Unbranded: The Risk in Household Consumer Names

“Advertising is based on one thing, happiness. And you know what happiness is? Happiness is the smell of a new car. It’s freedom from fear. It’s a billboard on the side of the road that screams reassurance that whatever you are doing is okay. You are okay.” –  Don Draper, Mad Men season one

“Identities are the beginning of everything. They are how something is recognized and understood. What could be better?” – Paula Scher, first female principal at Pentagram, the world’s largest independently-owned design studio

“A brand is the set of expectations, memories, stories and relationships that, taken together, account for a consumer’s decision to choose one product or service over another.” – Seth Godin, bestselling author



A wise man was he Don Draper. He understood the human need to belong, to feel safe. And his contemporary would understand, that today, reassurance comes from counting the likes for your Facebook status update, having an Instagram following that exceeds the following enjoyed by your friends, or your ramblings on Twitter being retweeted by someone even moderately famous. The lowly billboard barely gets a look anymore. And household consumer brands, not unlike many of Don Draper’s fictitious clients, are none the better for it.

On 15 August, 2017 the Wall Street Journal ran an article titled “This Isn’t An Advertisement: Time to Buy Shares in WPP” in which they argued that “As the stock market climbs ever higher, traditional advertising agencies look like a rare pocket of value – none more so than the largest, WPP”. And as if almost on cue, WPP cut its revenue forecast – blaming weak client spending – and sent its stock price crashing.

WPP’s announcement received all manner of reaction. The idea that it is only a matter of time before the rot spreads to digital advertising juggernauts Facebook and Google, in particular, received plenty of airtime. This conjecture resonated with those calling for the FANG “bubble” to pop. For many, Procter & Gamble’s revelation that it had cut digital marketing spend by over USD 100 million with it having very little impact on its business, only a few weeks prior to WPP’s announcement, only further confirmed this hypothesis. A chart not too dissimilar to the one below may also have been used to argue that the disconnect between FANG and WPP stock price performance will duly close. We consider this type of thinking to be a formulaic type II error.

WPP and Google Share Price Performance (Normalised)WPP GoogleSource: Bloomberg

An advertising agency’s business model is to aggregate advertisement placeholders across disparate media outlets and to provide an access point for advertisers to its network of placeholders. As the advertising market is becoming increasingly concentrated, with Facebook and Google grabbing all advertising spend growth, aggregating ad space is becoming a redundant competitive advantage. Especially when there is limited need for human interaction, and by extension privileged access, to place adverts on Google and Facebook. Advertising agencies have increasingly been disintermediated as access to ad space has become democratised.

Internet Share of Total Advertising Spend Advertising Spend ShareSource: Bloomberg Intelligence

Advertisers use ad agencies to communicate a uniform message about their product or brand to reach as much of their target market as is feasible. They typically focus on two types of advertising, one is the promotional kind to boost sales over a short period of time and the other is to increase awareness of their brand and to shape consumer perception – to create, in essence, a halo effect to drive long-term brand loyalty and sales. Household consumer brands, the likes of Andrex, Kleenex and Tide, produced by consumer goods corporations such as Procter & Gamble and Kimberly-Clark, generally spend the majority of their advertising budget on trying to create strong brand identities for their products.

Consumer goods companies combine their products’ strong brand identities with far reaching distribution. In turn, making their products available to as many consumers as is feasible. Awareness and availability have been the moats exploited most effectively by the largest and most successful consumer product manufacturers.

At a time of scarcity of information, consumers relied on brands as proxies for reliability and of quality assurance. You could be pretty much anywhere in the world and be comfortable with the fact that if you bought your regular brand of coffee, cereal, or soda that you would get what you expected. There would be no discovery, no adventure but there would also be no disappointment.

Today, however, the brand too is being disintermediated. We no longer need proxies. We have smartphones giving us access to a plethora of information at all times. We can instantly check reviews or recommendations for products, restaurants or hotels made my people who have experienced them. And being socially conforming animals, we tend to trust the judgement of other people over perceptions created by brands. Access to information has freed us to discover and try new things, which further frees us to make choices based on preference over perception.

Household consumer brands have been the mainstay on shelves across all major retail grocery and supermarkets chains for decades. Limited availability has made it difficult for little known brands to get much shelf space, especially as purchasing managers tend to take the low-risk decision of sticking to the tried and tested. Amazon and online retail in general, however, has no such constraints. There is no limit to the number of products that can be promoted on an online platform. At the same time, door-to-door delivery and third party logistics solutions have become far more affordable, enabling small businesses and sole proprietors to match delivery solutions offered by the largest of companies.

Distribution, too, is losing its lustre as a source of sustainable competitive edge.

The design services ad agencies offer their clients are a tax on the advertiser to gain access to an agency’s ad network. Advertisers have been willing to bear this tax historically. However, the effectiveness of traditional media outlets, particularly television, in getting the message across to the masses is being challenged by social networks and other disruptive technologies. It is unsurprising that advertisers are reigning in their ad spend budgets.

