independents and NOCs alike, have trimmed their capex projections in recent months and announced divestment programmes to dispose non-core operations (downstream and mature upstream) to re-emerging as leaner, more efficient businesses geared towards higher quality growth.

Price to Book vs ROE Oil and Gas

Source: Cerno Capital, Bloomberg

Aside from the attractive valuations, this sector offers a superior dividend yield and a low debt to equity ratio, on average. The trade-off between return on equity and book value is compelling on both absolute and relative terms, as displayed in Exhibit 2, in which a basket of equally-weighted global integrated O&G majors (red) sits at the bottom of the spectrum against other MSCI sectors in terms of book value with an above trend ROE.

Rather than take on the clearly high level of company specific risk entailed by stock picking in a sector with heavy government and regulatory overhang, a basket approach makes sense.

Table 1 features a putative basket of companies from Bloomberg’s global O&G universe. The criteria in this case were 1) attractive valuation 2) commanding asset position (exemplified through high proven reserves relative to market capitalisation) 3) high reserve replacement ratio from existing claims and 4) favourable cost structures. The resulting basket incorporates a mix of independent and quasi state owned majors from both developed and emerging economies, which helps to achieve diversification benefits, thereby minimising the impact of any company-specific risk.

a putative basket of  oil and gas companies

Source: Cerno Capital, Bloomberg

Global Oil & Gas companies have low growth implied in their current share prices. They have bona fide value credentials.

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.

Before addressing the particular merits of dynamic asset allocation it is worthwhile examining the attributes of its notional alternative: static asset allocation.

Termed in this manner, we might not immediately recognise static asset allocation. To a marketer’s attuned ears, it lacks intuitive appeal: stasis being less comment worthy than dynamism. Dynamism, after all, is an appealing personal attribute. Being called static is not often a compliment. It suggests a degree of unresponsiveness and lack of sensitivity to environment.

The practical application of what we have mischievously called static asset allocation is most commonly found in balanced strategies and mandates. A little bell of recognition is now heard. Balance has much greater intuitive appeal and practical application.

The balanced mandate, an exemplar being a constantly held mix of equities and bonds (say, 60/40 in relative proportions), owes its existence to the following four phenomenon:

– equity and debt are the two key, entirely dominant, asset classes of finance,

-by holding a proportion of bonds, the investor offsets the perceived high volatility of the equity return stream,

-the fixed nature of the allocation removes the risk of poor timing decisions &

-the mixed nature of the allocation somewhat reduces the effects of periods of bad performance in either part of the allocation.

Of course, the balanced approach is not immune to losses. It does not, in any way, address the effects from periods when both equity and debt perform poorly.

However, the experience of the 20th century, from which almost all our notions of financial return derive, reveals that, in the US, there was only one month since 1925 (September 1974) over which a 7 year rolling return was negative. The remarkably positive experiences of twentieth century investors explains the popularity and underwrites the endurance of the balanced (or, static) strategy.

The chart below describes this long period in the sun:

7 Year Annualised Rolling Returns 1926-2013 (US)

Source: Morningstar/ Cerno Capital

The question we should ask is whether the philosophical underpinnings of the static approach, or its dynamic alternative, holds greater appeal for the century we live in notwithstanding what transpired in the last?

Part of the answer to this lies in an imagination of future long term asset class performance and the factors that will shape it.

The product of our own meditation on these matters is the ineluctable conclusion that the debt mountain that has been built up in the second half of the 20th century is likely to cause great problems within financial assets in the first half of the 21st.

The 2008 crisis had at its cause indebtedness and the misunderstanding, mismarketing and mishandling of debts. The solution has been extraordinary dollops of liquidity, liquidity that is now in retreat. We are deeply concerned that many businesses and the consumer sector, at large, have become accustomed to super low interest rates and will have trouble weathering more normal interest rates. This suggests to us the beckoning of a period when both the equity and debt asset classes may struggle to record positive returns.

If this indeed transpires, this cratering of returns will pose great challenges for balanced managers on account of the flexibility that they have denied themselves. It will also place a substantial log in the path of the onward marching passive industry. For whilst ETF providers like to trumpet periodic innovations such as smart beta and putative ability to track alternative indices, their assets are substantially gathered in long only, headline index tracking strategies.

The appeal of passive investment rises as bull markets extend. For, during these times, index returns and reduced fee drag appear to be just the ticket. It is our belief that this appeal will tarnish if the next bear market envelops both bonds and stocks, as we believe it might. To have “gone passive” will cease to be quite the boast it is today for trustees of charities and educational endowments.

The merits of active or dynamic allocation are to be found first in both the flexibility to have sharply different allocations to debt, equity and cash over time and secondly in the ability to seek out and utilise other asset classes or sub classes of the main classes.

On the first point, it is hard to be doctrinaire as to the optimal approach: the allocation cat can be skinned in a number of ways. At Cerno Capital we use a three year forward return framework to guide our allocations. Three years allows us to frame our thoughts outside the very crowded near-term, long enough for valuation disparities and extremes to possibly mean revert but not so long that our clients find themselves disadvantaged by logically sound but practically profitless investment positions.

Flexibility also allows participation in specific asset classes whose attractions only manifest when the stars periodically align. For example, the corporate credit sector offered, in 2009, a once in a generation set of possibilities: deeply discounted paper with marvelously fat yields to maturity, secured against still robust cash flows. In the four years since 2009, valuations have travelled full circle to a point where future returns are likely to correlate very strongly with normalising government curves. The opportunity has been fully mined. It does not, therefore, make sense to retain a permanent allocation to corporate credit or its higher yield cousin.

