By JAMES SPENCE
In recent Investor Updates held at The Stafford Hotel in London, members of the Cerno team talked through the investment outlook and portfolio positions.
Nick Hornby and Ion Sioras provided topical input as to the nature of the current bear market against previous bear markets. In their presentation the described how inflation has led to a decline in valuations and therefore indices.
Fergus Shaw described the firm’s investment approach to non-equity assets and the search for steady return with both income and capital return characteristics.
James Spence and Fay Ren took the audience through a tour from EV sub assembly to the modern factory and the modern enterprise, highlighting the firm’s multi-cycle approach to investment which entails deep sectoral work to identify and invest around mega-trends. They identified the following mega-trends and portfolio companies tied into these: electric vehicle systems, cyber security, digitalised corporations, automation, efficient health care and nutrition.
Finally, Ed Bonsor and James Chenevix-Trench introduced the firm’s work on future economies in the realms of blockchain, space and alternative protein.
We capture below questions asked by investors at the two meetings and our responses to these.
Q: How investible is alternative proteins?
So far, they are predominantly private companies and there may well be a significant amount of time before they have a significant presence in public markets.
There are examples of lab-based animal proteins which are becoming commercially available.
BlueNalu for example makes cultivated seafood. They are on the brink of being commercially viable due to targeting high price point products such as blue fin tuna steaks, which are typically sold for US$150-160/kg, but they are able to produce an alternative for US$50-60/kg.
The next step for them will be passing regulation to be approved for public consumption in the US, which will be easier as they don’t have to pass through the department of agriculture and can just focus on the FDA.
Beyond Meat is the only significant listed concern. Impossible Foods remains private. However, companies such as Nestle have a focus on these areas and potentially represent the best means of gaining exposure.
Overall, many of these companies will come to the market or be acquired by organisations such as Nestle and when that happens we will have a good base of understanding.
Q: One of the problems must be that most of this work will be done through the R&D branch of a much larger parent organisation, making exposure to those trends very diluted
That’s exactly right, it is often the case that you don’t get adequate exposure to the thing you might most want exposure to.
Our general thesis of large, globally successful companies is that if you were to extract the R&D department and list them separately, they would be on a very high multiple, which is one of the great benefits of owning diversified companies. We have an option on the successes but that failures don’t tip the company over.
If the business is being run effectively and has a good baseline, the things that work, work well, and the things which don’t work, don’t matter.
Q: Do you see signs of large organisations spinning off their more interesting divisions?
It happens. Good examples would be Aptiv, which we own which was spun out of Delphi in 2017. This demerger created the opportunity to invest in the EV supply module without the legacy combustion business which we have done in Global Leaders.
ASML, also held in the Leader’s portfolio, manufactures the lithography machines which print the chips, fulfilling a systemically important role within the digital infrastructure supply chain, came out of Philips.
In one of our calls with ASML about the history of the business, they noted that Philips wasn’t interested in keeping ASML as they didn’t particularly believe in the business.
Philips is a fascinating example of a business which as been so successful in innovation across so many product groups that it sometimes misjudges the long term potential of what it has given birth to.
Q: With reference to the growth of automation, how do you think that will that interact with the rising population. How do you think that will change the role of humans within society?
I think we all want to believe that our children have working futures that extend beyond a few narrow skills reserved for humans.
Personally (James Spence answering) I am not a great believer in what has been referred to as a ‘technological gap’ between humans and machines. This has gained traction via the book Thank You for Being Late by Thomas Friedman in which a chart by Astro Teller (CEO of X laboratories, formerly Google X) depicted this gap.
His vision for automation in the future is a recipe for self-destruction. It describes digital as having a parabolic rise and governments, corporations and individuals as only progressing in a linear fashion.
The choices are ours. I think humans need to be deeply involved in all aspects the machine age, particularly the management of and the ethics surrounding. We need to have our hands on the off button.
Q: With reference to innovation in alternative protein, will the chickens be released?
We won’t need so many chickens. Chickens currently far outnumber humans on this planet, with around 24bn being raised at any one time.
The amount of energy dedicated to this practice if lessened could be redirected towards other necessary purposes and potentially be significant for issues such as global warming etc
This issue intersects with land use. Double the amount of land is currently used for livestock globally as against crop production.
Q: In terms of these futuristic opportunities in food, but also driverless cars and other technologies, the speed of uptake depends on the regulator’s ability to keep up and not hold innovators back. Does this present a problem for investment opportunities?
This is an archetypal entrepreneurial view: regulators are holding back the Elon Musks of the world.