If digital advertising platforms have been so effective at disrupting traditional advertising channels, how does one reconcile that Procter & Gamble cut digital spending and it had minimal impact on their business? Firstly, the company has long been the largest spender on advertising in US and the cut represents less than 5% of their total annual ad spend. Secondly, and more importantly, the company has spent billions year in and year out for decades in building brand identities for its product. Consumer behaviour patterns suffer from inertia. Brand loyalties and affinities will not be wiped out immediately but are likely to gradually fade away. Somewhat akin to the explanation on how one goes bankrupt in Ernest Hemingway’s The Sun Also Rises:

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

Lastly, digital advertising platforms’ major strength is targeting specific consumer groups based on precisely defined criterion. Such platforms are best suited to products that have a great deal of appeal to a select group of consumers. In such instances, the return on investment will tend to be high.  In contrast, household consumer brands have been built upon creating mass awareness and offering acceptable levels of quality – traits that are unlikely to garner much consumer enthusiasm and therefore likely to result in a low return on investment on digital media spend.


Investment Perspective

In our opinion, the decline of WPP is not a signal for the coming decline of Facebook or Google but rather a confirmation of their strength as legitimate advertising platforms. We expect the demise of the traditional advertising agency model to accelerate. The next great businesses of our generation are unlikely to rely on the advertising models of the past. While existing clients of ad agencies will continue to cut back spending or take away their business altogether. Neither outcome supports the flow of talent into the advertising industry. Without fresh and new talent entering to disrupt the industry, the industry is likely to cling even more strongly to the past. Traditional advertising agencies do not represent pockets of value, in our opinion, they are value traps.

The weakness in traditional advertising agencies also represents potential for deterioration in household consumer names, much like many of the constituents of the Consumer Staples Select Sector SPDR ETF ($XLP) and iShares US Consumer Goods ETF ($IYK). We would avoid investing in either of these ETFs at present and potentially look to get short some of the weaker names within the sector.

WPP vs. Consumer Staples Select Sector SPDR ETF (Normalised)WPP XLPSource: Bloomberg

Our analysis suggests that well-known consumer stocks such as PepsiCo ($PEP), Philip Morris ($PM), Kimberely-Clark Corp ($KMB), The Clorox Co. ($CLX), Dr Pepper Snapple Group ($DPS), Pinnacle Foods ($PF) and Tupperware Brands Corp. ($TUP) are susceptible to significant deterioration in fundamentals. We may cautiously look to short a basket of these names opportunistically.

To counterbalance our negative stance on a number of consumer stocks, if one is to get long consumer plays we find that the greatest upside potential is in aspirational brands.

We define aspirational brands as premium products that have appeal not only in the US but beyond its borders also. These brands have far more potential to benefit from the rising disposable incomes of consumers in emerging markets than do household brands. Companies that fall in the aspirational brand category include the likes of Michael Kors Holdings ($KORS)*, Estee Lauder ($EL) and Tempur Sealy International ($TPX).

* Note: We recommended $KORS as a long idea to LXV Research subscribers on 13 September, 2017

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Saudi Arabia: Excited by the Market not Transformation

“All change is not growth, as all movement is not forward.” – Ellen Glasgow

“The stock market is just too important to leave to the vagaries of an actual market now.” Babar Rafique, CFA of Setter Capital

“Successful offense brings victory. Successful defence can now only lessen defeat.”  – General Curtis Lemay

Gabriel:  Have you ever heard of Harry Houdini? Well he wasn’t like today’s magicians who are only interested in television ratings. He was an artist. He could make an elephant disappear in the middle of a theatre filled with people, and do you know how he did that? Misdirection.

Stanley: What the f*** are you talking about?

Gabriel: Misdirection. What the eyes see and the ears hear, the mind believes.

Swordfish (2001)


Failures and negative outcomes are often followed by a call to action. College football teams regularly fire successful coaches after a poor season, companies replace senior executives following a series of public relations mishaps, and rarely does an administration overseeing a recession survive the electorate.

The Great Recession gave us the Obama presidency. Coca-Cola losing market share to its rivals gave us the “New Coke” debacle. A spate of bad press and multiple revelations of past misconduct ultimately cost Travis Kalanick his job as chief executive of Uber. After failing to win a grand slam for three years in a row, Roger Federer parted ways with Stefan Edberg and started training with Ivan Ljubicic. The examples are countless. The results mixed.

One such recent call to action, with its own wrinkles, has been the national transformation plan announced by Saudi Arabia. The kingdom has come under severe economic pressure since the collapse in the price of oil. A monarchy has little appetite for political change. Any change therefore has to be either economic or social in nature with a view towards prolonging the political status quo. Prolonging the political status quo remains paramount.

Central to Saudi Arabia’s transformation plans are a more equitable participation by the private sector in the economy, enhancing downstream petrochemical capabilities and a reduced reliance on oil revenues. To reinforce the message of transformation, Mohammed Bin Salman (MBS), the driving force behind the plans and favoured son of King Salman, announced plans to publicly list Saudi Aramco, the state oil company.

The headlines have come thick and fast since MBS unveiled the kingdom’s Vision 2030 in April 2016: a USD 3.5 billion investment in Uber; a USD 17 billion international bond offering – the largest ever by an emerging market nation; a USD 20 billion commitment to a Blackstone infrastructure fund; an anchor investment into Softbank’s Vision Fund; King Salman’s dismissal of Mohammed bin Nayef – dubbed as the “the prince of counter-terrorism” in Washington – as Crown Prince and the ascension of MBS as successor to the throne; Saudi Arabia along with the UAE, Bahrain and Egypt placing economic sanctions on Qatar; and MSCI placing the Saudi equity market on its Emerging Markets Index inclusion watch list.