Presently we see a developing opportunity in merger arbitrage strategies. Specialist merger arbitrage and event driven managers make money by investing in and around announced acquisitions, mergers and other corporate activity. We anticipate activity will rise as companies become more expansionary into an improving global economic environment. However, merger arbitrage is not plausibly an evergreen investment for the flexible multi-asset class investor. There can be long drought periods: for example, capital committed in Europe over the past five years sat idle.

In the field of global macro, no two managers invest in an identical fashion, however certain firms have a greater concentration in strategies grouped around policy rates (the official rate of borrow that central bankers control). During a period when most key central bankers are operating what they term “forward guidance” which entails anchoring policy rates at their current levels for the foreseeable future, the managers with the highest dependence on short term rates trading are working within the most reduced opportunity set: another reason for flexible allocation.

Within mainstream equity strategies, we see plenty of reason to challenge the orthodoxy that emerging markets are intrinsically better places to invest than developed markets. We are fully cognisant of the long term trend for small capitalisation issues to outperform larger cap shares, however we would not invest in a static manner unless valuations were reasonable.

There are certain asset classes that lack a core attribute for long term investment but may prove to be excellent investments in certain periods. Good examples are found in gold and commodities, both of which lack income attributes.

We periodically deploy currency overlay strategies when we wish to hedge out foreign exchange risk: another example of necessary flexibility, to our minds.

Finally, when we read through our own choices to the strategies of the managers we might select as allocators, we are drawn to those that themselves secure adequate flexibility.

Our adherence to the credo and practices of active asset management are anchored on two beliefs: firstly, that a minority of investment teams and processes can secure meaningful outperformance against indexes and secondly that we reject the inbuilt biases that investors have carried forth from the twentieth century. As the warming comfort blanket of central bank support is gradually peeled away from our beds, we are likely to find additional evidence of the fundamental instability of global capital markets and global money flows throughout these markets. This, we contend, is a time to be flexible and not to buckle into strictures whose rationale is based almost entirely on past performance of a time past.

Extracts of this article appeared in the Charity Times, February-March 2014

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.

Emerging equity markets enjoyed a decade of relative outperformance over developed equity markets up to 2010. Since then, emerging equity markets have underperformed.

Headline valuations suggest emerging value in emerging equity markets. However we doubt whether the time is propitious and we remain cautious.

Furthermore, the emerging equity universe should not be treated as a homogenous block. A top-down  allocation model driven by country of listing is no longer sufficient given the increasing level of exposure to the emerging markets of developed market listed businesses.

We question the extent to which institutional investors fully understand their emerging market equity exposure.

Turning to the debt of the class, emerging market debt (EM debt) returns can be attributed to a number of factors including credit spread, carry and the risk free rate. We believe that the risk free rate will be subject to upward pressure over the coming quarters and this will present a further headwind for EM debt.

Institutional debt investors are enrolled in a vow of silence as to the liquidity characteristics of their markets. EM debt does not trade on exchanges, as equities do, and investment banks carry low inventories. Easy to buy, hard to sell and therefore dangerous.

The wish to protect against inflation is a base emotion within investor psychology: one that lies deep within.  Failure to offset inflation results in a decrease in real spending power. Over half a generation, the effects of this are meaningful; over multiple generations, families fall, countries fail and the formerly rich become only averagely endowed.

No sane investor would object to inflation protection: it would be akin to refusing indoor plumbing. However does the impetus to seek inflation protection entail investing differently from simply seeking to beat the rate of inflation, in the long run?

The question is: to what extent does the impetus to seek returns that are better than inflation result in a wish-fulfilment exercise? In this guise, certain assets are accorded inflation protecting powers and these attributes are then routinely overstated.

Our investigations suggest that several notable asset classes are flawed in this respect:

Commodities: historical returns should not be relied upon – due to a significant change in market structure, the long run expected return from commodities is lower than in the past

Inflation linked bonds: Investors have imperfect knowledge of how inflation linked bonds will perform under different inflation scenarios. Irrespective of theory, real yields may change when inflation rises and create losses for holder of ILBs

REITS should never be confused with the actual property they own. Direct property has good inflation protection features, but REITs do not

Gold: history provides little support for the contention that gold is an effective inflation protection asset

Equities do fine in moderate inflation environments but do not keep pace in high inflation environments

We all wish to beat inflation but it is not easily possible to commute this desire into being. That is because some assets are inimical to inflation, others are inherently unreliable, and the remainder are only partly reliable.

We contest that the asset with the best all-weather nominal (pre-inflation returns) is quite likely to have the best real (post-inflation returns).

Cross asset correlations have been rising for a number of years as the commodification of finance proceeds apace. In tandem with this, cross regional international equity market correlations have risen with the penetration of emerging markets’ consumer markets and the infiltration of emerging markets in the global production chain. Apple sells as much stuff in Asia as it does in Europe these days.

These factors alone have been challenging the Yale Model of endowment management where an investor seeks to avail himself of diversification benefits. The 2008 financial crisis blew these correlations up to levels never before seen.

Our view is that these effects are now dissipating, a process hastened by normalisation.

Correlation analysis, as practiced by financial firms, is riddled with mischievous thinking and scurrilous salesmanship. When correlations are deployed to make a point, or sell a security, beware! The Fed Model, which suggests that there is some relationship between bonds and equities is bunku

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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