It’s important, though, to also consider the alternative view where regulation may actually help drive the uptake of new technologies.
The decentralised finance industry would benefit hugely from regulation as it would sort out the credible actors from the bad actors, allowing certain technologies to cohere around legitimate platforms and consequentially proliferate into more widely accepted processes and standards.
Part of the problem around Washington is that the regulatory burden for these new technologies is being pushed around different agencies.
Specifically in cell-based alternative proteins, only Singapore has approved the sale of these products for human consumption.
However, at the moment all of these companies are early-stage R&D focused organisations which wouldn’t necessarily be able to sell products regardless of the state of regulation at this point in time.
They are currently focused on the challenge of generating infrastructure of significant enough scale to be able to mass produce their products to then begin to focus on accelerating through economies of scale.
At the same time, these regulatory issues are being tackled and the managers who we are speaking to in some of these specialised agri-tech funds do expect a watershed in the next 10 months for the regulatory landscape.
It makes sense that food deficient countries such as Singapore are incentivised to push through the technology as it a potential for solution for a point of vulnerability that has really been laid bare by the supply chain issues experienced through Covid and to this day.
On one level it is very difficult for regulators to get a grasp of some of the complex digital ideas.
On the other hand, the decision doesn’t always necessarily need to be made with a full understanding of the inner workings of the technology and can instead be one founded in ethics. For example, the decision not to clone Dolly the sheep wasn’t one that hinged on deep knowledge of genetic science but was in the realm of fundamental ethics.
The biggest trend in capitalist America is the mantra of personal freedom and the doctrine of selfishness. The spiritual leader of this movement is Ayn Rand (1905-1962) whose books many of the US billionaires reference. The predominance of the US view has large consequences for the global capitalist system, not all of them good.
Q: How would you comment on you asset allocation process at this difficult time?
The equity strategies are fully invested at all times. Here, we do not attempt any market timing. In the multi-asset strategies, led by Cerno Select, we do have flexibility.
The key word within the multi asset strategy is “unconstrained”. We don’t have boxes in which assets need to fit in like many other asset allocators. The unconstrained approach allows us to be 0% in any particular asset class. For the last 5 years we haven’t owned any long duration fixed income assets and have instead grown the steady return allocation. We view asset allocation as a competition for space in the portfolio.
Anything we invest in must have an intrinsic return structure attached to it and if it is an outward allocation to a specialist strategy, we interview the managers to assess their expertise. We avoid “investment tourism”.
The equity portion of the multi-asset fund is currently just under 50%.
At the peak of our desire to be invested, when we come towards the end of the bear market, that is the point at which we’d want to be more invested and we would bring that equity portion up.
Q: You mentioned that you are multi-cycle investors and stick with stocks for the long term. How often do you make changes within the funds?
Global Leaders currently has 28 stocks and is limited to 30 positions. It would not be unusual for a year to pass with no changes to the portfolio. Within the last 12 month, we’ve seen roughly 2 sales and 4 purchases. That is quite a high level of activity.
Ansys, which Fay mentioned, was previously owned for a number of years before leaving the portfolio due to a very high valuation (peaking at 50x P/E). It sat on the side-lines for three years and has now been reintroduced as its valuation has come down.
Pacific is a little less concentrated than Global Leaders. Here we look to own 35 positions or a few more. But in a similar way, we try to hold companies for as long as possible. The Asian market can be more dynamic and volatile compared to developed markets, so the turnover rate will be higher. Position sizing is more active within Pacific as against Leaders.
Q: Is it impossible to make money in a bear market such as this?
The two large inflationary bear markets that we have experienced over the last 130 years were from 1900-1921 and 1966-1982.
Despite the obvious fact that those were long and uncomfortable periods, stock selection can yield positive results.
Particularly in the ‘68-‘82 period. Whilst the index went nowhere, if you had the right stocks, you still could make a really good return. For example, in the 1970s the stocks to own were those that became known as the Nifty 50.
Q: Could you comment on your use of other managers in various sectors?
We think of this in the context of: what is the expression that we’re trying to achieve and how is this best done?
Vehicle agnostic means that we don’t mind whether this is achieved via direct exposure, ETF, or specialist management team. But we recognise that there are specialist management teams out there who have spent their entire careers in a certain area and if we have identified a strategy which fits within one of those structural themes, allocation to one of those management teams may be the best way to gain exposure.
We believe it has good to have a mixture of direct securities and third party managers alongside one another. It has certainly helped with our investment education in the past 15 years as we have gained a good purview.
