AIG, Robert E. Lighthizer, Made in China 2025, and the Semiconductors Bull Market

“The icon of modern conservatism, Ronald Reagan, imposed quotas on imported steel, protected Harley-Davidson from Japanese competition, restrained import of semiconductors and automobiles, and took myriad similar steps to keep American industry strong. How does allowing China to constantly rig trade in its favour advance the core conservative goal of making markets more efficient? Markets do not run better when manufacturing shifts to China largely because of the actions of its government.” – Robert E. Lighthizer

“Patience is essential. We should step back, take a deep breath and examine carefully the ties that bind us together.” Maurice “Hank” Greenberg, former CEO of American International Group, at the congressional hearing on US-China economic ties in May 1996

American International Group (AIG), the once venerable multinational insurance group, was founded in 1919 in Shanghai, where it prospered until the communists forced it to leave in 1950. AIG had to wait over four decades to re-enter the Chinese market. In 1992, AIG became the first foreign insurance company licensed to operate in China and established its first office on the Mainland in Shanghai.

We doubt it was sentiment that led China to grant AIG the license. After all, there is little room for sentiment in the high-stakes game of global trade.

In 1990, Maurice “Hank” Greenberg, then chief executive of AIG, had been appointed as the first chairman of the International Business Leaders’ Advisory Council for the Mayor of Shanghai. In 1994, Mr Greenberg was appointed as senior economic advisor to the Beijing Municipal Government. In 1996, at the time when China’s status as Most Favoured Nation (MFN)[1] was under threat due to a resolution put forth to the House of Representatives in the US, he was appointed as the Chairman of the US-China Business Council.

While all of above mentioned appointments may have raised an eyebrow or two, they do not amount to much in and of themselves. When we throw in the fact that Mr Greenberg had been part of the President’s Advisory Committee for Trade Policy and Negotiations since the 1970s – the official private-sector advisory committee to the Office of the US Trade Representative – we begin to realise the possible reason why the Chinese leadership took a liking to Mr Greenberg and afforded his company the luxury of becoming the first foreign insurer to operate in China.

In May 1996, Mr Greenberg, during a key congressional hearing on US-Sino economic ties, testified in favour of not only renewing China’s MFN status but also making it permanent.

There we have it: quid pro quo.

In June 1996, the House of Representatives endorsed China’s MFN status by a vote of 286 to 141. At the time of vote AIG had eleven lobbyists representing its interests in Washington. One of those lobbyists was Skadden, Arps, Slate, Meagher & Flom, where AIG’s affairs were handled by one Robert E. Lighthizer – the current United States Trade Representative.


Senior American and Chinese officials concluded two days of negotiations on trade and technology related grievances the Trump Administration has with China. As many may have suspected, the talks appear to have achieved little despite the US sending a team comprised of top-level officials including Treasury Secretary Steven Mnuchin, Trade Representative Robert Lighthizer, White House trade advisor Peter Navarro, Secretary of Commerce Wilbur Ross, and National Economic Advisor Larry Kudlow.

As part of the talks the US representatives have submitted an extensive list of trade and technology related demands. In our opinion, the demands represent a hodgepodge of objectives as opposed to one or two key strategic objectives the Trump Administration may have – symptomatic of the differing views held by the various members of the US team. We expect US Trade Representative Robert E. Lighthizer to slowly take control of proceedings and to set the agenda for US-China trade relations – after all he is the only senior member of the team with meaningful experience in negotiating bilateral international agreements.

Mr Lighthizer’s primary objectives with respect to US-Sino trade relations are (1) for China to open up its economy – by removing tariffs and ownership limits – for the benefit of Corporate America and (2) to put an end to Chinese practices that erode the competitive advantages enjoyed by US corporations – practices such as forcing technology transfer as a condition for market access.

Mr Lighthizer’s goals are ambitious. They will require time and patience from everyone – including President Trump, Chinese officials, US allies, and investors. For that, he will need to focus Mr Trump’s attention on China. He will not want the President continuing his thus far ad hoc approach to US trade policy. If NAFTA and other trade deals under negotiations with allies such as South Korea are dealt with swiftly, we would take that as a clear signal that Mr Lighthizer is in control of driving US trade policy.


Unveiled in 2015, “Made in China 2025” is China’s broad-based industrial strategy for it to become a leader in the field of advanced manufacturing. The strategy calls for directed government subsidies, heavy investments in research and innovation, and targets for local manufacturing content.

To date, China’s industrial base is dominated by manufacturing of basic consumer products such as clothing, shoes and consumer electronics. The overwhelming majority of technologically advanced exports out of China have been made by multinational companies. The Made in China 2025 strategy identifies ten key areas – such as robotics, electric and fuel-cell vehicles, aerospace, semiconductors, agricultural machinery and biomedicine – where China aims to become a global leader. And it is these very industries that Mr Lighthizer aims to attack for the benefit of Corporate America.

One area where China is clearly at the cutting edge of global research is artificial intelligence. According to research published by the University of Toronto, 23 per cent of the authors of papers presented at the 2017 Advancement of Artificial Intelligence Conference were Chinese, compared to just 10 per cent in 2012. And we suspect, especially given the Chinese leadership’s dystopian leanings, China is going to be unwilling to relent on its progress in artificial intelligence regardless of the amount of pressure the Trump Administration applies.

Artificial intelligence requires immense amounts of computing power. Computers are powered by semiconductors. China cannot risk its AI ambitions by being hostage to semiconductor companies that fall under the US sphere of influence. China, we believe, will pull out all the stops over the next decade to develop its local semiconductor industry manufacturing capabilities with an aim to end its reliance on US-based manufacturers by 2030.

Investment Perspective

Investors often talk about the one dominant factor that drives a stock. While we consider capital markets to be more nuanced than that, if semiconductor stocks have a dominant factor it surely has to be supply – it certainly is not trailing price-to-earnings multiples as semiconductor stocks, such as Micron, have been known to crash when trading at very low trailing multiples. Chinese supply in semiconductors is coming.

While we expect the bull market in tech stocks to re-establish itself sometime this year, if there was one area we would avoid it would be semiconductors.

[1] From Wikipedia: MFN is a status or level of treatment accorded by one state to another in international trade. The term means the country which is the recipient of this treatment must nominally receive equal trade advantages as the “most favoured nation” by the country granting such treatment. (Trade advantages include low tariffs or high import quotas.) In effect, a country that has been accorded MFN status may not be treated less advantageously than any other country with MFN status by the promising country. There is a debate in legal circles whether MFN clauses in bilateral investment treaties include only substantive rules or also procedural protections.

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

Oil: Opportunities Arising from Infrastructure Bottlenecks

“Allow yourself to stand back to see the obvious before stepping forward to look beyond” – Adrian McGinn

“The fact is, America needs energy and new energy infrastructure, and the Keystone XL pipeline will help us achieve that with good stewardship.” – John Henry Hoeven III, is an American politician serving as the senior United States Senator from North Dakota

“Is it in our national interest to overheat the planet? That’s the question Obama faces in deciding whether to approve Keystone XL, a 2,000-mile-long pipeline that will bring 500,000 barrels of tar-sand oil from Canada to oil refineries on the Gulf of Mexico.” – Jeff Goodell, American author and contributing editor to Rolling Stone magazine

“When a measure becomes a target, it ceases to be a good measure” – Goodhart’s Law

A concept that frequently occurs in the study of thermodynamics – the branch of physics concerned with heat and temperature and their relation to other forms of energy – is that of irreversible processes.  An irreversible process is a process once initiated cannot return the system, within which it occurs, or its surroundings back to their original state without the expenditure of additional energy. For example, a car driven uphill does not give back the gasoline it burnt going uphill as it comes back down the hill. There are many factors that make processes irreversible – friction being the most common.

In the world of commerce when a supply- or demand-side shock occurs in a particular industry, it sets into motion a series of irreversible processes that have far reaching consequences not only within the industry which the shock occurs but for adjacent and related industries as well. The commodity complex, more so than most other industries, is typified by regular occurrences of supply- and demand-side shocks.

When a positive demand- or supply-side shock occurs for a certain commodity, the immediate impact is felt in the price of said commodity. As the price of said commodity re-rates, the net present values and prospective returns from investing in new production capacities for the commodity obviously improve. Once return prospects start to cross certain arbitrary thresholds – be it cost of capital, target internal rate of return, or a positive net present value – the investment case for the new production capacities strengthens. In response to the strengthening investment case a new capital formation cycle starts to take root and the amount of capital employed within the industry begins to increase, in turn impacting both supply-side dynamics within the industry and the demand-side dynamics within other supporting industries.

Conversely, when a negative demand- or supply-side shock occurs for a commodity, existing producers of the capacity start to feel the pain and suffer from declining earnings as the commodity’s price de-rates.  A sharp enough decline in the commodity’s price can lead to marginal producers selling at prices well below their cash cost i.e. cost of production excluding depreciation and amortisation. At this point the capital employed within the industry begins to decline – this can occur in a number of ways including shuttering of supply, bankruptcies, suppliers changing payment terms, or lenders recalling or withholding loans.

The capital cycle set in motion by either demand- or supply-side shocks are difficult to reverse. Once capital starts entering an industry, it continues to flow in until the vast majority of the planned capacity additions are delivered, even if the pricing assumptions that underpinned the original decision making have changed for the worse. The continued flow of capital despite the adverse change in return expectations is due to what Daniel Kahneman and Amos Tversky call the ‘The Sunk Cost Fallacy’. The sunk cost fallacy is a mistake in reasoning in which decision making is tainted by the investment of capital, effort, or time that has already been made as opposed to being based upon the prospective costs and benefits. It usually takes a shock of epic proportions to alter such a behavioural bias, such as oil falling below US dollar thirty per barrel in 2016 forced OPEC to switch from a strategy of market share maximisation to that of production rationalisation.

