Cerno Capital Investment Letters 2017-10-25T12:59:10+00:00

Cerno Capital Investment Letters

Investment Letter – November 2017

Stock markets could fall 10% next week. This is a perfunctorily true statement but not worth tuppence as a prediction. For it is true every week of the year. 2017, so far, is an unusual year in that it has not featured a correction of 5% or more in world stocks. It remains our view that the chief risk in front line asset classes is the gravitational pressures exerted by valuations which have crept ever higher in the past 5 years. A correction in the equity market would have the effect of clearing the air. We are of the view that it would be unwise to be active selling during such a correction. For, in the lee of any correction, the proximate fundamentals will remain shaped by a picture of synchronous global growth, rising aggregates of industrial production, recovery in Europe and rising market shares of the world’s best companies in many industries. None of this plausibly presages a recession in corporate profits, in the near future. Other fundamentals to keep well in mind are interest rates and inflation. We are in the upward swing of an interest rate rising cycle and ultimately rates may do for the market but [...]

By | November 10th, 2017|

Investment Letter September 2017

Over the past 10 years - in the liberal parts of the world at least - political and financial economies have forked apart. The large scale corporate world has become stronger as government authority has paled. Doubtless, on the government side of the ledger, this is partly due to an erosion of faith in governments following their interventions to save banks and shore up the indebted after the Global Financial Crisis. Large companies which are not banks have been able to take a free ride on a progressively cheaper cost of capital and load up on cost-saving technologies. With freely available capital and cheap debt, companies have variously invested, bought out competitors, lifted their dividends and bought back their own shares. In the US, buy-backs have become a mania. Strong companies have become stronger and companies of all types have become greatly better at marshalling technologies. Technology, often spoken of as a disrupter and a general threat, has in fact facilitated a multitude of improvements in the way in which business is conducted: benefits that accrue to the adopting company if not always their customers who rightly sense they are being kept at bay. For example, by computer driven enquiry [...]

By | September 15th, 2017|

Investment Letter June 2017

On the last page of his book, Homo Deus, Yuval Noah Harari poses the questions: “What’s more valuable – intelligence or consciousness? Intelligence is decoupling from consciousness. What will happen to society, politics, [investment] and daily life when nonconscious but highly intelligent algorithms know us better than we know ourselves?” I have added the word investment. This book certainly sets the mind noodling. We are often being told – mainly by academics and parts of the FT – that there is little point in active asset management. Their conclusions, often as not, are based on the average performance of the average manager. We think not and wish to rebutt such a reductive line in reasoning. Who would ever be interested in the average outcome from an unsampled universe? In football, there is little point in supporting an average team – unless you happened to come from the town itself. That’s why people all over the UK (and wider) support Liverpool, Manchester United and Arsenal and why Mansfield Town – who finshed exactly half way down League Two last season – has an average home gate of 3,774. To our minds, the universe of – equity managers in this case – [...]

By | June 11th, 2017|

Investment Letter from Hong Kong March 2017

The stimulating free port of Hong Kong remains a compelling eye glass through which to comprehend China, its politics and economy. All its 5.5 million adult inhabitants are China watchers, by inclination or necessity. Their world view was formed, to some extent, by the Cultural Revolution. The most recent arrivals in Hong Kong are investors from China and increasing numbers of economic migrants from Europe, most notably France. The latter’s response to the despoir of home is to find hope in Hong Kong. "Try Hong Kong" they used to say, not always in kindness. Like London, Hong Kong operates as a safe-haven from volatile regimes: a portal through which Chinese capital passes, sufficiently easily to slay the notion that China’s capital account has effectively closed. Somewhere in the past two years - and its is difficult to say precisely when – the authorities in Beijing ceded their former near total authority on its currency policy with respect to the renminbi (RMB). The secondary effects of running so much capital through a thin spigot into Hong Kong are increasingly bad for the bulk of the population. Property prices there are debilitating to those without established ownership, small businesses struggle and young [...]