These are the headlines, the real change, however, is happening on the ground. Nowhere is change more visible than in the socioeconomic framework that has been the staple of the Al Saud dynasty. To understand these changes, let’s take a step back and understand Saudi Arabia’s economic model.

The Saudi Arabian economic model is straightforward and not too dissimilar to the economic model of other emerging markets generously endowed with natural resources. It is a model of government largesse in return for compliance and forsaking political freedom. It is a model where the lion’s share of profits in the economy is provided by the government.

Some of the ways the government provides profits include:

  • Transferring natural resources to the private sector at below market prices
  • Infrastructure spending
  • Being the largest employer in the country – even excluding the large government controlled private sector entities

The private sector is largely organised to exploit the profit making opportunities provided by the government. Refiners and converters acquire natural resources at subsidised rates and convert them to mid-stream and downstream products to capture the difference between subsidised prices and market prices plus a refining / converting margin. Energy intensive industries take advantage of subsidised energy prices. Contractors and construction companies bring in low cost labour from countries such as Egypt, Pakistan and the Philippines and bid for lucrative infrastructure contracts. Traders and retailers cater to the bulk of remaining local demand through imports.

The banking sector remains steeped in traditional lending practices with an almost non-existent shadow banking sector. There is limited participation by international creditors beyond lending to government and government related entities subsequent to the Al-Gosaibi / Saad Group scandal that rocked the Saudi financial sector in 2009. Topping it off, the Saudi Arabian Monetary Agency (SAMA) has adopted a tough and conservative regulatory framework requiring banks to remain well capitalised and adhere to prudent lending practices.

The Saudi Arabian economic model is unsustainable and true to Herbert Stein’s Law – “if something cannot go on forever, it will stop” – in 2016, it came to a stop. The government signalled that it was not willing, nor able to be the source of ever increasing private sector profits. It admonished the private sector for not doing its fair share in supporting the economy and addressing the challenges of youth unemployment.

Gasoline and diesel prices were increased. Feedstock subsidies for petrochemical producers restructured. Electricity and water tariffs revised. Municipal fees introduced for commercial activities. Airport taxes increased. Cigarette prices doubled with the introduction of “selective” taxation. Roll-out of a value added tax proposed.

These were some of the fiscal reforms. Austerity followed.

The government stopped awarding contracts for a large number of projects, vaguely classified as projects where the “scale of spending was not compatible with the economic and development returns hoped for them.” Contractors stopped receiving payments, which coupled with public sector borrowing crowding out private sector credit snowballed into an epic liquidity squeeze. With pressure mounting, the government, towards the end of 2016, pledged to settle its dues to the private sector.  Despite the pledge, around 70% of outstanding dues to contractors of public projects in Saudi Arabia remain unpaid, according to local broadsheet Okaz.

The Saudi Riyal Interbank Average Offered Rate – 3 Months Source: Bloomberg

Perks and financial benefits for public sector employees were also cut – based on our discussion with locals, we found that Saudis from all classes unanimously had the a priori belief that public sector pay was sacrosanct. By cutting public sector pay, the government crossed the proverbial line in the sand and we are not surprised that decision has since been reversed.

After fiscal reforms and austerity came protectionism.

According to McKinsey Global Institute, 4.4 million jobs were created in the kingdom from 2003 through 2013 – a decade of booming oil prices – about 1.7 million were taken by Saudis with the remaining being taken by foreign workers.

Much to its chagrin, the government remains the employer of choice for Saudis.

The public sector is bloated. Salaries and allowances accounted for 45% of government spending in 2015. Efforts to rein in spending will be in vain unless the private sector hires more Saudis. Half the population is under the age of 25. Attitudes of and towards the private sector must change. The government appears unwilling to take any chances and has, much to the private sector’s displeasure, opted not for the carrot but the stick.

Starting July 2017, the government implemented a “dependant fee” on all expatriate employees. This levy entails an expatriate employee paying SAR 100 (USD 27) per month for each of his or her dependants holding a residence permit. The fee will be increased annually till 2020. An expatriate employee with a wife and two children living in Saudi Arabia will be out of pocket SAR 14,400 (USD 3,840) annually from 2020 onward. Expatriates, holding work or residence permits, require exit and re-entry visas to travel in and out of Saudi Arabia. The cost of obtaining exit and re-entry visas was also increased starting July 2017. Predictably, we are receiving anecdotal evidence that expatriate employees are starting to relocate their dependants back to their home countries or leaving the kingdom all together.

During 2012, the government doubled the cost of expatriate employee work permits from SAR 100 (USD 27) per month to SAR 200 (USD 53) per month. It also introduced a fee to penalise companies that employed more expatriate staff than Saudi staff. Companies with 50% or more of the workforce comprised of Saudis did not incur any additional direct costs. Companies that failed to meet the 50% “Saudisation” threshold were required to pay a monthly fee of SAR 200 (USD 53) multiplied by the number of expatriate staff in excess of Saudi staff. For example, a company with 100 employees, 60 expatriates and 40 Saudis, would be required to make a monthly payment of SAR 4,000 (USD 1,067) to the government. These payments were to be utilised to support the training and development of the existing and prospective Saudi workforce. Starting January 2018, the monthly fee will be increased and will be applied to every expatriate employed and not just the number in excess of the total number of Saudi staff. The fees will be increased annually till 2020. In 2018, a company with 100 employees, 60 expatriates and 40 Saudis, will be required to make a monthly payment of SAR 14,000 (USD 3,733).