In the scenario where capital starts fleeing from an industry even though the sunk cost fallacy may not necessarily drive decision making – unless of course the decision makers have emotionally invested themselves in the negative prospects for the industry – reversing the tide of capital outflows can still be extremely difficult even in the face of improving prospects. This is partly explained by the lingering remnants of the emotional, psychological, or financial trauma that decision makers may have suffered through when the industry went through the negative shock. It often takes a sustained recovery either in terms of length of time or magnitude of price for the trauma to give way to rational decision making.

The turns at which behaviour begins to adjust towards more rational decision making often provide the most profitable trading opportunities.

Investment Perspective

Investing in commodities or equities of commodity producers is not for the fainthearted. Even the most sound investment thesis can be derailed by any number of factors, be it geopolitics, innovation, tax or subsidy reform, cartel-like behaviour, or simply futures markets positioning. Particularly in times of high levels of uncertainty, extreme investor positioning either long or short, or after a sustained move higher or lower in the price of the commodity, investors can be exposed to very high levels of risk. It is at such times that investing in companies that form part of the commodity’s supply chain can be a superior expression of one’s view as opposed to taking a direct exposure in the commodity or its producers.

We think that given the sustained move higher in oil, that has clearly wrong footed many, extreme positioning on the long side in futures markets and impressive revival in US shale oil production, one may be able to better express a medium-term bullish view on oil prices by investing in companies that service the oil and gas industry. Specifically, we consider, at this stage, being long equities of companies with products and services targeted towards oil and gas pipeline infrastructure to represent a more balanced risk-reward trade than simply being long oil or a generic energy ETF.

Brent Crude Oil and WTI Midland Price SpreadBrent WTI Midland Spread.pngSource: Bloomberg

To quote Bloomberg from its article Crude in West Texas Is Cheapest in Three Years Versus Europe:

Oil traders with access to pipelines out of West Texas to export terminals along the Gulf Coast are raking it in from the rapid supply growth in the Permian Basin. The 800,000 barrel-a-day output surge in the past year has outpaced pipeline construction and filled existing lines, pushing prices of the region’s crude to almost $13 a barrel below international benchmark Brent crude, the biggest discount in three years. That’s about double the cost to ship the oil via pipeline and tanker from Texas to Europe, signaling U.S. exports are likely to increase.

The infrastructure bottlenecks pushing down WTI Midland prices relative to Brent Crude prices are the direct consequence of underinvestment in pipeline infrastructure. This underinvestment is the result of either (1) the expectation that oil prices would remain lower for longer or (2) that shale production would not recover even if oil prices recovered. We think the reason is more likely to the former as opposed to the latter.

Oil prices have recovered both in terms of the magnitude and the duration of the recovery to such a degree that investors and decision makers are beginning to overcome the trauma caused by the sharp decline in oil prices between 2014 and 2016. And only now are they starting to invest in pipelines and other oil and gas infrastructure to benefit from the recovery in both oil prices and shale production.  Just as there was inertia in the change in investor attitudes towards oil and oil related investments, there is likely to be inertia – should there be a significant decline in oil prices from current levels – in stopping projects that have started and gone through the first or second rounds of investment.

Companies that manufacture components such as valves, flow management equipment, and industrial grade pumps, that are essential in the development of oil and gas pipeline infrastructure, we think, will be the primary beneficiaries of the recovery in oil and gas infrastructure investment. We also think companies specialising in providing engineering, procurement, construction, and maintenance services for the oil and gas services are also likely to benefit.

We are long Flowserve Corporation $FLS, SPX Flow $FLOW and Fluor Corporation $FLR.

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. 

The Price of Growth

 

“To act wisely when the time for action comes, to wait patiently when it is time for repose, put man in accord with the tides. Ignorance of this law results in periods of unreasoning enthusiasm on the one hand, and depression on the other.”  – Helena Blavatsky, Russian esoteric philosopher, and author who co-founded the Theosophical Society in 1875

 

“Intelligence is the ability to adapt to change.” – Stephen Hawking

 

“As soon as you stop wanting something, you get it.” – Andy Warhol

 

One of the universally accepted ideas in sport is that of home court advantage. The idea, after all, is not a difficult one to accept: Home teams have the crowd behind them, cheering them on, filling them with confidence; visiting teams, on the other hand, have to deal with the home crowd’s hostility, which saps energy. And the stats seemingly reinforce the idea. For example, over the course of the NBA’s history, home teams have won roughly 60 per cent of the games played in almost any given season.

The crowd is powerful.

When it comes to capital markets, the crowd has unquestionably been cheering on growth and mocking value. Leaving many a value investor confounded by the apparently unstoppable rise in the likes of Netflix, Amazon, and NVIDIA. While valuations may be stretched and fundamentals in some cases appear questionable, if we take a step back and consider the secular trend, the continued outperformance of technology becomes less puzzling.

Plotting total business sales of US corporates against the ratio of Nasdaq 100 Index to the S&P 500 Index, we find a strong correlation – 74.1% using monthly data – between the two data series. That is the outperformance of the technology focused Nasdaq 100 Index relative to the broader S&P 500 Index is positively correlated with US business sales.

Total US Business Sales versus Nasdaq 100 Index to S&P 500 Index Ratio Business SalesSources: Federal Reserve Bank of St. Louis, Bloomberg

Given the latency between data releases, this relationship does not provide a trading signal. The relationship, however, does appear to suggest that US business sales growth has largely been dependent upon the growth in sales at technology companies and the market accordingly has rewarded technology stocks.

Our goal here is not to espouse the merits of investing in technology or in growth. Instead, we want to focus on what we consider to be the most interesting part of the above chart – the period from 2003 through 2006. During this period US business sales grew strongly yet the ratio between the two indices flat lined i.e. the S&P 500’s price performance roughly matched that of the NASDAQ 100.[i]

Digging a little deeper, we plot the ratio of per share sales of the S&P 500 to per share sales of the NASDAQ 100 against the relative price performance of the NASDAQ 100 Index to the S&P 500 Index. Zooming in on the period between 2003 and 2007 we find that the comparable price performance of the two indices during this period coincided with the quarterly fluctuations in per share sales also being comparable. Similarly, during the years of significant relative outperformance by the NASDAQ 100 Index, we find that per shares sales of the index were increasing relative to the per share sales of the S&P 500 Index.

Nasdaq 100 Index T12M Sales to S&P 500 Index T12M Ratio (Quarterly Data)Per Share RevenueSource: Bloomberg

Next, we consider the relative performance of S&P 500 Growth Index to that of the S&P 500 Value Index. Comparing the performance of these two indices we find that while the Nasdaq 100 Index and S&P 500 Index achieved comparable performance during the period from 2003 through 2006, the value index significantly outperformed the growth index during this period. The value index peaked relative to the growth index in 2007.

 

Ratio of S&P 500 Growth Index to S&P 500 Value Index (Monthly Data)growth to valueSource: Bloomberg

At the time of the dotcom bubble the ratio of the growth index to the value index, on a monthly basis, peaked at 1.56. Today the ratio stands at 1.47.

The crowd may well be at the cusp of switching loyalties.

We look for clues in and around the period between 2003 and 2007 to help us determine whether the time for value is coming or not.

The cyclical low in the effective US Federal Funds Rate registered a cyclical low in 2003.

US Federal Funds Effective RateFed funds rateSource: Bloomberg

The Commodity Research Bureau All Commodities Spot Index registered a cyclical low in 2001 and MSCI Emerging Markets Index started its multi-year ascent in 2003.

CRB Spot All Commodities IndexCRBSource: Bloomberg

MSCI Emerging Markets IndexMSCISource: Bloomberg

The US dollar had its cyclical peak in 2002, the same year in which the Bush Administration imposed tariffs on imported steel.

In 2004, Congress approved a one-time tax holiday for US corporations repatriating overseas profits.

In 2005, George Bush signed a USD 286 billion transportation bill.

If we compare the events and market action that preceded and coincided with the relative outperformance of value during the years from 2003 to 2007 to that of today, we find many similarities across both policy-making and market action. With growth’s outperformance relative to value reaching levels last seen during the very same period, the signs are difficult to ignore. It may not be time to bail on growth as yet, but it certainly is not the time to have a 100 per cent allocation to it either.

 

Investment Perspective

 

Human nature is such that we desire that which is rare and take for granted that which is common. In the recent past growth has been elusive – and that which has been available has been heavily concentrated in the US and in technology. It is no wonder then that investors have rushed into US technology names without abandon.

Growth is no longer as elusive. We can find growth in Asia, Europe and other parts of the emerging world and across both old industries and new. With its abundance the price of growth should de-rate. Value, however, has become hard to find and it is this scarcity of value, we believe, that will bring about the inevitable shift in market leadership away from technology to other sectors.

Forewarned is forearmed.   

 

[i] The total return for the NASDAQ 100 Index for the period was 80.9% versus 74.05% for the S&P 500 Index.

 

Please don’t forget to share!

 

 

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. 