By | March 26th, 2017|

Investment Letter January 2017

The election of Donald Trump has caused perturbation from Baltimore to Beijing: a rude volte face to the graceful Obama years, a reversal of international liberal orthodoxy, a rebuttal of globalisation, an aggressive restatement of weaponised American hegemony, and on. Those that voted for him love it, much of the rest of the world is aghast. While many are offended, some are amused. In politics, the next few years will be a wild thrash. This may not last long and hopefully no warheads are loosened off. Part of the emerging mash of policy – on energy most notably – look like bizarre refutations of global trends that will not brook reversal. Others - resisting China’s claims over the Western Pacific - maybe overdue. There is more to come. Trump did not find time in the first week of his Presidency to fall out with Janet Yellen and the Federal Reserve. As sure as apples is apples, that will happen. It is not a great time to be an agency wonk in America. Under the last administration, even the hunting down of Osama Bin Laden was a meditative affair, a point captured in the line from Zero Dark Thirty where a [...]

By | January 31st, 2017|

Investment Letter December 2016

The election of Donald Trump has caused perturbation from Baltimore to Beijing: a rude volte face to the graceful Obama years, a reversal of international liberal orthodoxy, a rebuttal of globalisation, an aggressive restatement of weaponised American hegemony, and on. Those that voted for him love it, much of the rest of the world is aghast. While many are offended, some are amused. In politics, the next few years will be a wild thrash. This may not last long and hopefully no warheads are loosened off. Part of the emerging mash of policy – on energy most notably – look like bizarre refutations of global trends that will not brook reversal. Others - resisting China’s claims over the Western Pacific - maybe overdue. There is more to come. Trump did not find time in the first week of his Presidency to fall out with Janet Yellen and the Federal Reserve. As sure as apples is apples, that will happen. It is not a great time to be an agency wonk in America. Under the last administration, even the hunting down of Osama Bin Laden was a meditative affair, a point captured in the line from Zero Dark Thirty where a [...]

By | December 22nd, 2016|

Investment Letter November 2016

We draw close to the end of the Obama presidency. The very fact of it was remarkable even if the substance of it disappointed almost everybody. What comes next? The world, bar Vladimir Putin and those in America who will vote for Trump, would undoubtedly prefer Hillary Clinton to win the US election but it is hard to construct the case for much of a relief rally on the back of this. Trump gives the jeepers but Clinton commutes other risks, notably a perilous engagement with Syria and by proxy Russia. America is the land of second chances but it is also the place where the majority have had enough of the Clintons. New leaders are apt to express frustration with touchy technocrats at their monetary authorities, as Mrs May has just done. Carney bristled in a manner that betrayed an insecurity. There are genuine risks and undesirable side effects of QE that properly form part of the national debate and are not beyond the purview of this or any other Prime Minister. Politics certainly catches the eye. Last year David Cameron was Parliamentarian of the year at the Spectator awards. This year, he is in a garden somewhere in [...]

By | November 3rd, 2016|

Investment Letter September 2016

The outperformance of high quality equities has been one of the most distinguishing factors of the post global crisis period. “Quality” is loose moniker and there are disparate characteristics that can be construed as quality. More often than not it is associated with higher margin companies with solid balance sheets and well established and well defended business franchises. These types of companies are sometimes called defensive growth stocks. Investors who closely follow our work on equities will know that we sip from the same font as Michael Porter and his ilk of Harvard. Porter promulgated the Five Forces and attached them to his surname. He wrote his first paper on the subject in 1979 “How Competitive Forces Shape Strategy” and morphed that into the 1980 book “Competitive Strategy” rounding off his ideas with “Competitive Advantage” in 1985. https://www.amazon.co.uk/s/ref=nb_sb_noss_2?url=search-alias%3Dstripbooks&field-keywords=michael+porter A stream of other publications followed, as he noodled away on the same basic tune. His contention was that great companies stay great because they build, or happen upon, some advantage which they prosecute and defend mercilessly. He also argued that high market share was a defining characteristic of such companies and lent them the power and wherewithal to shape their industries [...]

