LXV Research

Consumer: Long Stuff / Short the Experience Economy

“I think if you give in and accept society’s stereotypes, then you start thinking, ‘I cannot dance till late at night because I’m 70.’” – Yoko Ono

“Through most of human history, our ancestors had children shortly after puberty, just as the members of all nonhuman species do to this day. Whether we like the idea or not, our young ancestors must have been capable of providing for their offspring, defending their families from predators, cooperating with others, and in most other respects functioning fully as adults. If they couldn’t function as adults, their young could not have survived, which would have meant the swift demise of the human race. The fact that we’re still here suggests that most young people are probably far more capable than we think they are. Somewhere along the line, we lost sight of – and buried – the potential of our teens.” – Robert Epstein, American psychologist, professor, author, and journalist

“The theory of Economics must begin with a correct theory of consumption.” – The Theory of Political Economy (1871) by William Stanley Jevons

The human brain is predisposed to stereotyping. Stereotyping serves as a social heuristic that reduces the amount of thinking we have to do as it allows the brain to cluster people into groups with a whole range of expected characteristics and abilities. Scientific studies have gone as far as to show that that the brain responds more strongly to negative stereotypes – something the mainstream media has long understood with programming and messaging tilted towards negativity to exploit the human predisposition.

One population group that has become much maligned by negative stereotyping are the millennials – the generational cohort typically recognised as having birth years between the early eighties and the early 2000s. Stereotypes depict millennials as a generation of entitled, fame obsessed, narcissistic and lazy young adults that continue to live off of their parents with the aim of postponing the rites of passage to adulthood as long as possible.

Millennials also have a reputation for being over-indulgent spenders that do not save for retirement. A recent report issued by Bank of America Merrill Lynch in partnership with Khan Academy, however, discredits some of the widely held stereotypes about millennials, particularly those relating to financial matters. For starters, the report shows that almost half of millennials in the United States have managed to save at least US dollars 15,000, while one out of every six of them have US dollars 100,000 stashed away in a savings account, investments, individual retirement accounts, or pension plans. Millennials’ financially savvy – it appears from the report at least – is on par with or exceeds that of the baby boomers and Gen Xers.

Millenials are even driving home ownership higher in the United States – the cohort make up the largest segment of American home buyers today. Economic recovery is the simplest explanation for why more millennials are buying homes. Millennials started entering the workforce just as the Global Financial Crisis hit. A significant portion of the generation found itself unemployed, underemployed, or underpaid. And only now that the economic and psychological overhang of unemployment and underemployment has worn off meaningfully, has it become possible for the generation to step into home ownership at large.

A second reason is that marriage rates amongst millennials have also risen slightly as they have gotten older and achieved a degree of financially stability. Irrespective of the generation, marriage is widely accepted as being the number one indicator of whether people buy homes or not.

Beyond these obvious reasons we also believe that there is growing disillusionment amongst young adults today when it comes to the gig economy, big tech, and the echo bubbles that exist within Silicon Valley and popular social networks. This change can be seen with Peter Thiel ditching Silicon Valley for Los Angeles, increasing hostility towards Mark Zuckerberg and Facebook, and the gradual exodus of residents from San Francisco.

One cure to disillusionment is to lay down roots. And nothing establishes roots quite like buying a home.

Investment Perspective

Capital markets are not averse from stereotyping either. Markets in recent years have bought into at least one of the millennial stereotypes and put capital to work behind it. One such stereotype being that young adults today prefer experiences over goods. While this may indeed hold true, we believe that a larger change is afoot and that millennials are reaching a stage in their development where priorities will shift away from spending on experiences to accumulating assets and goods.

The rise of social media gave rise to the increasing trend toward experiential consumption. Conspicuous consumption amongst millennials as compared to Baby Boomers and Gen Xers was less about “stuff” and more about experiences. Social media both explicitly and implicitly rewarded the sharing of experiences – users receive positive feedback and increased network engagement from sharing photos, videos, and comments. The positive feedback incentivised users to share more and sharing more required engaging in more experiences – attending more concerts, going to more trips to far off places and trying out more restaurants. While we do not see a wholesale change is this behaviour to take place anytime soon, we do think that the marginal user is decreasing social media engagement, reversing the trend of the last decade of increasing marginal engagement.