 

 

 

Containers and Packaging Companies: Challenges Aplenty

“It is not inequality which is the real misfortune, it is dependence.” –  Voltaire

 

“The strength of criticism lies in the weakness of the thing criticised.” Henry Wadsworth Longfellow, American poet and educator

 

“The only thing we know about the future is that it will be different.” – Peter Drucker

 

“Instead of working for years to build a new product, indefinite optimists rearrange already-invented ones. Bankers make money by rearranging the capital structures of already existing companies. Lawyers resolve disputes over old things or help other people structure their affairs. And private equity investors and management consultants don’t start new businesses; they squeeze extra efficiency from old ones with incessant procedural optimizations. It’s no surprise these fields attract disproportionate numbers of high-achieving Ivy League optionality chasers; what could be more appropriate reward for two decades of résumé-building than a seemingly elite, process-oriented career that promises to ‘keep options open’?” – Excerpt from Zero to One by Peter Thiel and Blake Masters

 

 

The Fractal Geometry of Nature by Franco-American mathematician Benoit Mandelbrot is a mathematics book that behind all the Greek symbols holds within it explanations of the elegant shapes, sequences and patterns that repeatedly occur within nature. In this book Mandelbrot outlines a theory called the Lindy Effect – a theory he developed but that was named after a New York diner where stand-up comedians used to gather – that advances the idea that the longer a technology or concept has survived, the longer it is likely to survive. More specifically, the future life expectancy of non-perishable items such as a technology or concept is proportional to their current age, such that each incremental period of survival implies an increasing remaining life expectancy.

Consumer packaged goods (CPG) companies, relatively speaking, have been around a long-time.

CPG companies have had a great run for well over five decades. During that time the well-established CPG companies – like The Kraft Heinz Company, Kimberley Clark, Procter & Gamble, Unilever, and PepsiCo to name but a few – have each created their very own ecosystems. These ecosystems are comprised of retailers, advertising and public relations agencies, media companies, trucking and warehousing solutions providers, container and packaging producers, and many other ancillary businesses that are almost entirely focused on servicing the dominant CPG company within the ecosystem they exist.

As CPG companies have thrived over the decades so too have the businesses that are focused on servicing them. And the larger the CPG companies have grown, the more dependent these businesses have become on them.

These dominant companies are now under threat. The threat comes from multiple angles including changing consumer tastes and shopping patterns, demographics, technological disruption, rising commodity prices, and more responsive niche competitors. The CPG companies have responded to these threats by becoming increasingly inward looking. That may appear to be a strange way to describe their behaviour but as we read through transcript after transcript of these companies’ earnings conference calls we find one common theme across all of them: cost savings. Some companies have hired strategy consultants like McKinsey & Co. to help identify areas of inefficiency and procedural optimisation, while others have launched clumsily named cost cutting initiatives such as “FORCE”, “SPORT”, and “Agility”. Many of the companies in face of investor scepticism are going out of their way to trump up their research and development capabilities and their focus on innovation; for the most part, however, the supposed innovations appear to us to be a doubling down on what has worked in the past or playing catch-up with niche brands that have blazed a trail in new market segments. Based on airtime given during the conference calls cost saving not innovation is obviously the key area of focus for most, if not all, of the major CPG companies today.

The focus on cost saving and efficiency is not surprising. The management teams at the leading CPG companies are comprised primarily of, in Peter Thiel’s words, “indefinite optimists”. And the consultants they hire too are likely to be indefinite optimists.  These indefinite optimists, as Thiel describes them, are far more like to alter and try to improve that which already exists than to create new products that will deliver meaningful revenue growth. Take for instance PepsiCo CEO Indra Nooyi’s response when asked about the company’s conservative expectations relating to their innovations in 2018 (emphasis ours):

“Internally, we’d like to do more, but we want to be very, very cognizant of the headwinds around us, some of which we don’t even understand at times because the consumer is not consistent.”

And The Kraft Heinz Company’s Chief Operating Officer Georges El-Zoghbi’s response when asked about the importance of brands to consumers in food and the investments they are making into brands (emphasis ours):

Brands matter most because the investment behind advertising, the investment behind promotions, the investments behind new products that come to market not only helps the brand, but stimulates overall category demands for everybody who is operating in those categories. So in an environment where there is changing consumer needs and changing go-to-market model, brands become a lot more important.

However, brands need nurturing and nurturing means investment and staying relevant with what consumers’ needs are and what consumer wants to buy. So for us, an investment in the brand has always been important. Now we’re even accelerating that to deal with an environment where consumers changing what they buy and where to buy it from. And we are accelerating the investments to deal with that. So we see now increasingly important to have stronger brands in those categories for everybody.

In an environment where LaCroix has become the leading carbonated water brand in the US without advertising, we see the above comments from PepsiCo and the Kraft Heinz Company as being symptomatic for management teams that are still coming to terms with the scale of the challenges they face in growing their revenue.

As the CPG companies’ face up to the challenges on the revenue side, we think their focus on cost savings and efficiency will only increase further. And this is bad news for businesses that exist almost entirely to serve these companies. As a case in point consider Procter & Gamble’s comment on rationalising costs relating to media spend (emphasis ours):

Looking ahead, we see further cost reduction opportunity through more private market placed deals with media companies and precision media buying, fueled by data and digital technology. We continue to reinvent our agency relationships consolidating and upgrading P&G’s agency capabilities to deliver the best brand building creativity. We’ve already reduced the number of agencies nearly 60% from 6,000 to 2,500, saved $750 million in agency and production costs, and improved cash flow by over $400 million additional through 75 day payment terms.”

 

 

Investment Perspective

 

Businesses providing undifferentiated, commoditised products with increasing production capacities are the most at risk of being hit by the cost saving drives being undertaken by CPG companies. Containers and packaging companies are, in our opinion, amongst the most vulnerable.

By containers and packaging companies we are referring to the likes of Ball Corporation, Crown Holdings, Bemis Company, Silgan Holdings, Sealed Air Corporation and Tredegar Corporation. These companies manufacture products such as flexible and rigid plastic packaging, metal packaging and steel cans for the consumer packaged goods industry.

The table below provides the share of revenue coming from major CPG companies for a number of the containers and packaging companies

Company Major CPG Companies’ Share of Revenue
Ball Corporation 27.9%
Crown Holdings 17.1%
Silgan Holdings 48.9%
Bemis Company 42.3%
Sealed Air Corporation 7.2%
Tredegar Corporation 12.0%

Note: Based on Bloomberg data as at 1 March 2018, revenue shares are calculated based on sales to The Coca Cola Company, PepsiCo, Unilever, Procter & Gamble, Nestle SA, Conagra Brands, Johnson & Johnson, Reckitt Benckiser, Dr Pepper Snapple, Campbell Soup, The Kraft Heinz Company, General Mills, Hormel Foods, TreeHouse Foods, Dean Foods, Mondelez International, Kimberly-Clarks, Kellog Company, and Tyson Foods

 

Most of the containers and packaging companies highlighted above sell largely commoditised products and are operating in highly competitive market segments, giving them little power when dealing with customers that in and of themselves possess a significant amount of marketpower. Moreover, the containers and packaging companies’ largest markets – namely developed economies – are characterised by excess capacity while their growth markets – emerging economies in Asia and South America – are witnessing deliveries of increased production capacities. Despite this a number of the companies continue to expand production capacities both in developed and emerging markets. It is then no surprise that return on invested capital for most of these companies is declining sharply.

Annual Return on Invested Capital (%)ROIC

Source: Bloomberg

 At the same time, in terms of trailing price-to-earnings ratios in a historical context, these companies appear to be richly valued with most trading at one to two standard deviations above their historical trailing price-to-earnings ratios.

Ball Corp Trailing Price-to-Earnings RatioBall

Source: Bloomberg

Silgan Holdings Trailing Price-to-Earnings RatioSLGN

Source: Bloomberg

Bemis Co Trailing Price-to-Earnings RatioBemis

Source: Bloomberg

Tredegear Corp Trailing Price-to-Earnings RatioTG

Source: Bloomberg

If one is to invest in the containers and packaging segment, we think manufacturers catering to highly regulated markets or delivering highly complex solutions is where to look. Manufacturers catering to the pharmaceutical segment, for example, would be those operating in highly regulated markets. Suppliers to the pharmaceutical market have to meet very high regulatory standards and their production facilities have to go through rigorous testing and audits to be validated for production. Customers of such manufacturers are unlikely to switch suppliers quickly or easily and are more likely to see validated suppliers as trusted partners whom they are likely to work closely with in developing new and innovative solutions.

The stocks of the more commoditised containers and packaging producers, in our opinion, are clearly ones to avoid and amongst them might even lie some very compelling short opportunities. While stocks of companies – such as AptarGroup $ATR – operating in more regulated segments of the containers and packaging sector or those delivering highly complex solutions may offer relatively more compelling investment opportunities.

 

Please share!

 

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

The Bull Market is Not Dead.

“Bulls do not win bull fights. People do.” – Normal Ralph Augustine

 

 “Stocks fluctuate, next question.”Alan Greenberg, former CEO and Chairman of the Board of Bear Stearns, in response to questions about the crash, October 22, 1987

 

“If you have trouble imagining a 20% loss in the stock market, you shouldn’t be in stocks.” – Jack Bogle

 

November last year, in Volatility Selling and Volatility Arbitrage Ideas Using Equities, we wrote:

 

Based on the tenets of Prospect Theory, the popularity of short volatility strategies is somewhat confounding. By investing in such strategies, investors are underweighting as opposed to overweighting a low probability event (a market crash). At the same time, they are giving preference to negative skewness, favouring small gains at the risk of incurring large losses.

 During October, 2017, the VIX recorded its lowest monthly average since the launch of the index dating back to January, 1993. What makes this statistic even more remarkable is that autumn months are generally more volatile with October being, on average, the most volatile month during the year.  The average level of the VIX for October, starting 1993, is 21.8 – more than double the 10.1 averaged last month.