By | September 14th, 2016|

Investment Letter July 2016

In the historical context, the landscape of modern investment has been defined by the relatively free movement of ideas, capital and increasingly, people. Through the eyes of most urban folk and the majority of the political elite, these are generally taken to be unalloyed gains, uncontroversial goods. That a larger number have voted for a distinctly different set of arrangements has delivered a shock. Far from being a “Lehman moment”, as some have termed it, last week’s vote has longer drawn out and more pernicious effects. With respect to the UK, we should expect a recession as investment decisions are reversed, cancelled or delayed. The principal manner in which these events connect into our clients’ portfolios is through currency. With pounds Sterling as a reporting currency, a natural level of protection can be achieved by buffering the falling pound with assets in other currencies. As a global investor, with no natural UK bias, this is more of a default than an option. It has not required, therefore, conscious risk taking outside of our normal range of operations to achieve a high measure of short term protection. We were able to make plausible assumptions about the impact of either possible result [...]

By | July 1st, 2016|

Investment Letter May 2016

There have been a fair number of reversals already this year: a retracement in oil prices, the cooling of the dollar, the rise of gold, recovery in commodity currencies… the list continues. The great immovable force is the backdrop of high indebtedness, now a pervasive global phenomenon. The Debt Supercycle describes the defining economic development of this and the previous generation during which general indebtedness, measured as a percentage of economic output, has increased by a quantum degree. Debt accelerated markedly in the 1990s with a great explosion of US debt and then further in the noughties and this decade in both direct and indirect consequence of QE policies. During the QE years, the Emerging Markets finally lost the great thing that stood them apart from Developed Markets: their relative low leverage at the state, company and consumer levels. The latest augment to the trend has emanated from China whose leaders have plainly decided to throw bad money after bad in their latest efforts to reflate aggregate growth back to the desired mark. The present economic cycle’s distinguishing factors reside in its very length and lowish growth, commensurate with what one might expect when debt begins to constrain growth rather [...]

By | May 9th, 2016|

Investment Letter March 2016

The particular combination of a supported Chinese currency, stronger oil prices and dovish Central Banks has been helpful to markets, at least in the near term, with benchmark equity indices striving to erase January’s precipitous falls. We have also seen a counter-trend recovery, although uneven, in Emerging Markets, part helped by a recovery in the value of their currencies against the dollar. This reversal in fortunes has posed more than a few difficulties for some managers who have explored the wilder shores of bear territory. No love has been shown to those shorting commodity currencies or taking bets against mining companies as both these asset groups have recovered strongly. Does it make us killjoys that we do not welcome the cloying attentions of the BoJ, ECB and the Fed? Each has offered highly market sensitive prognoses and policy tilts in the past month but, in our minds, their actions may add to the risk of larger reversals at some stage in the future. For, when the post Financial Crisis landscape is assessed from a greater distance by financial market historians, their conclusions will be highly bifurcated. They will, we think, offer plenty of support for the initial policy responses, as [...]

By | March 30th, 2016|

Investment Letter January 2016 (Part 2)

We were recently sent a piece of strategy research from a respectable macro consultancy. The article was entitled “No Recession = No Bear Market”. This statement of logic supposes that bear markets are the consequence of economic recessions, which they most often are. It ignores the possibility that measurable bear markets (-20% on a given index) could exist without a synchronous recession (generally acknowledged as two consecutive quarters of negative economic growth). Stock markets run well ahead of economies, foretelling them with accuracy. Our intuition here is that their foresight is maybe extended beyond normal time frames. Divining quite why is not a scientific matter subject to deduction alone. It is in the United States – the world’s largest economy, with the world’s largest stock markets – where expectations have furthest to travel in this regard. Only last month, the Federal Reserve adjudicated that economic conditions were robust enough to commence normalisation of interest rates. A cursory analysis of the Fed’s favoured indicators (measures of employment and wages) certainly seemed to supply sufficient reason from them to have done so. However, other measures reveal more threatening trends. Industrial production in the US has recorded two consecutive months of decline; this [...]