The introduction of the “expat levy” in 2012 created demand for Saudi staff. Predictably salaries for Saudis went up, an intended consequence of policy. However, given the challenging economic environment and based on a number of discussions we have had on the ground, this time companies are more likely to shed expatriate staff over hiring additional Saudi staff.

Cost of doing business is going up. Capital investments are shrinking. The consumer is retrenching and the expatriate population maybe declining. All factors contributing to declining private sector profitability.

New Letters of Credit Opened – Six Month Moving Average (SAR in million)Source: SAMA

Where will the growth in profits come from to drag the economy out of its doldrums? Government plans highlight seven industries that will receive concentrated government support; chief amongst them is the petrochemical sector.

The petrochemical sector is at the core of Saudi Arabia’s non-oil economy. In 2015, petrochemical products accounted for USD 30 billion in exports, representing almost two thirds of total non-oil exports. Olefins – ethane and LPG derivative products – account for three quarters of total petrochemical capacity. While aromatics – naphtha derivative products – contribute 13% of capacity.

Local production is skewed towards commoditised chemicals – unsurprising given the generous subsidy regime, which incentivised management teams to capture the spread relative to market prices as opposed to venturing further downstream. A lower price of oil and expectations of further subsidy reform places the onus on producers to increase value creation by focusing increasingly on specialty chemicals. This is not without risks. Producing specialty chemicals requires technical expertise that is in limited supply both locally and regionally. Developing technical expertise requires time and investment. There also needs to be a cultural shift towards innovation and research & development – no mean feat given the government’s majority ownership of and influence over a number of the major producers.

Shale, not for the first time, may scupper Saudi ambitions. As a major new source of natural gas, shale has revived the US petrochemical industry. With the Permian Basin’s level of natural gas production expected to increase by 5.5 million cubic feet per day between 2016 and 2020, the revival is only getting started. Majors such as Dow Chemical and ExxonMobil have already announced major investment plans to expand their production capacities in the US. Even Saudi petrochemical giant SABIC is looking at investment opportunities in the US.

Economic reform is one aspect of the transformation. Privatisation (read: selling state assets to shore up finances) is another. Everything is up for sale.

The success of the government’s privatisation efforts hinges not only on the quality and price of assets but also the robustness of the legal and regulatory framework governing those assets. With a judicial system steeped in bureaucracy and a reputation for arbitrary interpretations, the system is in real need for change. Yet, signs of legal and regulatory transformation remain largely absent. As a case in point, the kingdom still does not have a bankruptcy law. The absence of which has long discouraged failure and by extension curtailed innovation.

Saudi Arabia is only at the very beginning of a long and arduous journey towards sustainability.  Rational thinking dictates that Saudi Arabia must remain committed to transformation. Political will to stay the course, however, remains untested with signs already emerging that it is waning. Ultimately, all decisions in a monarchy come down to one person and their desire to do the right thing weighed against their need to be celebrated. In Saudi Arabia, that one person happens to be a thirty-something prince who has designs on becoming king. In a world where Donald Trump is President, we now know popularity tops all.


Investment Perspective

The Saudi Riyal is the primary determinant of the cyclical direction of the equity market. At first glance, that may appear to be a strange statement given the currency is pegged to the USD. The peg, however, is precisely why asset prices must adjust to reflect the value of the currency. As the currency moves from being undervalued – real effective exchange rate (REER) below 100 – towards fair value, equity market performance deteriorates, as witnessed late 2014 onwards. While cyclical upturns in the equity market are witnessed as the currency moves from being overvalued – REER above 100 – towards fair value, as witnessed near the start of the millennium.

Tadawul All Share Index vs. Saudi Riyal REER (Inverted)Sources: Bank for International Settlements, Bloomberg

The Saudi Riyal is the most overvalued it has been in over fifteen years. The question, therefore, for those weighing up the opportunity of investing in the Saudi market, is whether they believe the currency can become even more overvalued. The answer to which lies in whether you (i) are an oil bull or bear; (ii) believe the Saudi government can reduce its budget deficit; and (iii) are in the Saudi Riyal devaluation camp or not.

Whilst all three points require a discussion, in and of themselves, to summarise our views on the first two, we are of the opinions that (i) oil price risk lies to the upside; and (ii) the Saudi government has undertaken a number of initiatives that will enable it to reduce its budget deficit. For these reasons, we are of the opinion that the Saudi market may be at the beginning of a cyclical upturn.

With respect to the USD peg, we contend that the peg is inextricably linked to political stability and maintain that prolonging the political status quo remains paramount. In a country where local demand is almost entirely met through imports while exports are largely commoditised goods priced in USD, the political concerns relating to a de-peg or devaluation outweigh the potential for economic gains. We think, the powers that be will maintain the peg till the point of maximum absorbable pain. And the willingness of the government to sell its assets only confirms our thinking.