With all that being said, we do consider the short volatility trade to be richly valued. That does not mean we expect the equity market to crash, instead the differential between implied and realised volatility has tightened to such a degree that this gap can easily close and invert. The trade can become loss making without a meaningful correction in equity markets.

 

Poorly structured short-volatility products and the limited – almost non-existent – down-side risk to going long volatility has, in our opinion, led to the emphatic short-squeeze in volatility witnessed over the last ten days or so. The tail has well and truly wagged the dog. That is, higher volatility has led to the sharp correction in the market. Not the other way round. The late-afternoon equity sell-off on Monday 5 February is indicative of as much.

S&P 500 Index on 5 February, 2018SPX 5 FebSource: Bloomberg

XIV, SVXY and other products of their ilk are not the first, and are almost certainly not going to be the last, poorly conceived investment products to blow-up. Think back to portfolio insurance, synthetic collateralised debt obligations (CDOs) and CDO-squared as a reminder. There has been plenty of commentary, and no shortage of memes, lambasting regulators of and speculators in short-volatility products alike – many of the critics make valid arguments that should give regulators pause for thought. For investors the time, however, is not to reflect on the flaws of these products but rather to focus on whether the blow-up of these products can lead to a contagion into adjacent markets or is this just a shake-out of weak hands.

The most convincing argument for the recent correction being a shake-out of weak hands comes from the US corporate bond market. US corporate spreads have been benign in the face of the recent spike in volatility – a first in a very long-time.

US Corporate Yield Spreads vs. VIX IndexCorporate yields and VIXSource: Bloomberg

The narrative of rising inflation expectations leading to the correction in equity market has taken hold in some quarters. Firstly, looking at the USD 5-year, 5-year inflation swap rate, there has not been a sharp increase in market-based inflation expectations. In fact, the increase in inflation expectations was much sharper immediately after Trump won the election than at any time during the last year. Secondly, high inflation does not negatively affect equities. If inflation is high but stable, it is nominally positive for equity markets and is unlikely to cause any damage to the real economy. Moreover, historical data suggests that the highest levels of price-to-earnings multiples are witnessed during periods when inflation ranged from 2 to 3 per cent.

 

An unexpected acceleration in inflation followed by unanticipated changes in monetary policy, however, can have significant negative consequences for the economy. The Fed, to date, has not shown any signs of panic. As long as the Fed continues on the path of slow and steady rate hikes, we do not expect Fed rate hikes to derail the economy or the equity market. If, however, the US economy overheats in response to the recently passed tax reforms and the tight labour market, the Fed may be forced to react aggressively, which could be catastrophic for both the economy and equity markets.

USD 5-Year, 5-Year Inflation Swap Rate5Y5YSource: Bloomberg

The one change coming out of the recent sell-off, in our opinion, is that volatility has made its secular low. We suspect that retail investors are unlikely to return to short volatility in droves. We also have a hunch that private banks and wealth managers will not be offering short-volatility products to their high-net worth clients any time soon. Volatility, therefore, should stabilise closer to its longer-term average – we do, however, expect volatility to be structurally lower than the past due to the increased prevalence of passive and systematic strategies, which implicitly dampen volatility during a stable market environment.

A necessary corollary of higher volatility is that investors have to be more discerning in security selection.  Active management may soon be back in vogue.

 

 

Investment Perspective

 

In the after-math of the recent market sell-off we have heard market legends claim that “macro is back” or that it is an “exciting turn for macro trading”. At the same time, we have heard old hands speak of the trauma of 1987 and how it shaped their approach to markets going forward. What we do not hear or read of enough though is that as traumatic as 19 October, 1987 was, it was also the buying opportunity of a generation. The S&P 500 compounded at an annualised rate of 18.9 per cent over the next ten years.

We do not expect returns from equity markets for the next ten years to be like those witnessed between 1987 and 1997. We, however, also cannot ignore that global equity markets had a major break out last year.

 

MSCI All Cap World IndexMSCI ACWISource: Bloomberg

We have one simple, singular thought when it comes to equity markets today. Until we come across evidence to the contrary, we think investors should figure out what they want to own and buy it with both hands.

 

 

 

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. 

China’s Strategic Gains

“Let a hundred flowers bloom; let a hundred schools of thought contend” – Chinese poem that inspired the name for Mao Zedong’s Hundred Flowers Movement

“Everything is relative in this world, where change alone endures.” – Leon Trotsky

“Many forms of Government have been tried, and will be tried in this world of sin and woe. No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of Government except for all those other forms that have been tried from time to time.” – Winston Churchill

Democracy, according to Freedom House, peaked in 2005. Between the years 1970 and 2005 democracy flourished greatly. As recently as 1973, countries such as Spain, Portugal and Greece were dictatorships, and only forty-five out of the world’s then 151 countries were counted as  free democracies by Freedom House. Driven by massive social change at a global level, the number of free democracies had grown to 120 nations by the end of the twentieth century.

Over the last decade, however, democratic institutions have experienced a significant decline. And 2017 saw this trend accelerate. The reversal in fortunes of democracy has emboldened the likes of China and Russia to push for increasing acceptance of the ideologies underpinning their respective brands of governance across the developing world.

The Trump Administration’s inward looking policies and hostility towards pluralist international agreements have opened the door for China to replace the United States as the key power broker in Asia and the developing world. Take, for example, Trump’s decision to withdraw the US from the Trans-Pacific Partnership (TPP), which was followed up by Xi Jinping’s rousing support for globalisation at Davos in January 2017 and again at the Belt and Road Forum in Beijing in May 2017. And it is not just bravado; China is pushing for greater integration amongst Asian economies by driving negotiations for the Regional Comprehensive Economic Partnership (RCEP) – a proposed 16-nation free trade agreement that includes the ten member states of the Association of Southeast Asian Nations (ASEAN) and Australia, China, India, Japan, South Korea and New Zealand.

Chinese efforts to wrestle away US influence in Asia are not limited to the RCEP alone.

In May 2014, Xi called for an “Asia for Asians” – a security concept encouraging Asian nations to step up and assume leadership in administering regional order. Xi’s words were provocative at the time but are progressively coming to reflect the emerging reality in Asia.

The China-Pakistan Economic Corridor (CPEC) – a collection of infrastructure projects under development across Pakistan valued at USD 62 billion – is a formalised strategic alliance that will connect landlocked parts of China to the port of Gwadar on the Arabian Sea and gives China substantial influence over Pakistan.

China has also deepened ties with countries, such as the Maldives, Sri Lanka and Nepal, that have traditionally fallen in India’s sphere of influence. Leveraging its position as the Maldives’ biggest debt holder, China has entered into a free trade agreement with the Maldives in November last year and also received the government’s endorsement for its “Maritime Silk Road” plan. Sri Lanka too has capitulated under the burden of Chinese debt and has handed over the strategic port of Hambantota to China on a 99-year lease. Chinese firms also control a container terminal in Sri Lanka’s capital Colombo. In Nepal the Left Alliance, a pro-China and communist party, propelled by China’s pledge to invest over USD 8 billion in developing Nepal’s infrastructure won the recent elections by a landslide and will take power in March 2018.

China’s deepening ties within Asia, while true to Xi’s “Asia for Asians” mantra, form part of its much larger vision: the Belt and Road Initiative. The Belt and Road Initiative, at times dubbed the Chinese Marshall Plan, is an ambitious economic policy centred on international infrastructure development. It will span four continents and encompasses the construction of two broad networks:

– The “Silk Road Economic Belt” a land based transportation network combined with industrial corridors along the path of the Old Silk Road that linked China to Europe; and

– The “Maritime Silk Road” a network of new ports and trade routes to develop three ocean-based “blue economic passages” which will connect Asia with Africa, Oceania and Europe

Scepticism, when the Belt and Road Initiative was unveiled by Xi Jinping in October 2013, ran high. For all its ambition, the fact remains that there are few countries that trust China. The US retreat and the promise of new infrastructure, however, have seen bottlenecks and political roadblocks fall by the wayside and the initiative has started to gather momentum. Quoting from Caterpillar Inc.’s fourth quarter earnings call (emphasis ours):

“Lastly, we expect to see continued growth in Asia Pacific, led by China. Our forecast is for China to remain strong through the first half of the year, and then slow in the second half, which reflects normal seasonality. In addition to China, we expect most other countries in Asia Pacific to grow, largely driven by investments in infrastructure.

Equipment manufacturers such as Caterpillar are seeing increased demand out of China and the Asia Pacific. Excavators and loaders, such as those produced by Caterpillar, are amongst the most commonly used earthmoving equipment at construction sites. The increase in orders for such equipment from China and the Asia Pacific are tell-tale signs that the Belt and Road Initiative is underway.

While sceptics will remain and there will be many hurdles along the way, the importance of the Belt and Road Initiative to China cannot be overstated. It is seen as being so important by Chinese leadership that during the Communist Party of China’s 19th National Congress, the following statement was deemed to be a necessary addition to the Chinese constitution:

“Following the principle of achieving shared growth through discussion and collaboration, and pursuing the Belt and Road Initiative.”

Some have speculated that because the Belt and Road Initiative is inseparably connected to Xi Jinping, the inclusion of the above statement into the constitution is a means by which Xi will extend his leadership beyond his term. We, however, think that this objective was already achieved by the enshrining of “Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era” into the constitution. The Belt and Road Initiative is China’s path to rebalancing its economy, creating ripe markets for its “Made in China” policy to be a success, and moving up the manufacturing value chain.