By | January 26th, 2016|

Investment Letter January 2016

For the past six post-crisis years, equities have been at the vanguard of financial risk asset performance. We believe they have now entered a bear market. The economic recovery that took place post the crisis was unusual and perhaps we should expect this bear market to be different, too. For although it is sometimes possible to identify the epicentre of the problem, the challenges facing the world today have several facets. US equities account for 52% of the global benchmark. The bull market there has looked tired for some time and, last year, was predicated on a group of earnings light, concept heavy technology stocks to support the index. An equally weighted index of stocks described the topping out of US equities more clearly. The proximate issue in the US is the earnings cycle which has been cajoled to a degree of efficiency where further gains are much more marginal. The strength of the dollar, driven by higher short term rates, is sinking international earnings on translation. Demand for US equities is greatest from the companies themselves as executives have diverted the savings from weak labour and low oil into buying back and cancelling their own shares, to boost earnings [...]

By | January 20th, 2016|

Investment Letter December 2015

The best performing global equity sectors in 2015 have been Consumer Discretionary and Technology (both +4.6%), hardly a bonanza. The worst two have been Energy (-23.7%) and Materials (-15.9%), deflation in two nutshells. Whilst the positive side of the coin has not been very positive at all, the dispersion in sector returns has been high. When full year numbers are in, we will see that the top quartile of active global equity managers will have done well, relative to the pack. Active investors favour dispersion in returns as it conveys a rich set of opportunities. Indiscriminate bull markets are less joyful than would appear, as good companies do not necessarily outperform: most asset managers having a bias to good companies. My colleague, Fergus Shaw, points out that the poor performance of the latter two sectors has scuppered the fund managers who have chosen to play what traditionally are referred to as late cycle themes. They have also conspired to keep value strategies in the dog house. Connecting observations about where we reside on the business cycle and stocks and sectors is a popular way of thinking about investment. In a casual way, it is a topical way of framing ideas. [...]

By | December 15th, 2015|

Investment Letter October 2015

With a few exceptions, 2015 will be remembered as an unremarkable year for financial returns in mainstream portfolios. As a multi-asset investor with a bias to longer term investment the lack of opportunity has been comment-worthy, a phenomenon in itself. Like London tube trains that are too packed to enter, we have remained on the platform many more times than we have boarded this year. A measure of caution has been warranted and that, in our context, has meant the use of cash. Cash, which was built up to 30% in June, helped take the edge off the steep falls of August. More importantly, cash has provided the necessary flexibility to consider both critical and supportive positions on different theses. For we have sought to avoid what mountaineers call being “rim rocked”; the point at which you can go neither up nor down. Caution and patience have been warranted as we bivouacked whilst waiting for better opportunities. Some of these have begun to arrive, but only recently. Since late August, the central topic has been China: its currency and its economic growth profile. Between August 11 and 14, the Peoples Bank of China (PBoC, China’s central bank) weakened the RMB [...]

By | October 29th, 2015|

Investment Letter September 2015

Sinology used to be a specialist occupation of a few classically trained civil servants: it lead to a career in the foreign service and postings to Hong Kong and Beijing. Suddenly, everybody is a sinologist. We have described the change in fix of China's currency on August 11 as a regime change: https://cernocapital.com/rmb-regime-change/ On reflection, that perhaps accorded the Chinese authorities too much forethought in the matter. The true state of affairs may  have been more akin to a crise de confiance brought about by some very poor export data against the prospect of the first rise in US interest rates since 2006. In the context of the RMB’s appreciation versus neighbouring currencies, the move has economic rationale (and some smokescreen cover with the context of introducing more flexibility to currency management), however, by making such a small move and then backing away from the policy on August 14, the authorities ceded some influence, respect, not to mention a big round amount of foreign exchanges reserves, whilst gaining very little in relative export pricing. In the global currency race, China is shackled. The steep correction that then ensued and rippled round world equity markets in an indiscriminate fashion, has been directly [...]