Increasing social media disengagement – however small it may be – also means that the marginal dollar of conspicuous consumption will no longer be going toward experiences, it will be going elsewhere.

Millennials are stepping into homeownership and the wave of home buying is only getting started. With increasing homeownership comes increasing consumption, new homeowners have to fill up their houses with everything from furniture to lawnmowers. The marginal dollar of conspicuous consumption will be spent on stuff. For the homeowners this will be household goods. For the non-homeowners this will be on clothes, shoes, sports equipment, and health and beauty products.

In our recent trade ideas we added a long in Lululemon Athletica ($LULU). The idea was based on our thesis of increasing consumption of stuff. We consider the likes of Nike ($NKE), Ralph Lauren ($RL) and Under Armour ($UAA) as names that we see as beneficiaries of increasing conspicuous consumption by millennials both in the United States and overseas.

On the other hand, we consider restaurants and other experiential economy companies to be prime candidates to short. We certainly would avoid stocks of companies such as McDonald’s ($MCD), Starbucks ($SBUX), Darden Restaurants ($DRI) and cruise ship operators such as Carnival Corp ($CCL) and Royal Caribbean Cruises ($RCL).

We are getting long $UAA and $RL and short $CCL.

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.

Oil: Fighting the Myth

“This one will really take you back,” said the Great Winfield. “Sheldon’s Western Oil Shale has gone from three to thirty.”

“Sir!” said Sheldon the Kid. “The Western United States is sitting on a pool of oil five times as big as all the known reserves in the world – shale oil. Technology is coming along fast. When it comes, Equity Oil can earn seven hundred and fifty dollars a share. It’s selling at twenty-four dollars. The first commercial underground nuclear test is coming up. The possibilities are so big no one can comprehend them.”

“Shale oil! Shale oil!” said the Great Winfield. “Takes you way back, doesn’t it? I bet you can barely remember it.”

“The shale oil play,” I said dreaming. “My old MG TC. A blond girl, tan from the summer sun, in the Hamptons, beer on the beach, ‘Unchained Melody,’ the little bar in the Village…”

“See? See?” said the Great Winfield. “The flow of the seasons! Life begins again! It’s marvellous! It’s like having a son! My boys! My kids!”

The Great Winfield had made his point. Memory can get in the way of such a jolly market, that malaise that comes with the instantly gone, flickering feeling of déjà vu: We have all been here before.”

– Excerpt from The Money Game (1976) by Adam Smith (aka George Goodman)

Muscle Memory: Misnomer

Complicated skills that humans can overtime perform without much thought, almost automatically, such as riding a bike, playing the guitar, or knitting a sweater, are often thought of as being held in muscle memory. Think back to Karate Kid and Mr Miyagi’s ‘wax on, wax off’ training regime – popular culture fed us the idea of muscle memory and we gobbled it up.

While it is true that certain skills may require the strengthening of various muscle groups, the reality is that learning and retention of new skills occurs in the brain, not in muscles. The process of acquiring new skills causes changes to the structure of the brain. Magnetic resonance imaging (MRI) scans reveal that there is a visible increase in the number of the connections between the different areas of the brain that are required for the skill being acquired. This structural change alters the information the brain transmits to the muscles, thereby altering the movements produced by the muscles.

Ideas: Power

The ability to imagine a reality that neither exists today nor has existed in the past, to give birth to an idea, is one of the truly remarkable gifts endowed to humanity.

Ideas are the seeds of progress. It is ideas that enable large scale human cooperation that transcends self-interest, race, and borders.

Simple ideas: Highly contagious

Ideas are powerful. Simple ideas that are fully formed and easily understood are also highly contagious. Once a simple idea has taken hold, it is difficult, almost impossible, to eradicate.

Peak oil was a simple idea and it was easy to understand, making it both powerful and contagious. It was so contagious in fact that it bordered on belief; it was hardly ever questioned. And the parabolic rise in the price of oil during the last decade was taken by many as confirmation of that belief.