China’s expanding influence in Asia comes at the cost of increasing insecurity amongst Japan, India, and the US. The Trump Administration, while being irreverent towards globalisation, contains amongst its ranks deep-seated China sceptics – Director of the White House National Trade Council Peter Navarro and Trade Representative Robert Lighthizer chief amongst them – we think it is unlikely that the US will forfeit its position within the global order without a fight.

India, wary of the Chinese-Pakistani alliance, too, is trying to up the ante. Indian Prime Minister Narendra Modi has signalled a USD 250 billion revamp of India’s armed forces by 2025 and 2017 saw India entering into new defence deals with Israel, Russia and the US. At the same time, India is trying to shore up relations with its neighbouring countries. It extended USD 4.5 billion in project financing to Bangladesh to support infrastructure development, committed USD 500 million in investment for the Chabahar Port in Iran, and also entered into an estimated USD 2 billion agreement with Iran for cooperation in the rail sector.

While China is unlikely to win over western democracies, Japan or India anytime soon, the overtures of Chinese money-fuelled infrastructure projects are likely to prove too tempting for most developing nations. And this, we think, is the reason the Belt and Road Initiative should continue gathering momentum.

Investment Perspective

Equity markets globally have started 2018 with a bang. This year’s most eye-catching market action, in our opinion, however, occurred on 2 January at the Karachi Stock Exchange in Pakistan. Why? Well, for starters, Trump’s first tweet of the year:

“The United States has foolishly given Pakistan more than 33 billion dollars in aid over the last 15 years, and they have given us nothing but lies & deceit, thinking of our leaders as fools. They give safe haven to the terrorists we hunt in Afghanistan, with little help. No more!” – @realDonaldTrump

Given that Pakistan was to receive over USD 255 million and USD 900 million in security assistance from the US for 2016 and 2017, respectively, the freezing of these disbursements subsequent to the US President’s tweet was bad news for Pakistan. Yet the Pakistani stock market went up and has continued to go up since.

 

Karachi Stock Exchange 100 IndexKSE100.png

Source: Bloomberg

Two days after President Trump’s tweet against Pakistan, China unveiled that its second overseas military base would be built in Pakistan.  The base will be built at Jiwani, a port close to the Iranian border on the Gulf of Oman and will be a joint naval and air facility for Chinese forces.

China’s growing influence in Asia is real. The Belt and Road Initiative is gathering momentum. The investment implications of these developments may prove to be profound over the next decade. For now, it is a signal that China wants to increase its influence in Asia. Stability is a necessary condition in order to achieve further influence. For this reason, as we noted in Our Thoughts On and Investment Ideas for 2018, China bears stand to be disappointed in 2018.

An added corollary is that one should not be shorting the stocks of construction equipment providers.

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. 

 

Our Thoughts On and Investment Ideas for 2018

“No one’s ever achieved financial fitness with a January resolution that’s abandoned by February” – Suze Orman, American author, financial advisor, motivational speaker, and television host

 

“Nobody wants a prediction that the future will be more or less like the present, even if that is, statistically speaking, an excellent prediction.” – Nathan Myhrvold, formerly Chief Technology Officer at Microsoft

 

“It requires a very unusual mind to undertake the analysis of the obvious” – Alfred North Whitehead, English mathematician and philosopher

 

The start of a new year is as a good time as any to take stock of one’s portfolio and by extension the investment views underpinning it. Having undertaken the exercise internally, we take this opportunity and share some of our thoughts and investment ideas for the year ahead.

The ideas we present here are amongst our top convictions based on a 6 to 12 month investment horizon. As ever, we remain flexible and should circumstances and / or the data change our investment views too may change.

 

  1. Japan continues to outperform

We issued a piece on Japan last month, where we argued that the Japanese economy is quite possibly on the cusp of a virtuous growth cycle. This view is predicated on the fact that Japan is already at the forefront of the robotics revolution and has a demographic profile that makes it uniquely sheltered from the potentially negative socio-economic consequences of the increased proliferation of artificial intelligence. Moreover, Japanese companies are flush with cash – cash holdings of companies listed on the Tokyo Stock Exchange are now more than 140 per cent of Japan’s GDP – that they can use to invest in robotics and automation.

Long iShares MSCI Japan ETF ($EWJ).

 

  1. A bull market in uranium

 “The key to the ‘capital cycle’ approach – the term Marathon uses to describe its investment analysis – is to understand how changes in the amount of capital employed within an industry are likely to impact upon future returns. Or put another way, capital cycle analysis looks at how the competitive position of a company is affected by changes in the industry’s supply side.”

– Excerpt from Capital Returns Investing Through the Capital Cycle: A Money Manager’s Reports 2002 -15 edited by Edward Chancellor

 

When it comes to uranium sector, plenty have cried wolf over the years as the commodity’s price crashed following the Fukushima Daiichi nuclear disaster in March 2011. When prices fell below the cash cost of the marginal producer, many felt the bottom was close. Instead, prices continued falling and even dropped below the cash cost of the most efficient producer.

Uranium 308 Physical Spot Price UraniumSource: Bloomberg

Uranium miners cut capital expenditures in response to the decline in price. Some producers even went as far as buying from the spot market to fulfil their deliveries as it became cheaper to buy in the market than to produce. Despite the struggles, supply cuts were few and far between – given tepid demand, the lack of capacity curtailment became a major impediment to any improvement in prices. That is, until recently. In January, 2017, KazAtomProm, the national operator of Kazakhstan for import and export of uranium, announced plans to cut production by 10 per cent – representing approximately 3 per cent of global uranium production. Spot prices rallied in response to the announcement but faded due to slow implementation of the cuts while demand also remained tepid. This past November, Cameco Corporation ($CCJ) – the world’s largest publicly listed uranium company – announced that it would suspend production at two of its mines, representing approximately 9 per cent of total global production,  for ten months by end of January, 2018. Less than a month later, Kazakhstan announced that it would cut 20% of its production for the next three years. These announcements sparked a yearend rally in uranium prices.

Our analysis suggests that the announced production cuts, without any improvement in demand dynamics, are sufficient to bring the uranium market into balance over the course of the next 18 months. If demand picks up, however, the market could quickly fall into a deficit, which would push prices up to much higher levels.

Long Global X Uranium ETF ($URA).

 

  1. US inflation, wage growth and velocity of money all pickup

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 WG

Sources: Bureau of Labor Statistics, National Federation of Independent Business

This discrepancy is largely due to headline figures masking the underlying trend. The outsized impact of a handful of industries distorted the average. Based on the data from the Bureau of Labor Statistics (BLS) 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

As the oil and gas extraction industry is no longer a drag on headline wage growth, there is increasing evidence of wage growth picking up. Based on a recent article, “In Cities With Low Unemployment, Wages Finally Start to Get Bigger”, in the Wall Street Journal:

“Workers in metro areas with the lowest unemployment are experiencing among the strongest wage growth in the country. The labor market in places like Minneapolis, Denver and Fort Myers, Fla., where unemployment rates stand near or even below 3%, has now tightened to a point where businesses are raising pay to attract employees, often from competitors.”

Rising wages in the US will have disproportionately higher impact on the disposable incomes of low and lower-middle class households. As poorer households’ disposable income increases, they are more likely to increase consumption as opposed to increasing savings, especially when compared to upper and upper-middle class households. Moreover, the spending patterns of poorer households are starkly different to those of richer households – for one they are more value conscious. Retailers and quick service restaurants catering to lower and lower-middle income households are likely to be amongst the greatest beneficiaries of higher wages.

The inevitable corollary is the rising wages will place increasing pressure on businesses to improve productivity. This coupled with the incentives within the new US tax bill for increasing capital spending – cutting the corporate tax rate from 35 to 21 per cent and a capital expensing provision – we expect capital expenditures in the US to pick up during 2018.

Small Business Job Openings Hard to Fill vs. Capital Expenditure PlansJobs hard to fill vs Capex Plans

 Source: National Federation of Independent Business

The combination of increased capital expenditures and higher wages means corporate cash piles will start turning away from financial engineering and toward investment. Flows out of Wall Street and into Main Street should translate into velocity of money picking up ergo higher inflation.

Long Wal-Mart Stores ($WMT), Dollar General ($DG) and Dollar Tree ($DLTR).

 

  1. Industrial commodities continue to rally

In our last post of 2017, we outlined our bullish view on industrial commodities. To summarise, on the demand side we think there are two key forces that will determine the trajectory of industrial commodities during 2018. The first is construction activity in China which, given the Chinese Communist Party’s goal to make housing more affordable and transform rural residents into urban residents, should remain strong over the course of the year. The second is US capital investment, which we expect to pick up in 2018 given the incentives for capital investment created by the new tax bill. On the supply side, China’s supply side reforms are well documented – capacities at coal mines have been curtailed, steel mills have been shuttered and the supply of natural gas rationed. The results of these reforms thus far have been largely positive. Given the supply and demand dynamics, we are of the opinion, barring short-term volatility, the risk for industrial metals remains to the upside.

Long Vale SA ($VALE) and United States Steel Corporation ($X).

 

  1. Emerging markets: Oil exporters outperform oil importers

The sharp drop in oil prices in late 2014 has been a welcome windfall for oil importing emerging markets. Money that was previously being used to pay for oil imports has gone into productive investments as well as increasing consumption. Since the number of oil importing nations far outstrips the number of oil exporting nations, the drop in oil prices has supported the synchronised global economic recovery that we are enjoying today.

