By KATIE DODD
In recent Investor Updates held at The Stafford Hotel in London, members of the Cerno Capital team talked through recent performance, the investment outlook and portfolio positions.
James Spence provided an overview of the performance, key drivers and outlook for the two equity strategies (Cerno Global Leaders & Cerno Pacific), including reasons why margins have been so strong across Global Leaders companies, and the type of growth vectors we seek to identify in our equity holdings, with Microsoft and Accenture as examples.
Fay Ren continued on this theme, delving into Linde, Hamamatsu and Hengli in greater depth.
James also spoke about the opportunities created by AI, and how we seek to capture this across the portfolios.
Fergus Shaw spoke about the importance of a well-diversified portfolio and described the firm’s investment approach to non-equity assets, specifically our steady return holdings and why these are well positioned for capital return.
Finally, Michael Flitton looked at further allocations within the Select strategy including our holdings in Copper and Japan, as well as explaining why we have been recently allocating to fixed income.
We capture below questions asked by investors at the two meetings and our responses to these:
You mentioned a very exciting investment opportunity, could you elaborate on this?
JS: The most reliable bull-market in the world for my money is in cyber-crime. The more I learn about Artificial Intelligence and the digitisation of corporations, the greater the opportunity there is for malfeasance. From a personal security perspective, it is hard not to be connected and we are all prone to being targeted. Obviously, we do not invest in crime but we do invest in companies for whom security is a growing part of their business. Security is an identified growth vector for Microsoft, Ansys, Aptiv, Keysight Technologies, Rockwell and VISA.
Take Microsoft for instance. Security is a very necessary adjunct business for them but that adjunct has now become a division with US$20bn in annual sales, growing at a great clip. Whilst there are also opportunities in early-stage security companies, there is always the risk of obsolescence, key person departures and IP mobility. Microsoft is active in M&A in this field, having made 11 notable acquisitions in the past 8 years. We prefer to own the large consolidator, the setter of standards.
What is the market cap of the Investment Trusts that you own?
FS: The smallest Investment Trust that we own has a market cap of around £500mn, and the largest one has a market cap of around £3bn.
Notably with the fall in values the whole UK Investment Trust sector could be bought for £150bn. Valuations are taking a while to recover but I think we will see buy-outs and takeovers and that could well prove to be a catalyst.
Any change in your thoughts around hedging equities?
MF: We don’t hedge in the equity portfolios which are pretty much fully invested (Global Leaders is mandated to be fully invested at all times) but we do deploy hedges in the multi-asset strategies.
In the TM Cerno Select fund, put options currently cover around 3% of the equity exposure would rise to as much as 9% cover if the market fell (option cover increases naturally as you approach strike prices for out of the money options).
The use of options are difficult for many reasons. They are attractive at the moment because volatility is so low. So most of the money you make in options is when the change in volatility goes from low to high. What’s characterised this cycle has been its longevity. It is not easy to call the top of equity markets. The issue with options is that they have an expiry date so if you don’t chose the right period when you expect things to happen you can bleed premium continuously. Our preference tends to be if we have a view around the relative attractiveness of something and it is too expensive, you should own less of it and that’s what we have been doing. Ownership of bonds should create that counterbalance if things do turn.
In terms of foreign exchange, the decision around owning that asset is active, do we own the asset or the currency – and at the same time, GBP is our home currency. So the Select portfolio is currently 40% GBP, which is because of naturally UK domiciled assets. Calling where currencies are moving is quite hard, its not something we tend to get involved in and the outlook for Sterling is quite mixed. The UK has a lot of leverage – low population growth, low productivity – so we’d expect that Sterling underperforms over the long-term basis but, near term, we’re reporting the highest inflation in the OECD so that supports owning Sterling.
Where are you on the geopolitical point of view on Pacific in particular?
JS: If we are talking about Pacific region, the first country’s name that comes up is China. I have begun to believe with greater conviction that the endemic economic issues in China are tilting the balance of policy away from nationalism and aggression to something a bit more pragmatic. These endemic issues are centred around the turning of their property cycle and the lower cash-flow from land sales into regional governments’ coffers. You have less demand for properties because much of the demand was predicated on investment demand and capital values aren’t rising outside of certain niches so there’s less reason to invest in property. It’s a troubled sector – but it’s a massive sector in the Chinese context.