To some our scepticism over the transformation plans and concerns around shrinking private sector profitability may appear contradictory to our view of a potential cyclical upturn in the equity market. To that we would counter that markets are made at the margin. We are seeing evidence of economic activity picking up; improving money supply metrics; and we expect the government to move from a heavy- to even-handed approach to reform. That being said we do have a number of concerns that we highlight below.

Saudi Arabia Money Supply M2 YoYSource: Bloomberg

A quote from Babar Rafique of Setter Capital best captures our major concern around the Saudi equity market: “The stock market is just too important to leave to the vagaries of an actual market now.” In a country bereft of social activities, the equity market is embedded in the social fabric – making it ripe for policymaker intervention. Our discussions with brokers and asset managers lead us to believe that is indeed what has happened.

Take for instance, the performance of the equity market on 25 April 2016, the day MBS’s interview unveiling plans for the country’s transformation was aired. It is important to note that the interview was pre-recorded and most of the facts had already been drip fed to the public or revealed in a Bloomberg article published on 21 April 2016.

Tadawul All Share Index (19 to 26 April 2016)Source: Bloomberg

We leave it to you to guess at what time the interview started airing.

As a second case in point, we consider the best performing stock across the Saudi market since Salman bin Abdulaziz Al Saud became king. The stock happens to be Saudi Research and Marketing Group (SRMG). The performance of this stock is staggering. So much so that its return is more than 2.5 times the return of the second best performing stock over the period. When we consider that the company has failed to turn a profit since 2012, the performance is even more remarkable.

Why has this company caught our attention? We quote from the company’s profile on Wikipedia:

From 1989 to his death in 2002, Ahmed bin Salman was the chairman of the company. Then, his younger brother Faisal bin Salman became the chairman of the company. On 9 February 2013, Turki bin Salman succeeded Prince Faisal as chairman of the SRMG when the latter was appointed governor of the Madinah province. Prince Turki’s term as chairman ended in April 2014 when he resigned from the post.

From 1989 to April 2014, each appointed chairman happened to be a son of King Salman.

While we have found other instances of curious market action coinciding with government announcements, we do not want to belabour the point any further.

Another concern we have is valuation. The market is not cheap at around 18 times trailing twelve months’ earnings as compared to the MSCI Emerging Markets Index which trades around 16 times trailing twelve months’ earnings.

Lastly, any discussion related to Saudi Arabia is incomplete without considering geopolitics. We are not political analysts and therefore will limit the discussion to matters that we consider important to investing in Saudi Arabia. To that end, we find it important to highlight concerns around the Qatar Crisis. Saudi Arabia traditionally opted for a defensive stance and used backchannels and its wealth to achieve its geopolitical ambitions. The current leadership, however, has opted for offense. We believe the change in stance has been caused by insecurities that arose out of Obama’s Asian pivot and US disengagement in the Middle East region. As an added benefit, geopolitical tensions redirect the population’s attention away from economic hardship and foment nationalism. Irrespective of the motivations behind the move, we believe that Saudi Arabia’s and its partners’ move to isolate Qatar damages the investment case for the GCC region as a whole. Further, if Saudi Arabia continues to take the more aggressive approach it only increases the political risk premium that should be attached to investments in the region.

We are long the iShares Saudi Arabia Capped ETF $KSA.    

The Case for a Pickup in US Inflation

“Given the right economic conditions, business will make substantial efforts to train workers. When the economy is moving along at a healthy pace and firms are eager to hire additional personnel, individuals with few qualifications begin to find opportunities.”

“Labor is the largest cost of the business sector. It has two determinants: employee compensation rates and worker productivity. When employee compensation rates increase, labor costs increase. When worker productivity increases, business pays less to get a job done. Both rising compensation rates and stagnating productivity in the United States have made critical contributions to inflation.”

– Excerpts from Profits and the Future of American Society, S Jay Levy and David A. Levy (1983)


“[I]nflation will remain rather limited as long as bad money, here the vellon, is still driving out the good silver money. For this means that the total money supply is scarcely changing.”

“[U]nexpected reversals of monetary policy seem to be the rule, especially when inflation accelerates, and if uninformed rulers try to react to consequences not foreseen by them. As a consequence, one can expect no damage from inflation in the real economy only as long as it remains small and smooth.”

– Excerpts from Monetary Regimes and Inflation, Peter Bernholz (2003)


Inflation principally comes in one of two forms:

  • Rising resource prices; or
  • Wage growth outpacing productivity growth.

Given the services-biased structure of the US economy, wage growth outpacing productivity growth has a far greater and more sustainable impact on US inflation than do rising resource prices. With wage growth in structural decline, inflation has remained tepid in the US despite the best efforts of policymakers.

Services as a Share of GDPServices ShareSource: The World Bank

During the recent Fed meeting, the Federal Open Market Committee downgraded its 2017-18 inflation forecasts lower. Despite this, Fed Chair Yellen argued that weak pricing pressures are transitory. We are in agreement with Janet Yellen and find that US inflation is on the cusp of turning sustainably higher.

To assess the prospects of US inflation on a look forward-basis we analyse the relationship between inflation, wage growth and productivity growth. As proxies, we use the annual change in US CPI for urban consumers to represent inflation, the US unit labour costs for the nonfarm business sector to represent wages and US output per hour for all persons for the nonfarm business sector as a measure of productivity.