As the old saying goes, “Low prices, cure low prices”, the synchronised pickup in global economic activity caused in part by lower oil prices is resulting in demand for oil exceeding expectations. At the same time Russia and OPEC are maintaining high levels of production discipline. Moreover, our analysis suggests that the likes of Mark Papa and Harold Hamm are correct in calling out the Energy Information Administration (EIA) for its optimistic projections for shale production. We think that shale production will disappoint leading to higher oil prices in 2018.

Higher oil prices should lead to oil exporting emerging markets outperforming at the expense of oil importing emerging markets.

Long iShares MSCI Russia ETF ($ERUS) and long iShares MSCI Saudi Arabia ETF ($KSA).

 

  1. Robotics and artificial intelligence adoption accelerates

 At a human level, the pace of adoption of robotics and artificial intelligence, while being cognizant of the possibilities for human advancement, concerns us. We worry that the blind, unchecked development of artificial intelligence could one day tear through the social fabric that binds us together and spread the venom of protectionism across the globe. The business case for artificial intelligence adoption, however, is very strong. A performance gap between early adopters of the technology and laggards will become increasingly evident over the coming years. A widening of this gap is likely to result in an adopt-or-die type of scenario for the laggards. And may even lead to a “winner-takes-all” type of environment where even second-best is not good enough to survive. Companies have no choice but to invest in robotics and artificial intelligence.

Our advice: learn a foreign language. If you have children, encourage them to learn a foreign language too. While Google and others may develop tools to reduce the friction of translation, one can never truly understand a culture without understanding its language. In a world where nations are becoming increasingly inward looking, we need to increase our cross-cultural understanding and there will be, in our opinion, great reward for those that can facilitate such understanding. Learning a foreign language is the first and most critical step in this process.

Long ROBO Global Robotics and Automation Index ETF ($ROBO).

 

  1. The first trillion dollar company

While this may not materialise in 2018, we think before this bull market is done we will have witnessed the world’s first publicly listed trillion dollar company. It could be one of tech giants – such as Apple, Amazon or Google – or it could be the successful listing of Saudi Aramco. Either way, we think a trillion dollar company will ring the bell at the market top.

 

  1. China bears disappointed

 After the botched currency devaluation efforts of 2015 and 2016, the Chinese government has deftly managed its economy by balancing between fiscal stimulus, risk management within the financial system, and supply-side reforms on the industrial side. While there have been hiccups, such as the gas supply crunch witnessed late last year, the economy has continued to grow smoothly. We expect 2018 to be not too dissimilar with the Chinese government continuing to strike a balance between using the stick and offering the carrot. We expect China bears to have little to celebrate in 2018.

 

  1. Onslaught of cyber-attacks

 In 2017, cybercrime came of age:

  • US-based consumer credit reporting agency, Equifax, suffered a massive data breach compromising the data of over 143 million of its customers
  • WannaCry a ransomware was unleashed in May 2017 and targeted computers running Microsoft Windows by encrypting data and demanding ransom payments in the Bitcoin cryptocurrency
  • NotPetya ransomware attack forced shipping giant Maersk to halt operations at 76 port terminals around the world, which translated into an estimated financial cost of USD 300 million
  • Television network HBO was hacked in late July. A group of hackers claimed to have stolen roughly 1.5 terabytes of information from the company, including scripts and episodes of popular TV show Game of Thrones

The above are but a few examples of the cyber-attacks that took place in 2017. In an increasingly hyper connected world, we expect the scale and frequency of cyber-attacks will only increase.

Long Cyber Security ETF ($HACK)

 

  1. Household consumer stocks underperform

 We wrote about avoiding household consumer names in October last year – namely constituents of the Consumer Staples Select Sector SPDR ETF ($XLP). We maintain this view for 2018 as we consider their valuations to be stretched for businesses that are increasingly susceptible to disruption and shifting consumer preferences towards more niche brands.

 

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. 

Industrial Commodities: A Sustainable Bull Market?

“We must not forget that housing is for living in, not for speculation. With this in mind, we will move faster to put in place a housing system that ensures supply through multiple sources, provides housing support through multiple channels, and encourages both housing purchase and renting. This will make us better placed to meet the housing needs of all of our people.”

– Excerpt from Xi Jinping’s speech at the 19th Communist Party of China National Congress

 

“Commodities tend to zig when the equity markets zag.” – Jim Rogers

 

“Let the market, not politicians, determine the flow of rice, oil and other commodities. Lower, more stable prices will ensue.” – Steve Hanke, Co-Director of the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise

 

“Capital is money, capital is commodities. By virtue of it being value, it has acquired the occult ability to add value to itself. It brings forth living offspring, or, at the least, lays golden eggs.” – Karl Marx

 

Industrial metals have had a great run starting in late 2015 and early 2016; equities of industrial metal producers even more so. Given this rally and the uncertainties around the Chinese investment-led growth model, one of the more difficult investment questions we have struggled with is: whether this bull market in industrial metals is sustainable or not? Our analysis seems to suggest that it is.

Commodity Research Bureau (CRB) US Spot Raw Industrial IndexCRB

Source: Commodity Research Bureau

We have a fairly straightforward framework to help us develop our initial opinion on the outlook for industrial metals. The framework is centred on Chinese money supply metrics, both M1 and M2, and essentially functions as a heuristic for capital spending in China. Chinese capital spending, as is widely accepted, has been the primary driver of demand for industrial commodities over the last two decades.

As a part of this framework we monitor the dynamic between two measures of money supply, M1 and M2. As M1 is a more narrowly defined measure of money supply consisting of the most liquid components – such as physical cash, checking accounts and demand deposits – of overall money supply, any increase in M1 relative to M2 is indicative of a move away from saving and toward investment. For example, companies that hoard cash tend to hold it in the form of time deposits and other financial assets, should the need to make capital investments arise, they would have to unwind these financial investments. This unwinding of financial investments into cash results in M1 increasing while M2 remains unchanged. To monitor this dynamic we simply calculate the ratio of M1 to M2. A higher number means M1 is increasing relative to M2 while a low number means M1 is declining relative to M2.

The ratio of M1 to M2 has been increasing since the end of 2015, indicating a higher propensity to invest than to save in China.

  Ratio of China Money Supply M1 to China Money Supply M2M1 to M2 China

Source: The People’s Bank of China

While this ratio is informative during periods the ratio is trending, either upwards or downwards, it adds little value during periods it is stable, as witnessed between 1999 and 2007. In such periods, we rely, instead, on the year-on-year growth in M1. If M1 to M2 ratio is stable, then a growing M1 is indicative of an increase in the absolute level of investment in the economy.  As a rule of thumb, growth in China’s M1 has tended to manifest itself in higher industrial commodity prices 4 to 8 months down the line.

Chinese M1 increased rapidly between the end of 2015 and early 2017 but has started to decline since. So while this signals a decline in the rate of growth in investment, the metric remains positive. This combined with a higher propensity to invest over saving, as indicated by the M1 to M2 ratio, suggests that the level of investment in China should remain healthy during the first half of 2018 and support continued demand for industrial commodities.

CRB US Spot Raw Industrial Index vs. China M1 YoY Growth (Lagged 6 Months)M1 YoY China vs CRB Industrial Metals

Sources: The People’s Bank of China, Commodity Research Bureau

This framework has worked well as a timing tool for investing in industrial metals since the turn of the century. It may continue to work well, we suspect, as long as Chinese demand is the primary determinant of commodity prices. The limitation, however, is that the framework is purely Chinese demand centric and does not take into consideration substantial demand creation or destruction from other parts of the world; nor does it give weight to changing supply-side dynamics.

On the demand side, we think there are two key forces that will determine the trajectory of industrial commodities during 2018. The first is construction activity in China, ergo housing demand. While the second is the incentives within US tax bill for corporations to increase capital investment in the near term.

Xi Jinping in his speech at the Communist Party of China’s 19th National Congress addressed the need to “put in place a housing system that ensures supply through multiple sources”. To our mind this is as much to do with affordability as it is to do with the supply of housing, which is why Xi specifically mentioned encouraging renting as part of the solution.

Earlier in the year, the Chinese government announced that it will allow, on a trial basis, the development of rental housing projects on rural land – the trial will be conducted in 13 cities including Shanghai, Beijing, Guangzhou and Shenzhen. According to data from Centaline Property, 10 cities have already allocated land for rental housing construction. Chief amongst them is Beijing, where authorities expect to supply 6,000 hectares of land for residential housing by 2021, almost a third of which will be for rental housing. Beijing has even gone as far as announcing a new rental housing policy, which guarantees the same education rights to the children of the tenants of rental properties as the rights afforded to the children of property owner. The new policy even enables tenants renting government-subsidized housing to have their household registration (“hukou”) on their rented homes.

The government is clearly very serious about developing the rental housing market. And key private sector participants are responding to the government’s signals. Not long after the National Congress, China Construction Bank – one of the big four banks in China – launched a loan product for home renters.  China Vanke, a leading residential real estate developer in China, indicated that it aims to provide up to 100,000 apartments for long-term leases, up from the 24,000 rental units operated currently. AliPay, Alibaba’ mobile payment platform, announced that it would enable users across eight cities and based on their credit history to rent residential properties through the platform without having to pay deposits.

The Chinese government’s objective is to make housing more affordable. House prices in major cities have become exorbitantly high and this is a factor contributing to the dampening in the rate of Chinese urbanisation. If the government’s goal of transforming the Chinese economy into a consumption-led, as opposed to investment-led, economy is to be achieved, urbanisation needs to continue unabated for many more years. Simply because urban consumers clearly outspend rural consumers – after all, the Joneses do not live in rural China.