By | September 15th, 2015|

Investment Letter June 2015

At the time of writing, the Greek crisis has entered an intense phase. A clash between political logic and economic reality. The logic of coaxing Greece back to the European bosom is compelling, as is the domestic logic of remaining in the Eurozone (on better terms), when compared with capital controls, ejection from the euro and the attendant risks of social breakdown. However, when thinking this through, we remain focused on the simple weight of debt set against the underlying weak drivers of the Greek economy, rampant capital flight and the lack of a prospect of material forgiveness. These combined suggest that, at a later stage, default and capital controls are more than likely. Throughout the negotiations, markets appear to have assumed, to a greater degree than is perhaps warranted, that some form of “extend and pretend” strategy will prevail. This, plus the lack of planning on either side for default, capital controls and a host of consequential events, leads us to be somewhat cautious in predicting any resolution. Paul Donovan of UBS expresses the key issue well when he writes: “A broad membership of the euro was never likely to be viable in economic terms, as the euro was [...]

By | June 25th, 2015|

Defining Megatrends: Demographics & Debt

When investors talk of long-term trends, they are often referring to the next three to five years. Few envisage horizons past the ten year mark. Yet super long-term trends do exist and are slowly but definitively changing the world socially, economically and politically. In our minds, some of the largest of these are demographics, debt, the technology of energy provision and gene-based medical discoveries. We address the first two, which represent more of a threat than an opportunity, in a chart book. https://cernocapital.com/wp-content/files_mf/1434122306LTSS_DemographicsDebt.pdf The world is getting older. This fact has been acknowledged and fretted over by academics, economists and governments, though relatively little can be done on a supra-state basis. In the recent past, people worried about world population exploding to unmanageable levels, which at the time seemed realistic. They  noted that the world’s population doubled twice in the 20th century. However, future demographic shifts in many countries from today will be driven by longevity and low fertility rates. This will lead to a sharp fall in working population relative to retirees, and eventually to a decline in overall numbers as the fertility rate is on trend to fall below the replacement rate (2.1 children per woman). In many [...]

By | June 12th, 2015|

Investment Letter May 2015

The tale of the tape is that global equities are up 7-ish and bonds down 2-ish year to mid-May: a 9-ish variance in favour of equities. This, most basic of summaries of the key asset allocation call between the frontline liquid asset classes, is, however, significant. A 60-40 investment style, the acme of balanced investment, would therefore have yielded 3.4% to mid-May, applying these proportions to the above returns. If this can proxy as a sensible benchmark, then most investors will be happy enough with actual returns from their portfolios, which will, in many cases, be ahead of this. Cash alone, if held in a winning currency and translated into a weaker currency, could be construed as a winning strategy: the dollar index is up 5.2% year-to-date. And although it has been popular to surmise that currencies are the key to a world that is split by reformers versus deformers, those prosecuting QE and those not, it has not exactly been the route to much bacon outside trades that favoured the dollar over the euro. With regards to the pound, the market got progressively more short sterling, whilst the canny Australian badger quietly dug the sett on which a blue [...]