Comparing inflation to wage growth less productivity growth, we find the relationship to have moderately positive correlation. The R-squared using quarterly data from Q4 1997 to Q2 2017 is 0.52. This relationship is much stronger during periods the two measures are trending, either positively or negatively.

Change in the Consumer Price Index vs. Wage Growth less Productivity GrowthCPI vs WG less PGSources: Bureau of Economic Analysis, Bureau of Labor Statistics

The differential between wage growth and productivity growth has been trendless since 2011, swinging from negative to positive and back on an almost quarterly basis. No wonder then that the inflation environment has remained benign, much to the frustration of the Fed, who has pulled out all the stops to fight deflationary tendencies within the economy.

Despite the seeming absence of inflation, we find that inflationary forces have been gathering steam since 2014. This has failed to show up in the headline data due to the outsized impact of a handful of industries caught up in downturns.

Based on data provided by the Bureau of Labor Statistics, wage growth has outpaced productivity growth across a majority of industries from 2014 through 2016. However, workers in the oil and gas extraction, media related and retail focused industries have suffered from declining wages and this has kept a lid on overall wage growth.

Annualised Wage Growth less Productivity Growth by Industry (2014 to 2016)WG less PG IndustrySource: Bureau of Labor Statistics

As the base effects of the negatively impacted industries unwind, we fully expect, headline inflation measures to turn up and begin to exceed consensus expectations. Giving further credence to our assertion is the tightness in the US labour market. The jobs opening rate and the number of small businesses identifying job opportunities as hard to fill are either at or near their highest levels since the turn of the century. At the same time, US U-3 unemployment is at its lowest level since 2000.

US Jobs Opening RateUS Job Openings RateSource: Bureau of Labor Statistics

 US Small Business Job Openings Hard to FillJobs hard to fillSource: National Federation of Independent Business

US U-3 Unemployment RateUS UnemploymentSource: Bureau of Labor Statistics

Historically, periods of labour market tightness when businesses are facing difficulty in filling job openings have preceded increasing wage growth. Comparing the US Small Business Job Openings Hard to Fill index to US wage growth lagged by one year, we find this to be the case up until the end of 2012. Since 2013, however, the relationship appears to no longer hold true. The number of businesses reporting job opportunities difficult to fill has been increasing while wage growth has remained largely absent.

Small Business Job Openings Hard to Fill vs. Wage Growth (Lagged One Year)Job Openings vs WGSources: Bureau of Labor Statistics, National Federation of Independent Business

Once again, the relationship is seemingly impaired at the headline level due to the outsized impact of a handful of industries. Based on data provided by the Bureau of Labor Statistics, wage growth has been positive across a majority of industries from 2014 through 2016. The oil and gas extraction industry, unsurprising given the collapse in the price of oil in 2014, has been a major drag on overall wage growth.

Annualised Wage Growth by Industry (2014 to 2016)Wage Growth IndustrySource: Bureau of Labor Statistics

Going forward, the oil and gas extraction industry should no longer be a drag on headline wage growth and may even have a positive impact on it if oil prices continue to increase. We therefore expect wage growth to pick up as businesses increasingly pay up or hire lower skilled labour and train them up to fill outstanding job openings.

Small Business Job Openings Hard to Fill vs. Capital Expenditure PlansJobs hard to fill vs Capex PlansSource: National Federation of Independent Business

The effects of the structural deflationary forces of globalisation, migration / labour mobility and declining trade union membership are also abating. The lion’s share of gains from outsourcing has already been realised. Politicians are increasingly pandering to populous movements and turning to protectionist policies, making labour migration far less frictionless. Trade unions have held very little appeal to younger workers that entered the workforce in recent years.

The inevitable corollary is the rising labour share of corporate profits will place increasing pressure on businesses to improve productivity. We therefore expect capital expenditures to pick up. Businesses will increasingly invest in automation and robotics to overcome the challenges of wage inflation and labour market tightness.

Small Business Capital Expenditure Plans vs. Productivity Growth (Lagged One Year)Capex plavs vs PGSources: Bureau of Labor Statistics, National Federation of Independent Business

Increased corporate spending will not only lead to improvements in productivity but to an upturn in the overall US business cycle. Capital investment has been the one missing ingredient in the US economic recovery since the Global Financial Crisis.  As businesses spend more, corporate profitability will pick up, which will lead to increased hiring and higher wages, which will feed into further investments into automation and robotics.

Our base case is, therefore, that the current US economic expansion will be the longest ever recorded. And the business cycle will only come to a turn after unemployment levels fall below 4%, inflation exceeds prevailing expectations and policymakers begin to respond to the unexpected consequences.


Investment Perspective

US median household income has been rising and we expect it to continue to rising as wage growth accelerates.

US Median Real Household IncomeUS Median Household IncomeSource: US Census Bureau

At the same time, US household balance sheets have been repaired with the household debt to disposable income ratio in decline since the Global Financial Crisis. More so, the debt service to disposable income ratio is at comfortable levels for US households. There is ample room for households to take on more debt, especially for the poorest households who are the likeliest to benefit as wage growth picks up.