Despite the willingness shown by some of the large private sector developers at the early stage – it is not too difficult to nudge companies dependent on government largesse – the challenge for the government will be to create a system in which property developers are able to offload inventory to recoup their investment shortly after delivery, as opposed to collecting rents over many years. Solutions to this problem can involve mobilising capital from pension funds and other institutional investors into rental properties, developing capital market infrastructure to increase the number of real estate investment vehicles such as real estate investment trusts or other forms of securitisation, or simply facilitating increased investment by international real estate income funds into China.

Notwithstanding the challenges, the key point for us is that the Chinese government has a goal that ultimately creates an additional source of demand for housing and thus construction. This incremental demand can only be bullish for the demand for industrial metals.

The incentives for US capital investment created by the potential tax reform maybe somewhat more subtle than the overtures of the Chinese government but might ultimately prove to be as bullish, if not more, for industrial commodities. The key provisions in the tax bill in this regard are the:

  1. Corporate income tax rate being cut from 35 per cent to 21 per cent, effective 1 January, 2018
  2. Capital expensing provision that permits businesses to completely write-off, or expense, the entire value of investments in plant and equipment for five years. Starting the sixth year, this provision is gradually eliminated over a five year period

Cutting the corporate tax rate from 35 to 21 per cent is bound to increase investment into the US. On top of that, the capital expensing provision within the proposal incentivises both new capital that comes into the US as well as existing capital to be put into plant and equipment. At a time where companies are struggling to recruit adequately trained staff and productivity growth is non-existent, the capital expense provision is likely to result in a substantial increase in the demand for capital goods — and for industrial commodities.

Coming to supply, China’s supply side reforms are well documented – capacities at coal mines have been curtailed, steel mills have been shuttered and the supply of natural gas rationed. The results thus far have been largely positive.

 

Investment Perspective

 

Deflationary forces reward businesses that delay investment and maintain low levels of inventory. The lack of capital investment and the absence of excess levels of inventory, in turn reduces the risk of impairment, write-down or liquidation. Without write-downs or liquidation, the business cycle continues, albeit unimpressively. This has been the case since the Global Financial Crisis and especially after commodities peaked in 2011/12.

What if given the supply and demand dynamics, however, we are at the early stages of an industrial commodities bull market?  What if the depleted inventory levels combined with reduced production capacities leads to a feeding frenzy whereby rising prices result in rising demand? The latter is the very dynamic witnessed in the semiconductors market this year. And we certainly see it is a plausible, albeit low probability, scenario for industrial metals for 2018.

We are of the opinion, barring short-term volatility, the risk for industrial metals remains to the upside.

We are long Vale SA ($VALE) and United States Steel Corporation ($X). We will be looking to add other names and direct commodity plays on any meaningful pullbacks.  

 

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 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. 

 

Japan: Bullish Because Of Not In Spite Of Demographics

“The aging and decreasing population is a serious problem in many developed countries today. In Japan’s case, these demographic changes are taking place at a more rapid pace than any other country has ever experienced.” – Toshihiko Fukui, the 29th Governor of the Bank of Japan

 

“I have experienced failure as a politician and for that very reason, I am ready to give everything for Japan.” – Shinzo Abe

 

“Here is the reality of Japan’s demographic crisis: at eight births per 1,000 people, Japan’s birthrate in 2013 was among the lowest in the world. Meanwhile, the proportion of the population over 65 is now 25%, the highest in the world. In 2010, Japan’s population peaked at 128 million. Current projections show the population dropping below 100 million by 2048 and as low as 61 million by 2085. The country’s working-age population has been declining since the late 1990s, making it increasingly difficult to care for Japan’s retirees.” – Saskawa Peace Foundation USA

 

Japanese stocks are breaking out (have broken out?). Irrespective of which measure of market performance you prefer, the TOPIX or the Nikkei, the recent performance of Japanese stocks has been impressive. And, if you are wondering, it is not because of a weakening yen.

Tokyo Stock Price Index (TOPIX)topix

Source: Bloomberg

Nikkei 225 Indexnikkei

Source: Bloomberg

Japan’s demographic challenge is well-documented. More than a quarter of the population are 65 years old or older. Birth rates are at record lows. And since one of the market truths many of us have come to know and accept is that “demography is destiny”, we know that Japan’s economy will only continue to struggle. With the prevalence of this type of thinking, it is no surprise that many have been confounded by the recent rally in Japanese stocks.

Channelling our inner Charlie Munger we inverted and asked ourselves: under what scenario would Japanese-style demographics be the precursor to an economic boom? In our attempts to answer this question we have to come to the conclusion that the Japanese economy is quite possibly on the cusp of a virtuous growth cycle because of demographics not in spite of them.

We arrived at this conclusion due to one simple reason, we think that the Japanese economy is well-placed to lead and reap the benefits of the coming robotics revolution. Concurrently, Japan’s demographic challenge means, while the country is not entirely immune, it is uniquely sheltered from the potentially negative socio-economic consequences that may arise from the increased proliferation of robotics and artificial intelligence. (We have previously articulated some of our concerns around the unbridled development of artificial intelligence in Artificial Intelligence and Meaningful Work.)

Unemployment is low. Labour force participation levels are high. The overall population is declining while the elderly population is increasing and the labour force dwindling. Corporates are hoarding cash – companies listed on the Tokyo Stock Exchange just set a new record –their cash holdings are now more than 140 per cent of Japan’s GDP. The enormity of the level of cash holdings is better appreciated when compared to the 43 per cent of US GDP equivalent held in cash by US corporations – this 43 per cent includes the much talked about cash held offshore by the likes of Apple and Microsoft.

Japanese Unemployment Rate (%)unemployment

Source: Bloomberg

Japanese Labour Participation Rate (%)labour participation

Source: Ministry of Internal Affairs and Communications

The confluence of all these factors makes Japan ripe for the uptake of robotics to really accelerate but for one missing ingredient: capital investment. Although there is some evidence of capital investment picking up, Japanese companies have continued to demonstrate high levels of restraint when it comes to capital spending.

Despite the investment restraint shown by corporations, necessity, invention and a focused robotics strategy introduced by the government in 2015 – New Robot Strategy – has already positioned Japan at the forefront of the robotics revolution. We think there are a number of factors that will push Japanese corporations towards increasing capital investment and lead them to aggressively adopting robotics and artificial intelligence.

During the campaigning for the recent elections, opposition leader Yuriko Koike – governor of Tokyo and former Minister of Defense – called for a punitive tax on corporate cash reserves in order to encourage companies to invest more. While Koike’s new Party of Hope was resoundingly thumped by Prime Minster Abe’s Liberal Democratic Party (LDP), Koike’s criticism of corporate cash hoards resonated with members of the LDP. The government of Japan, we expect, will exert increasing amounts of pressure on companies to force them into spending their cash piles by increasing capital investment and paying higher wages.

When President Trump came into office he promised to shake up global trade in order to put America first and cut the US trade deficit. He brought in global trade hawks – Secretary of Commerce Wilbur Ross, Director of the White House National Trade Council Peter Navarro, and Trade Representative Robert Lighthizer – to form part of his administration. To date, very little of note has been achieved by the Trump administration on the trade front. With Trump also having failed to deliver on the domestic policy front, however, we think he will seek to overcompensate by taking a more aggressive stance on US trade policies. Especially as the president has the power to levy trade tariffs on countries without needing approval from Congress. More importantly for Japan, however, we think the Trump administration is also likely to become more aggressive in calling out countries they deem to be “currency manipulators”. And with the yen significantly undervalued in terms of its real effective exchange rate, there is little room for the Bank of Japan to talk down the yen. Moving forward, Japanese companies are unlikely to be able to rely on an undervalued currency to drive exports. Quality and sophistication – two traits that have traditionally been the hallmarks of Japanese products – will have to come to the fore. And that requires capital investment and potentially re-shoring of some manufacturing capabilities back to Japan.

The Chinese government’s strategic plans are progressively more focused on increasing local consumption and having much more of its population employed in higher-paid positions. This requires Chinese businesses to move up the value chain. And it is in response to such government objectives that industrial companies in China have started to move into the production of higher-value added goods – venturing into territories normally occupied by Japanese companies. As the threat from China intensifies, Japanese industrials will have to respond by increasing the complexity and quality gap between them and the competition. The Japanese, however, do not have the luxury to call upon a deep pool of labour. They instead will have to invest in robotics and automation if they are to have a chance of staving off the Chinese threat.

Given all the above factors, we think it is not a question of if but when Japanese companies will start increasing capital investment. And we think that the time has come.

Japanese Industrial Production vs. the Unemployment RateIP vs UnemploymentSources: Ministry of Economy Trade and Industry, Bloomberg

 

Investment Perspective

Corporate profits as a share of GDP, in Japan, are making new highs. Higher profits combined with high levels of cash and low levels of leverage encourage companies to undertake capital expenditures. Capital expenditures increase private sector profits and create demand for credit to the benefit of banks. Et voilà, a virtuous economic cycle.

Japan Credit to Private Non-Financials (% of GDP) vs. TOPIX IndexTopix vs Private Credit

Sources: Bank for International Settlements, Bloomberg

While not so simple, Japan indeed is on the cusp of a virtuous private sector profit cycle. So the question to our minds is not whether one should have an allocation to Japan or not but rather should the allocation be currency hedged or not. And to do that we say, ignore those calling for the yen to 200 and do not hedge. On a real effective exchange rate basis, the yen is significantly undervalued.