So when the price of oil crashed during the second half of 2014, the immediate reaction of the global investment community was not that peak oil was a myth but rather that OPEC (read: Saudi Arabia) had been greedy. That the cartel had artificially kept supply constrained to maximise its earnings and that the greed had comeback in the form of shale to bite the cartel in their proverbial behind.

The resilience of the peak oil concept is the very reason we think that oil prices recovered sharply during the first half of 2015 and that dedicated energy focused private equity funds were able to raise so much capital in a relatively short amount of time. As market participants witnessed the sharp drop-off in rigs across shale oilfields, it reminded them that cheap oil would eventually run out and higher prices would be needed to satisfy global oil demand – muscle memory or not, investors proceeded to bid up the price of oil.

Ideas that have taken hold in people’s minds are difficult to eradicate. And this is precisely the reason why an even sharper drop in the price of oil was needed to debunk peak oil as a myth. As oil prices tanked during the fourth quarter of 2015 and January 2016, a new idea took hold: the existence of shale placing a cap on the price of oil, i.e. if oil prices were to move above an arbitrary price, usually quoted to be between US dollar 65 to 80 per barrel, for a prolonged period of time, shale producers would ramp up production and flood the market with excess oil.

As oil prices recovered during 2017 so too did US oil production – US output has climbed by approximately 1.2 million barrels per day since January 2017. This surge in production is being seen by many as confirmation of both the responsiveness of shale oil producers and the existence of a cap on the price of oil. We beg to differ.

Investment Perspective

While the surge in US shale production has been impressive and may well continue for the remainder of 2018, we consider the supply and demand dynamics of oil to be decidedly in favour of steady or higher oil prices over the medium term:

The cyclical upturn in the global economy has supported oil demand, which grew by around 1.6 million barrels per day in 2017 and based on OPEC estimates is going to grow by a similar amount in 2018 and reach almost 100 million barrels per day.

Even though US shale oil production is increasing, it is not overwhelming the market. Suggesting that shale production is not exactly like a tap and that there may even be infrastructure related bottlenecks that constrain supply growth.

The anticipated phasing out of the combustion engine by electric powered vehicles, we think, will take far longer than oil bears expect. Beyond the intangible benefit – at least at an individual consumer level – of doing what is good for the environment, consumers receive very few, if any, tangible benefits in switching to electric vehicles. (We accept that there are some notable exceptions in countries where governments have incentivised electrical vehicle adoption through tax breaks, subsidies, etc.)

There simply are not enough electric vehicle charging stations across any automotive market of meaningful size. Any large scale roll out of electric vehicle charging stations would, in our opinion, have to be subsidised, directly or indirectly, by governments as any such roll out does not, at this stage, make commercial sense, even as an industry-wide joint effort.

China has been a strong proponent of electric vehicle adoption over the years.

China’s recent pollution crackdown, at face value, also appears to be a continuation of its policy of promoting electric vehicle adoption. The reality, however, is that the crackdown has placed immense pressure on China’s already limited natural gas supplies, fuelled discontent amongst its citizen and driven China to import record amounts of LNG.China simply cannot afford for the adoption rate of electrical vehicles to accelerate. We, therefore, think that China is likely to gradually phase out any remaining incentives for electric vehicle adoption as opposed introducing further incentives promoting adoption.

In addition to the above we do not think the market is fully pricing in the potential disruptions to supply from:

A collapse in Venezuelan crude production;

The increasing probability of the Trump Administration pushing through reinstatement of economic sanctions on Iran;

Sustained cooperation between Saudi Arabia and Russian in managing supply; and

Slashed exploration and production budgets across the non-state owned oil majors.

Positioning in futures markets remains stretched, making the price of oil susceptible to a sharp correction, especially if trade war rhetoric continues to ramp-up between the US and China. We would see any such correction as an opportunity to build a position in our most favoured oil plays.