The second major issue is youth unemployment which is growing and needs to be handled with care because the real geopolitical flashpoint in China is when the workers find common cause with the students. I think the authorities have become quite keenly aware of this. I think the rhetoric is tuning down, and what I hear from European and US sources, the feelers are going out to engage with China.
They aren’t making a big noise about it but re-engagement rather than isolation is the current thinking in Europe and Washington which is quite good news. The background to this is the common thought in diplomatic circles that Covid was a very bad period for international diplomacy as face-to-face contact was interrupted.
The other interesting phenomenon in North Asia is to observe that Japan and South Korea are slowly and steadily getting on a bit better because the WWII generation is getting older and passing away and young people in both countries feel less hung up about these issues. The cultural exchanges, mainly pop culture, are proliferating.
Whilst India is somewhat of a individualistic state in terms of their political allegiances across the world you could also say that they’ve always been that way and they see the potential benefits of not being wholly in the US ambit.
FR: We have made position changes in the Pacific portfolio with geopolitics in mind. Last year we pivoted towards more domestically-oriented businesses in China, away from the sensitive industries such as Biotech and companies with a lot of US exposure for example.
One of the companies we sold last year was Wuxi Biologics which was put on the US unverified list even though it was taken off later, but the share price hasn’t recovered. So any implications will have an actual impact on the share price, so we don’t really want the tail wagging the dog. The fundamentals matter less at that stage and it will have an effect on the portfolio and that is why we have pivoted. We don’t own Chinese semiconductors. We don’t want companies in the headlines being sanctioned even though they might very much sit within our innovation orientated mandate.
There hasn’t been any mention of pharma stocks. Do you have any involvement with these?
JS: There is a sizeable healthcare position in both portfolios but it is centred around hardware not molecules. Philips, for example in the Global Leaders strategy. Medical equipment for Philips is now a defined and growing segment. It’s quite hard to go into an operating theatre and not see Philips machines being involved in the procedure. Likewise, Thermo Fisher, everything from test tubes to high-tech equipment.
But in terms of pure pharma, that is medicines and drug development, I have always struggled. I listen to pharmaceutical specialists and I see the difficulties they have in predicting the effectiveness of certain companies’ compounds, i.e. formulations, drug discoveries which are very difficult to do. It is an area that doesn’t line up particularly well for us.
We like CROs (contract research organisations) which are about large-scale tests, which is a growing industry in the world in terms of economics.
FR: Thermo Fisher bought PPD which is the second largest CRO globally two years ago. We like the economics of that, and we like the economics of medical equipment but we don’t play with compounds.
Do you gage Artificial Intelligence to be a large opportunity for your strategies?
JS: Yes. Inverting that question a little bit, if I was an allocator into a global growth strategy, I would want to make sure there was plenty of potential exposure, optionality to that growth. It is remarkable that, in quarterly results presentations, generative AI was barely mentioned until the most recent ones. In Microsoft’s call, Satya Nadella (CEO) was almost foaming with enthusiasm.
I have three central beliefs with respect to generative AI. The first is that it will proliferate very rapidly. If Cloud computing took a full 10 years to be properly adopted, generative AI will take 3 or less. The second belief is that aspects of generative AI will become generic (spread widely and not uniquely). That may make building moats around some applications of generative AI quite difficult. The third is that the corporate sector see it as a large cost saver and therefore a margin enhancer. Large corporates invest big in cost savings. That’s a well-established trend.
In terms of specifics, here is a list of companies we own in the portfolios that will benefit. None of these are bets on AI per se or uniquely, but all would benefit. Some are what we term picks & shovels, like microchips, others, like Accenture, are delivering services in AI.