US Household Debt to Disposable IncomeUS Household debt to disposable incomeSource: Bloomberg

 US Household Debt Service RatioUS Household DSRSource: Bloomberg

As poorer households’ disposable income increases, this cohort is more likely to increase consumption as opposed to increasing savings, especially when compared to upper-middle and upper class households. Poorer households shop at Walmart not Whole Foods. They eat at McDonald’s not Shake Shack. We expect retailers and quick service restaurants catering to lower and lower-middle income households to be amongst the greatest beneficiaries of higher wages. We are particularly bullish on the prospects of Walmart ($WMT).

Consider the relationship between US wage growth and $WMT revenue growth lagged by one year. The revenue growth measure does not adjust for store openings, corporate actions and other extraordinary events that may have occurred during intervening periods. Despite the lack of adjustments, this dirty measure has shown a strong relationship with wage growth.

$WMT’s revenue growth has flat lined in recent years as wage growth has been trendless. As wage growth picks up, we expect investors to increasingly come to recognise $WMT’s growth potential and rotate out of Amazon and into $WMT.

US Wage Growth vs. Walmart Revenue Growth (Lagged One year)WMT vs WGSources: Bureau of Labor Statistics, Bloomberg

A derivative of accelerating wage growth and labour market tightness is business’ increasing investment in automation and robotics. We are at the beginning of a long-term secular trend towards automation. Rather than picking winners at this early stage in the trend, we recommend positioning in a basket of automation and robotics related companies. The most obvious way to play this theme is the ROBO Global Robotics and Automation Index ETF ($ROBO).

Lastly, another derivative of accelerating wage growth is that the Fed is likely to increase interest rates at a faster pace in 2018 than currently anticipated by the market. We expect the short end of the curve to rise faster than the long-end, resulting in a classic bear flattening.

US Wage Growth vs. Effective Federal Funds RateEffective FFR vs WGSources: Bureau of Labor Statistics, Bloomberg

We are long $WMT, $ROBO and looking to get short the short-end of the Treasury yield curve.

Biotechnology: Where the Promise of Life Meets the Reality of Markets

The case for investing in biotech and pharma stock








Billy:    So you got a job, where you play with all these toys.

Josh:    Yup!

Billy:    And they’re gonna pay you for that!

Josh:    Yup!

Billy:    SUCKERS!

Big (1998)

“Youth comes but once in a lifetime.” – Henry Wadsworth Longfellow, American poet and educator

“Demography is destiny.” – usually credited to French philosopher Auguste Compte

“The rewards for biotechnology are tremendous – to solve disease, eliminate poverty, age gracefully. It sounds so much cooler than Facebook.” – George M. Church, professor at Harvard & MIT

“Price gouging like this in the specialty drug market is outrageous. Tomorrow I’ll lay out a plan to take it on.” – Hillary Clinton


Hollywood movies went through one of their many curious phases during the late eighties. It was a phase in which adults were becoming children and moviegoers treated to cinematic atrocities such as Like Father Like Son, Vice Versa and 18 Again. Big starring Tom Hanks also came out during this time and turned out not to be half bad.

Human fascination with reversing the vicissitudes of old age is nothing new. Tales of magical sources of water that could reverse the ageing process and cure sickness can be found in ancient folklore across civilisations.  Legend even has it that Florida was discovered by the Europeans while searching for the mythical “Fountain of Youth”.

Our search for the elusive elixir that can reverse the ageing process, increase our lifespans and cure all sicknesses known to man continues to this day. Only the means have changed, not the goals. We no longer set out on journeys to far-off lands in search of mythical bodies of water. Instead we have replaced the ships with laboratories, the sailors with scientists and the paddles with test tubes, in the process creating what is now known as the biotechnology industry.

The term biotechnology was coined by Hungarian engineer Karl Ereky in 1919 to describe the process of creating products using raw materials sourced from living organisms. The roots of the discipline, however, can be traced at least as far back as the nineteenth century and to the work of Gregor John Mendel, an Austrian Augustinian Monk. Mendel’s development of the “Laws of Inheritance” is at times recognised as the foundation on which the principles of genetics are built.

Today, biotechnology has become almost synonymous with the application of engineering and biological sciences in pursuit of delivering improvements to human health, the environment and agricultural production. It is a time-consuming, expensive, and risky pursuit that strongly divides public opinion. And one that requires the coming together of engineers, scientists, patient capital, and an accommodative regulatory environment to thrive. Even then success is not guaranteed.

Despite the challenges, the industry has made great strides over the last two decades. In 1997 the industry achieved two major, yet controversial milestones. The first was the cloning of Dolly the sheep and the second was the first set of tests of gene therapy on humans. In 2003 the Human Genome Project was declared complete. In 2015 the Mexican government approved the world’s first vaccine to treat dengue – the world’s fastest-growing mosquito-borne disease.

Notwithstanding all the progress, the need for much more remains.

The developed world, while rich, remains demographically challenged. Needing more effective drugs and better healthcare for its ageing population. While in low income countries, a half dozen or so deadly infectious diseases claim millions of lives each year. The spread of these diseases may be contained by the development of easy-to-use and accurate diagnostic tools.

The prospects for biotechnology are strong as ever, which makes its demand for capital just as strong.


