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 not, we surmise, for a while. It is a matter of conjecture how far the rates cycle will go. Consumer confidence and activity will be watched avidly for signs of fatigue. All the world’s main Central Banks have effectively become “dual mandate” even those that do not operate under the constitutional imperative to promote growth and control inflation. We continue to believe inflation will creep back into the picture. The main measures of inflation remain abeyant even if conditions precedent is in place. Output gaps are being progressively closed: Germany and Japan are already closed, and UBS economists estimate that it will close in US by the third quarter of next year.

It is dangerous to be complacent on this front as the prospect of higher inflation is not front of minds and therefore, were the data to trend that way, it would have a pronounced effect on relative performance of the main asset classes. The direction of travel within our clients’ portfolios is to bulwark inflation protection and add assets which will plausibly respond well to a flick up in bond yields.

Looking around the world as the year draws to its end, we note the exceptional performance of Asian markets which have been as hot as woks in a busy restaurant. Our portfolio engagement with this was segmentary via significant allocations in India and Japan: two markets that are far apart in geography and with few if no confluent themes. Also relevant to performance has been the Asian subsidiaries and Asian customers of constituent stocks in the Global Leader strategy. The Asian dimension of these businesses are available at lower implied earnings multiples than pure plays. We note that Unilever Indonesia – an example of a pure play – now trades on 48x forward earnings.

Drilling down into the detail it is worth noting that whilst overall earnings estimates within that region are running strongly positive in aggregate, there are more Asian sectors on an earnings downgrade path than an upgrade. Sector fortunes are far from uniform. The better areas are concentrated in Technology Hardware and Software.

On the hardware side, we are in years of plenty for chip makers with demand progressing from multiple sources: examples being autonomous vehicle development, the Internet of Things and of course the smart phone. Samsung Electronics enjoys the happy coincidence of leading in both microchips and screens and sustaining a leading presence in smart-phones.

When it comes to Asia and software, most heads turn to the “BAT” stocks: Baidu, Alibaba and Tencent. However, a wider phenomenon is at work. Expenditure on software by companies in the US now eclipses that on capital goods. There are many ways to gain exposure to this: via smart adopters of technology as well as providers themselves. We own Oracle in client portfolios as it has leadership in cloud database provision to companies. Oracle is no longer the noise in the software industry as other more consumer oriented players are operating on larger scale at the commodity end of the market for cloud enabled services. However, Oracle remains the leading player in the business segment via the tool set it places around the databases. Oracle’s customers include Amazon itself and SAP.

In an analogous development, within the payments arena, all the buzz is concentrated around Financial Technology (FinTech) start-ups and smartphone enabled platforms. Most of these piggy-back on existing credit card platforms. VISA makes twice the money from a phone activated payment than one via a card.

We have just finished reading Niall Ferguson’s excellent new book The Tower and the Square in which he analyses the multi-fold tensions between hierarchical structures (such as governments) and the disruptive effects of networks (starting with the Gutenberg press and running up to the advent of Facebook). Ferguson is entertainingly caustic about the true intentions of Facebook and Alphabet (parent of Google). He points out that they have been masters at turning their customers into the product and their monopolistic intentions. The Brins and the Zuckerbergs of this generation learnt at the knees of Gates and Jobs: all share common instincts.

At some point, it may prove unwise to overweight the new monopolists. For now, the Tech Titans can try to dismiss the attentions of EU Commissioner Margrethe Vestarger as “political crap” (Tim Cook, Apple CEO on CBS 20/11/16), but what if the US’s own Department of Justice took an interest in their practices? The notion that anti-competitive behaviour cannot take place in tandem with (favourable to the consumer) price declines warrants re-examining. There is ample possibility of giant missteps by the tee shirted capitalists, especially given their hard-to-credit dyslexia on matters of editorial responsibility and blind spots toward the negative aspects of the “communities” they help build.

On the one hand, capitalism looks very well. Leading companies have become very adept on so many fronts. On the other hand, trends now well underway look to undermine wider society. America, for example, is already home to many failing communities. 10 years from now, when we have had successive waves of automation, AI and robotics, business owners with access to capital markets will be richer still and the rest who are not engaged in servicing their whims may be very sad indeed. Some form of income re-distribution will be needed.

A letter detailing some changes to portfolio manager responsibilities can be found on the page that follows. Please also reference our new website which has been developed by Adam Hawkins who has joined from Clyde & Co to run the firm’s infrastructure.

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By |2017-11-13T17:15:38+00:00November 10th, 2017|Investment Letters, Other Posts|

About the Author:

James is a co-founder of Cerno Capital and lead manages a number of the firm’s collective and private portfolios. After qualifying as a chartered accountant in London (Coopers & Lybrand, 1989) he relocated to Asia. Between 1991 and 2004 he worked as an equity analyst, head of research, and latterly as an equity strategist at WI Carr, Paribas, HSBC and UBS, based variously in Hong Kong, Singapore and Jakarta. James graduated from the University of St Andrews, Scotland with an MA in Philosophy & Logic in 1986. James is a Member of the Chartered Institute for Securities & Investment.