By | June 2nd, 2015|

Investment Letter April 2015

Last week, the investment group at Cerno Capital made its customary annual trip to the GMO London conference. This is the only such investment conference that the whole team attends, such is the esteem in which GMO is held here on Sackville Street. For those readers not familiar with the firm, GMO is an acronym for three of its four founders: Grantham, Mayo and Otterloo. It retains Jeremy Grantham, as its spiritual and philosophical head, present in London. Founded in 1977 and headquartered in Boston, its roots are as an equity value house; to this core product set, it has added fixed income, multi-asset, quantitative and farmland over the years. GMO manage US$116bn. The reason for our assiduous attendance is that GMO is a firm that uses long-term value as a discipline and is packed full of interesting thinkers and ‘honest Johns’. They undertake primary research on markets, and in doing so develop new frontiers in understanding. In this, GMO have acted as a motivator and the inspiration for our own primary work. At the conference, a great deal of ground is covered in a day, to the benefit primarily of endowment and pension fund administrators. GMO operates institutional minimum investment [...]

By | April 29th, 2015|

Investment Letter March 2015

In an environment where asset markets lack the depth of opportunity, opinion has become shrill, sustainable advances more elusive, investment potholes ever deeper. Currency attribution has begun to loom large in portfolios. This can be perceived in a number of guises: dollar strength, euro weakness, EM weakness, yen stability. Like beans on a drum, there is so much activity that it is not easy to discern the prime mover. In this regard we think it is the proximate change (euro rates falling) rather than the prospective change (US short term rates rising) that is acting as prime mover. Viewed this way round, the landscape is more defined - for the time being - by euro weakness than dollar strength. If so, this can been cited as a convenient reason why dollar strength has not yet tipped EMs into crisis. Bond values are down but they are down on account of changing currency rates, not yet amplified by rising rates. Looking through the range of large EM debt funds, mid month returns were beginning to stretch down to double digit losses. They have since recovered to much more modest drawdowns. Does Fed Governor Janet Yellen peruse the listings of EM debt [...]

By | March 27th, 2015|

Investment Letter February 2015

In the famous outlaw film of 1969, Butch Cassidy and the Sundance Kid, two anti-heroes of quite distinct personalities combine forces. The early scenes of the film are filled with tales of derring-do, laddish behaviour, drunkenness and opportunistic heists. By virtue of their charm - and the contrasting blockheadedness of the authorities - the pair have the audience entirely on their sides. As the film progresses, in response to their success in holding up his trains, E.H. Harriman of the Pacific Union Railroad begins to pursue them down in a more determined fashion, employing a mythic tracker to do so. One begins to sense a certain fatality in each attempted evasion. In the end, they are cornered by the Bolivian army in a barn and make a futile effort to shoot their way out. The film closes with a frozen frame and a volley of gunshots. The determined but ultimately futile efforts of Mr Tsipras and Mr Varoufakis are brought to mind. Some distinctions need to be made immediately: our Greek anti-heroes are entirely sincere individuals, with no trace of criminality. This should be made clear. However, if we allow for this imaginative construction to persevere, anti-heroes they plainly are. [...]

By | February 27th, 2015|

Investment Letter January 2015

Last year’s winners could be described as a near equal assemblage of deflationary and reflationary themes. The six best performing mainstream financial assets were as follows: China Shanghai ‘A’ shares Spanish government bonds Italian government bonds German bunds S&P 500 Nasdaq Composite Excluding Chinese shares, whose rise was boosted margin, margin that is now being clamped down on by the authorities there, yesteryear’s five winning strategies were made up of two measures of the US growth story and three measures of the European disinflation story. Like the Vesper Martini which puts gin and vodka in the same glass: it shouldn’t work, but it did. To say so though, is to flatter the US. Earnings expectations, other than pockets of Technology and Healthcare, have not held up to expectations. The aggregate earnings out-turn has been modest. Modest earnings in a strongly rising market spells one thing: multiple expansion. And for US equities, rising PEs are more of an explanatory factor for the market’s rise than earnings and dividends together. “The carry trade is still on”, cries Ewen Cameron Watt from the top of the Rock. That argument, though perhaps reductive, has worked for the last five years. However, two things need [...]

By | January 26th, 2015|