 Japanese Yen Real Effective Exchange RateYen REER

 Source: Bank for International Settlements

While this is a broad market call, we do want to highlight two sectors – one to overweight and the other to avoid. One of the sectors we are most bullish on in Japan is the healthcare equipment and services sector comprising of companies such as Olympus Corporation and Terumo Corporation. Japan is at the forefront of elderly patient care – its population has the longest average lifespan in the world. Healthcare equipment and services providers in Japan have supported the Japanese healthcare sector in facing the challenges posed by a rapidly aging population by delivering cutting edge solutions. As the US and Europe increasingly face up to the demographic challenges Japan has already gone through, there is an inevitable opportunity for Japanese healthcare equipment and service providers to increase their global reach and grow their exports to the US and Europe.

The one sector that we prefer to avoid in Japan is the financial sector. If a capital investment cycle kicks-off in Japan, as we expect it to, Japanese companies do not need to borrow – they are already sitting on so much cash – and this perhaps means that this spending will not automatically lead to an increase in demand for credit and nor does it imply that a meaningful rise in interest rates will be forthcoming.

We are long the iShares MSCI Japan ETF ($EWJ) as well as a select number of healthcare equipment and services providers.

 

  

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.  

 

Artificial Intelligence and Meaningful Work

“One of the most robust findings in the economics of happiness is that unemployment is highly damaging for people’s wellbeing. We find that this is true around the world.”

“Not only are the unemployed generally unhappier than those in work, but we also find that people generally do not adapt over time to becoming unemployed unlike their responses to many other shocks.”

Excerpts from “Happiness at work”, CentrePiece magazine, Autumn 2017, London School of Economics and Political Science

 

“Participating in the satisfying work of innovating enriches lives by endowing them with purpose, dignity, and the sheer joy of making progress in challenging endeavors. Imaginative problem-solving is part of human nature. Participating in it is essential to the good life – and no elite minority should have a monopoly on that.”

“The technologies our species is developing might either hold the keys to unlocking human potential — or to locking it up more tightly than ever.”

Excerpts from “Meaningful Work Should Not Be a Privilege of the Elite”, Harvard Business Review, 03 April, 2017

 

“Viewed narrowly, there seem to be almost as many definitions of intelligence as there were experts asked to define it.” – “Abilities Are Forms of Developing Expertise”, Robert J. Stenberg, Educational Researcher, April, 1998

 

 One day the AIs are going to look back on us the same way we look at fossil skeletons on the plains of Africa. An upright ape living in dust with crude language and tools, all set for extinction.” – Ex Machina (2014)

 

In Matilda, the children’s fantasy movie directed by Danny DeVito and based on Roald Dahl’s book of the same name, the lead character, six-and-a-half year old Matilda, on her first day of school correctly calculates the result of 13 times 379 in her head – much to the amazement of her teacher and classmates. If such an event had taken place in our classrooms, we too would have been astounded and many, if not all, of us would have described young Matilda as being intelligent or even a genius. Yet if we told you that we have a machine that can solve the very same problem in less than a nanosecond, would any of you describe it as being intelligent? We suspect not; although, some may describe the person who designed the machine as being intelligent.

What then is intelligence?

We conducted an informal experiment (read: an impromptu poll on Whatsapp) involving our school friends. We asked our friends a simple question: who was the most intelligent person in our year group at school? The experiment covered three different schools from three different cities. Without exception, the choice was unanimous for each school.

After collecting their responses, we asked each of our friends a follow-up question: what is intelligence? Some gave us the Oxford Dictionary definition, others referenced IQ or some other standardised test scores while others still bifurcated intelligence into ‘book smarts’ and ‘street smarts’. Each person’s interpretation of what intelligence is was somewhat unique. Despite that, each person came to the same conclusion of who the most intelligent person at school was.

Exploring some of the academic research available on the understanding of intelligence, we found that opinion of what intelligence is was just as, if not more, divided amongst academics and researchers.

While we, collectively as a race, may not have a unified understanding of what intelligence is this has not impeded our shared progress. We, however, do not have the luxury of not understanding artificial intelligence, its possible evolution from here on out and what it means for the future of employment.

Millions of blue-collar manufacturing jobs have already been automated away by machines. This was the low hanging fruit for artificial intelligence. It has been widely accepted for well over a decade that technology would gradually replace workers in process-oriented roles where the objectives are well defined and the operating environment is controlled. The development of artificial intelligence, however, now threatens to automate away non-routine jobs across a vast number of industries. PricewaterhouseCoopers has predicted that 38 per cent of American jobs could be automated by 2030. They identify jobs in industries such as human health and social work, financial & insurance, education, mining & quarrying and public administration & defence as those with high level of susceptibility to automation. McKinsey Global Institute is even more apocalyptic as it estimates that as many as 800 million workers worldwide may lose their jobs to robots and automation by the year 2030.

A survey of history reveals that many new technologies have been sub-optimally utilised for years, sometimes even decades, before a more effective use of the technology has been discovered. If artificial intelligence is being sub-optimally utilised, it may not be the case for long. In May this year, Google unveiled its AutoML project, which is based on the concept of an artificial algorithm becoming the architect of another artificial intelligence algorithm without the need for a human engineer. Facebook has also started incorporating AutoML into parts of its architecture while Microsoft invited teams to compete in an AutoML implementation competition.

Why does AutoML matter?

Until now, engineers and developers have used trial and error to choose the best algorithm or set of algorithms to solve problems. After model selection engineers are also heavily engaged in the iterative process of optimising the algorithm and its parameters to the specific problem at hand. This entire process is resource intensive. It requires hundreds, if not thousands, of man hours and mind-boggling levels of computing power. As a consequence, costs of solving a single problem can run into the millions of dollars.

AutoML, on the other hand, automates the entire process of model selection and optimisation; saving computational capacity by not having to optimise and re-optimise models; and significantly reducing development time from weeks and months to days. AutoML capabilities will only grow over time and the complexity of problems it is able to solve is also likely to increase.

The progress of AutoML has been rapid. Take the case of AlphaGo, the Go playing artificial intelligence developed by Google’s DeepMind, which defeated the world’s number one human Go player. AlphaGo was a technological marvel with 48 artificial intelligence processors and data from thousands of Go matches built into it. It was no match for AutoML, however. DeepMind developed AlphaGo Zero an algorithm that was only given the rules of Go and then proceeded to teach itself and create an algorithm to play Go – all without any additional human input. AlphaGo Zero defeated Alpha Go at its own game only 40 days later. In fact, during a period of 72 hours, AlphaGo Zero beat the original by a margin of 100 to 0. What is even more startling is that the AlphaGo Zero only utilises 4 artificial intelligence processors – a 12 fold improvement over AlphaGo in terms of processing power requirement.

If the example of AlphaGo Zero is a peek into the future of non-routine, dynamic capabilities of artificial intelligence then the role of humans in the workplace is at risk of being marginalised to oversight and system refinement.

Adoption of artificial intelligence outside the technology sector remains limited. Few companies have deployed it at scale. However, the business case for artificial intelligence adoption is strong. A performance gap between early adopters of the technology and laggards will become increasingly evident over the coming years. A widening of this gap is likely to result in an adopt-or-die type of scenario for the laggards. And may even lead to a “winner-takes-all” type of environment where even second-best is not good enough to survive.

As adoption increases, the implications for the human workforce are likely to be far reaching. To quote Wired: “The AI threat isn’t Skynet. It’s the end of the middle class.” The threat of artificial intelligence is seen as being so grave that many have toyed with the idea of a universal basic income – a guaranteed living wage paid by government – as a possible solution should artificial intelligence result in widespread job losses for the middle class. But what of human dignity and the meaning we find at work in solving problems and in collaborating with our colleagues? And what of our right to pursue happiness if we can no longer fulfil our ambitions and aspirations but rather live from one government hand-out to the next?

 

Investment Perspective

 

“We are subject to the processes and trials of evolution, to the struggle for existence and the survival of the fittest to survive. If some of us seem to escape the strife or the trials it is because our group protects us; but that group itself must meet the tests of survival.

So the first biological lesson of history is that life is competition. Competition is not only the life of trade, it is the trade of life – peaceful when food abounds, violent when the mouths outrun the food.” – The Lessons of History (1968), by Will and Ariel Durant

Away from capital markets, the personal investment implications of the development in artificial intelligence are far reaching. While we can be accused of being pessimistic, we do not want to be ignorant to the challenges artificial intelligence poses. We understand and acknowledge not only the benefits the technology could deliver to businesses but also in solving problems humans have struggled with for decades and centuries. Artificial intelligence may one day help us overcome cancer or develop early warning systems for natural disasters – such possibilities excite us. The blind, unchecked development of artificial intelligence, on the other hand, scares us as it could one day tear through the social fabric that binds us together and spread the venom of protectionism across the globe.

For those of us with children, we have many difficult decisions to make and challenges to overcome in helping our children prepare for the world that awaits them. In our humble opinion, the risk-reward for teaching and learning foreign languages is skewed to the upside. While Google and others may develop tools to reduce the friction of translation, one can never truly understand a culture without understanding its language. In a world where nations are becoming increasingly inward looking, we need to increase our cross-cultural understanding and there will be, in our opinion, great reward for those that can facilitate such understanding. Learning a foreign language is the first and most critical step in this process.

We encourage all of you to learn and to encourage your children to learn at least one foreign language.

On the capital markets side, we reiterate our earlier call that we are at the beginning of a long-term secular trend towards automation and recommend positioning in a basket of automation and robotics related companies through the ROBO Global Robotics and Automation Index ETF ($ROBO).

Follow us on Twitter @lxvresearch

 

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.