Suppliers – Semi exposure names
- ASML/TSMC: supplier of Nvidia GPUs used for AI training
- Samsung: increasing need to memory in big data
- Disco: chiplets for enhancing specific sections of a chip
- Tokyo Electron/Hamamatsu: SPE equipment suppliers
- Atlas Copco/Ansys: suppliers to foundries & chip designers
Software efficiency enhancement using AI
- Microsoft: OpenAI – Office suite/security product enhanced by AI
- Accenture/Globant: AI/Security consultant
- Adobe: Firefly – AI enhanced Creative suite
- Glodon: AI driven imaging capabilities,
- Kingsoft: cloud office software – exploring potentials leveraging AI
- Aptiv: auto software – signal processing, power distribution, connectivity
- Affle: more efficient ad matching with targeted demographics
Healthcare
- Thermo Fisher/Wuxi A: enhanced CRO molecule discovery/matching capabilities
- Philips: Ai driven surgical robots + medical imaging capabilities
You say you’ve got a lot of ‘dry powder’ in the Select portfolio. What are you waiting for in order to deploy that?
FS: Equity is an obvious place to go. We are looking for growth or for prices to fall, and that might influence the timing we add to this allocation.
MF: In terms of the relative attractiveness of bonds and equities, we argue in favour of bonds at the moment. Equities and bonds are priced differently in different environments. Equities seem to be pricing for the advent of a bit of disinflation coming through, bonds don’t seem to be pricing that. So if we do get a bit of disinflation, bonds will benefit. Equities will benefit too, but it’s our view that it’s a safer bet to place with bonds.
Is this lowest equity exposure you’ve held in the Select portfolio?
FS: It is around 40% now, if you look at the long term history of the strategy, the highest we’ve been is 72% and the lowest 25%.
On Music Royalties (Hipgnosis), which has obviously been a contentious area, what do you think about where we are? What is the state of that market, and why do you think the market has been so punishing?
FS: I think there are a few things going on for music royalties. We’re still going through a period where there are opportunities to buy these assets. This was very much the pitch of the manager of our vehicle, Merck Mecuriadis at Hipgnosis Songs Fund, and he was the first one to really jump on it hard. I remember in our first meeting he said, “Guys this is an opportunity, I can go buy these catalogues of music and I can get them on multiple of 12x-14x earnings. This window won’t be open for long”. So, he hit the market and raised capital hard, and he bought great catalogues doing exactly as he said he would and that has highlighted the opportunity. Others have since come in, private equity players are in the game now and they are paying much higher valuations, so the typical multiple we are now seeing is 20x price to earnings. Merck has done a good job buying catalogues.
The challenge we face is that it’s a new asset class to the listed space so the holders and potential investors are not as familiar with the asset class as they would be bonds, equities, etc. We haven’t seen Merck sell any catalogues, and we wouldn’t really want him to as he’s bought them and now he’s harvesting them for income. But there is a lack of transaction value to confirm the valuations that the independent valuers put on the catalogues. We are in discussions with the board. They mandated a second, independent valuation to assess the assumptions made by their original independent valuers.
All have come back with the same answer, saying you are doing the right thing. So the valuations appear to be fine, the long term discount rate of 8-9% sounds reasonable, it hasn’t changed much over time and is reasonable next to bond yields. In terms of the vehicle we own, Hipgnosis, there is a catalyst over the next year in that there will be a continuation vote on this investment trust and given it is on a 40% discount to NAV at the moment, that will be interesting. Hipgnosis have Blackstone waiting and sitting to buy this catalogue. We have been in touch with the board to say that that would be an okay outcome, but you’d have to be completely clean on transaction values. We’ve been doing a lot of work with Hipgnosis on this investment, and we will see an outcome in the next year.
What is your attitude to defence stocks? Have ethical grounds shifted given the war in Ukraine?
JS: We don’t own any. It is an area that needs to be approached with care. What we do own is a great part of broad industrial supply, there will be parts of the companies that we own (Rockwell, for example, which is all about manufacturing and communication and security) that will also lead into the defence complex.
We don’t skip the ethical component of this question. Are defence companies a necessary part of the economic landscape? Yes. When we set out our stall as the type of companies we invest in, do we need to invest in defence companies? No.
Apart from the whole ‘bang-bang’ thing, do we believe a defence company would be as good in terms of their metrics that we look at? Probably not. One major issue for me is I don’t like companies that have very small amounts of customers when those customers are, in fact, nation states. I like companies that have a lot of customers, not dominated by nation states.