Russia: Tailwinds, Not Geopolitics

“Russia is a riddle wrapped in a mystery inside an enigma.” – Winston Churchill

“The secret of politics? Make a good treaty with Russia.” – Otto von Bismarck, founder and first chancellor (1871–90) of the German Empire

“Sometimes it is necessary to be lonely in order to prove that you are right.” – Vladimir Putin

In 1985, members of Hezbollah, the Sh’ia political party and military group based in Lebanon, kidnapped four Russian diplomats in West Beirut. The terrorists “warned that the four Soviet captives would be executed, one by one, unless Moscow pressured pro-Syrian militiamen to cease shelling positions held by the pro-Iranian fundamentalist militia in Lebanon’s northern port city of Tripoli.” The militants ended up killing Arkady Katkov, a consular attaché and one of the four kidnapped diplomats.

Moscow, upon hearing the news of Mr Latkov’s death, dispatched Spetsgruppa “A” – also known as the Alpha Group.

The Alpha Group was formed in 1974 by Yuri Andropov, the chairman of the KGB at the time, in response to the Black September attacks at the Munich Olympics in 1972. Although founded under the KGB, the unit survived the collapse of the Soviet Union and operates today as a stand-alone counter-terrorism and counterintelligence unit under the auspices of Russia’s Special Forces.

The Alpha Group successfully rescued the three remaining diplomats after being dispatched to Lebanon. How they achieved this feat though is a chilling tale of brutality and effectiveness.

According to one version of how events transpired, the Alpha Group kidnapped twelve Shi’a, one of whom was the relative of a Hezbollah leader. The kidnapped relative was castrated and shot in the head, his testicles stuffed in his mouth, and his body shipped to Hezbollah with a letter promising a similar fate for the eleven other captives if the Russian diplomats were not released. In an alternate retelling of events, the unit is said to have abducted one of the kidnapper’s brothers, and sent two of his fingers home to his family in separate envelopes.

Russia allegedly has a longstanding policy of targeting family members of terrorists. The reports of Alpha Group’s rumoured operation in Lebanon are in keeping with this tradition.

Hezbollah has long since heeded Otto von Bismarck’s advice and made a ‘good treaty’ with Russia. Today, Russia and Hezbollah operate closely as allies in the Syrian civil war and in their support for Bashar Al Assad in the conflict

The recent poisoning of former Russian spy Sergei Skripal in the UK has set-off a wave of diplomatic expulsions. The United Kingdom, accusing Russia as being behind the poisoning, made the first move by expelling twenty three Russian diplomats. In a show of solidarity, twenty six other nations, including the US, followed Britain’s lead and expelled Russian diplomats. Moscow, rejecting the accusations, has announced the closure of the British Council and US consulate in St. Petersburg and the expulsion of British and American diplomats.

While the saga continues to make the headlines, we believe neither the British nor the Americans have the wherewithal to sustain a diplomatic dogfight with the Russians. Britain still has the not-so-small matter of Brexit negotiations to deal with and its economy cannot afford to close itself off from Russian capital or Russian consumers. The Trump Administration, on the other hand, is fighting too many battles on too many fronts and a diplomatic standoff with Russia, as it appears at least, is way down the list of priorities.

While geopolitics will always be a concern when one invests in Russia, we think the political risks are no greater today than they have been in the past. We think both the US and the UK will either make good with Russia over time or there will be little development in solving the murder and the issue will be demoted to background noise. We certainly do not see Russia backing down – Putin after all remains ready to exploit the ‘us against them’ siege mentality to the benefit of his popularity amongst Russians.

For now, we prefer to focus on cyclical tailwinds that Russia is enjoying today and not the geopolitics.

Investment Perspective

The sharp drop in the oil price in late 2014 forced Russia to move the ruble to a floating exchange rate. The move led to a sharp drop in the ruble as the artificially overvalued currency adjusted to the new regime. The inflation that followed was painful and the Central Bank of the Russian Federation responded by hiking interest rates. The combination crippled economic activity.

No sector suffered more in the economic slump than the consumer sector. As inflation ravaged the Russian consumer in 2015 and 2016, consumer spending dropped off a cliff – leading to high levels of consolidation across consumer facing companies. Only the largest were able to withstand the challenging environment. And even then, they too had to adapt and become leaner and more efficient.