Investment Perspective

At its simplest, money is made in capital markets by either clipping coupons or riding a wave of liquidity to capital gains. With interest rates as low as they are, correctly anticipating where liquidity is headed is critical for the health of investors’ portfolios.

Stock pickers follow all sorts of styles of investing. At their root, investment styles are heuristics for anticipating the flow of liquidity. Value investors position themselves based on price. Growth investors focus on the rate of change of revenues and earnings. Technical analysts search for repetitive behavioural patterns. And so forth.

Our approach to anticipating liquidity movements within equity markets is informed by Richard Bernstein’s earnings expectations life cycle framework, outlined in his illuminating book Style Investing: Unique Insight into Equity Investing. While Bernstein modelled the evolution of earnings expectations, in our opinion, his approach can just as easily be applied to sentiment. For expectations are ultimately fractals of sentiment.

Earnings Expectations Life Cycle

Earnings Expectations Life Cycle.pngSource: Style Investing: Unique Insight into Equity Investing, Richard Bernstein (1995)

An area where we find sentiment, and therefore earnings expectations, at a turning point is healthcare, specifically biotechnology and pharmaceuticals. The sectors peaked in July 2015 and as surely as night follows day, stories of fraud started surfacing after the peak. The bad news did not end there, politicians started taking turns to add to their misery – none more so than Hillary Clinton, whose “price gouging” tweet sent the sectors into a tailspin.

Nasdaq Biotechnology Index and S&P Pharmaceuticals Select Index

NBI Index

Source: Bloomberg

The under performance of the two sectors, since their peak, relative to broader market indices has been noteworthy.  Biotech has under performed Nasdaq by more than 40% while pharma has trailed the S&P 500 by more than 50%. Investor apathy can be brutal.

The under performance of biotech and pharma during 2016 has not been entirely unwarranted. It was a challenging year for new drug approvals, which fell to a six-year low. The US Food and Drug Administration (FDA) only sanctioned 22 new medicines for sale, down from 45 in 2015.

Nasdaq Biotechnology Index / Nasdaq Composite Index

NBI Relative

Source: Bloomberg

S&P Pharmaceuticals Select Index / S&P 500 Index

SPSIPH Relative

Source: Bloomberg

For biotech, earning expectations have duly followed price action as opposed to the other way around. Given recent price action, we expect earnings expectations to start getting revised upwards.

NBI Blended Twelve-Month Forward EPS Expectations vs. Index Level

NBI Index and Earnings Expectations

Source: Bloomberg

Investors have been fleeing the sectors without abandon. That is, until recently. Using the iShares Nasdaq Biotechnology ETF ($IBB) and the SPDR S&P Pharmaceuticals ETF ($XPH) as proxies, we find that investors are rushing back into biotechnology. $IBB shares outstanding have increased by more than 25% year-to-date. Although pharma has lagged, the bleeding has stopped and we expect investor interest to pick up.

 ETF Shares Outstanding


Source: Bloomberg

Although investor interest in $IBB has picked up, the move is still in its early stages. Comparing the annual rate of change of shares outstanding for $IBB and the PowerShares QQQ Trust Series 1 ($QQQ), we find that capital flows relative to stock remain biased towards Nasdaq over biotech. Our models suggest that the trend should be more favourable for biotech over the remainder of 2017 and in 2018.

Annual Rate of Change of ETF Shares Outstanding


Source: Bloomberg

Despite investor interest increasing, we have received significant push-back on healthcare, especially biotech, with one investor citing the adage “Growth under performs value in a rising interest rate environment”. With central banks becoming increasingly hawkish and with biotech squarely in the growth camp, the scepticism may be reasonable. Yet the recent out performance of healthcare stocks is eye-catching.

The current state of markets makes us question if the market is beginning to focus on the world’s need for better drugs and improved healthcare? We also wonder if liquidity will start to rotate out of the increasingly politicised and polarising technology plays such as Facebook, Google and Amazon and into healthcare and the other laggards.

The regulatory environment, despite the Trump administration’s challenges in passing healthcare reform (or any reform for that matter), should almost certainly be more supportive for healthcare than it was under the Obama administration. Ironically, in large part due to President Obama, who gave the industry a parting gift when he signed the 21st Century Cures Act into law in December last year. This legislation is intended to expand medical research and speed up the approval of new drugs and medical devices. Predictably, the pace of new drug approvals has picked up in 2017. By May, 20 new treatments had been approved as compared to 22 for all of 2016.

Reduced regulations around drug approval, especially those that make the process of getting new drugs to market faster and less expensive, can greatly improve returns on investment. Improved returns incentivise management teams to increase research and development budgets and embolden them to pursue mergers & acquisitions. We believe that Gilead Sciences’ decision to acquire Kite Pharma is just the start of the trend of increasing mergers & acquisitions within the biotechnology and pharmaceutical sectors.

If this bull market in equities is set to continue, and we certainly are amongst those that believe that it still has legs, we contend that healthcare will be one of the sectors leading it higher.

In sectors where individual companies are fraught with idiosyncratic risks, we tend to prefer a core and satellite approach as opposed to taking concentrated positions in a handful of stocks. In this case, $IBB and $XPH form our core while a basket of our most favoured biotech, pharmaceutical and healthcare stocks, identified in our trade ideas, makes up the satellites.

We are long $IBB and $XPH.