The key characteristics we look for in an external manager is someone who can clearly and concisely express what they do and whose portfolio structure and performance track record backs up those impressions.
We want managers who are aware of their own limitations and their advantages according to their size, and that naturally leads us to managers who are smaller in size and specialised in one particular area.
Q: Do you have a view on Secure Income REIT merging with LXI?
Yes, we’re running with it and continuing to hold the shares.
We think it allows for the creation of a much larger vehicle and effectively allows LXI to buy a large pool of property assets without incurring any of the transaction fees or costs which we view as positive.
Q: How do you hold Gold?
They’re held via physically backed ETFs. That’s a step better than synthetic or partially backed, but less cumbersome than physical metal.
We don’t hold the miners, there are times where that would be advantageous, however it’s a tricky trade to time.
Q: Seeing as you own Gold, have you ever thought about buying Crypto as a digital store of value?
No. We are not convinced by the concept of crypto as Digital Gold. To be called this implies a level of reliability and a lack of correlation to equity assets.
It seems fairly evident that as crypto assets went up, they were strongly correlated with high risk assets such as the NASDAQ, and when this contraction started it was clear they were going to do less well.
Secondly, we need to consider the utility of crypto assets. I appreciate the curiosity value and the potential for short term profits, but they don’t have a natural return attached to them. So they haven’t currently passed those tests, but we’re keeping an eye on them.
We’re aware that Ethereum has potentially a better use case than Bitcoin and will continue to monitor.
It’s important to also note the difference in our interest in blockchain from interest in crypto-currencies.
Crypto-currencies we see as something of a speculation, whereas blockchain could function as widely adopted digital infrastructure through which new mechanisms of commerce can take place, partially through these crypto-currencies, via mechanisms of trade, smart-contracts and exchange.
Q: Are you more likely to own a Coinbase style asset than a crypto-currency then?
I think there isn’t enough regulation in Coinbase.
On the subject of regulation, for the entrepreneurs in this sector, regulation would be the best thing as it would coalesce standards around certain companies and platforms, and they should therefore welcome regulation even though there is a spiritual challenge to this in that crypto was originated as a form of financial “punk” culture.
Q: Can blockchain become a product which is economically viable, in that in enables commercial users to generate profit?
As mentioned, we think it is essential to invest in assets that have an intrinsic return and cryptocurrency doesn’t necessarily fit that criterium. Instead we’re looking at the potential for disruption which blockchain that cryptocurrencies have brought to the fore.
This may not represent a new revenue source for the incumbent corporates, rather it could and perhaps should be a source of efficiency for the users.
For example, if you’re talking about something like merchant fees which are charged by credit card companies, if you can use blockchain smart contract functionality for that instead, you can bring down the fees for the user, much the way that e-commerce increased the cost efficiency for the consumer when buying from a retailer.
You may have smaller margins, but the efficiency that it brings is a transformation which we see in almost every new technology. Efficiency drives adoption.
Another example of this would be international telephone calls. As the cost comes down, transactions go up.
So a reduction in margin in blockchain should see a corresponding rise in volume of transactions, which would be hugely beneficial to the scale and real life applicability of the technology.
Q: How would you see that interacting with the inherently decentralised nature of blockchain? Part of the appeal of blockchain is that it isn’t owned by a centralised body, so how would they remedy those two issues?
That’s an interesting point to make. Obviously when we talk about central bank digital currencies, we’re talking about a scenario where the government has actually increased its institutional oversight, which is of course the antithesis of the founding philosophy of Bitcoin.
I think that’s an interesting conflict which we haven’t necessarily solved yet. However, the point of blockchains is that not all of them have to be de-centralised.
Q: Which of your investments play into these new technologies?
Obviously, we think about the immersive internet in the context of Microsoft and Tencent and how they may go onto develop economies themselves, perhaps through a centralised blockchain system.
In space, we have invested in the Seraphim Space Investment Trust in the multi-asset portfolios. We had been talking to the managers of the trust since well before they listed.
In alternative proteins, Nestle have ambitions in that area. On nutrition there can be no mistake that significant change is taking place. Part of that can be seen through the trends of vegetarianism and veganism, and part of that is ecological. You can see from the way that Nestle is re-orienting its portfolio that it is taking these changes seriously and working hard to keep up with these changes in consumer tastes.
One of the initiatives for us is to understand how these companies operate before they start appearing in the market or being bought up by other larger organisations such as Nestle.
We aim to keep an eye on these things which are coming over the horizon. These are potentially transformational and as owners of Global Leaders who are at the vanguard of their industries, we need to be tuned into what is coming in the future.