The rebound in oil prices last year has lifted the economy out of recession, supported the ruble and allowed the central bank to aggressively cut interest rates – cumulatively the central bank has cut the policy rate by 9.75 per cent since January 2015. The policy rate now stands at 7.25 per cent, well above the central bank’s target inflation rate of 4 per cent.

In response to the economic upturn, we expect Russian consumer demand to recover as increased economic activity translates into higher employment rates and higher wages. This recovery in consumer spending in turn should fuel further improvements in economic activity. The combination of increasing economic activity and significantly lower interest rates will encourage, we think, Russian corporates to increase capital investment.

Based on the Levy-Kalecki profit formula:

Profits – Tax = Gross Investment + Government Deficit + Net Exports – Workers’ Saving

Increasing capital investment and higher consumer spending (lower workers’ savings) both contribute to higher profitability. If Russian consumer spending and capital investment do increase as we suspect they will in 2018, the profitability of Russian companies, too, should be much higher. Specifically, consumer companies that have come out of the slump much leaner and with much larger market shares are well placed to benefit from the cyclical upturn in the Russian economy.

For those of you that have frequented Bond Street in London or Dubai Mall in the United Arab Emirates will be all too aware that Russian consumers have a taste for the finer things in life. Demand for luxury handbags, expensive automobiles, and beachfront properties all goes up when the Russian consumer is spending. For this reason we think that some of the leading European fashion houses will also be amongst the primary beneficiaries of the improvements in the Russian economy.

We have been long Russia since the start of the year and remain long. Next week, we will be adding a number of European fashion houses as long trade ideas as means to play the Russia theme, especially for those of you that cannot directly invest in Russian assets.

Trade Wars: Two Can Play That Game

“One day, she’ll start sending you mixed signals, and you’ll get mad because she finally learned how to play your game.” – Unknown

“Hold out baits to entice the enemy. Feign disorder, and crush him.” – The Art of War by Sun Tzu

“A slander is like a hornet; if you cannot kill it dead at the first blow, better not to strike at it.” – Henry Wheeler Shaw, 19^th century American humourist who used the penname Josh Billings

The United States is the only western country that continues to apply the death penalty to this day. Capital punishment is used as legal penalty across 31 American states and by the US federal government and the US military. The Bill of Rights – the first ten amendments to the US Constitution that were adopted in 1789 – included as part of the Eighth Amendment the prohibition of cruel and unusual punishment. Following the Bill of Rights, punishments such as drawing and quartering, public dissection, burning alive, and disembowelment were recognised as cruel and unusual punishments and consequently outlawed by the Supreme Court.

Capital punishment also survives in the People’s Republic of China till this day. Cruel and brutal practices in serving the death penalty were also abolished in China but much later than they were in the US. One practice used by the Chinese was particularly barbaric. Far more barbaric than any practice that may have been used in the US even prior to the passing of the Bill of Rights.

The ancient Chinese practice known as lingchi – more commonly referred to as death by a thousand cuts – was not officially outlawed in China until 1905. Lingchi was a long, drawn out punishment, intended to test how many cuts a person could withstand before dying.

President Donald Trump has this week announced plans to impose tariffs on Chinese imports amounting up to US dollar 60 billion. The plan is based on applying a 25 per cent import duty on a yet to be determined list of Chinese products. Mr Trump has unleashed the firing squad with the intent, according to US officials, of derailing Chinese high-tech ambitions. General Secretary Xi Jinping has identified ten key areas – such as robotics, electric and fuel-cell vehicles, aerospace, agricultural machinery and biomedicine – as part of his “Made in China 2025” initiative. These are the sectors that the Trump Administration aims to attack through the planned tariffs. Mr Trump and his band of trade warriors, not content with import tariffs alone, are also looking to introduce legislation placing new restrictions on Chinese investment into the US in the aforementioned industries.

In hope of rattling the hornet’s nest some more, the Trump Administration granted temporary exemptions – until 1^st May – on steel and aluminium tariffs announced earlier this month to a number of US allies, including the European Union, Australia, South Korea, Argentina, and Brazil.

To top it all off, President Trump replaced national security adviser Herbert Raymond McMaster with super-hawk John Bolton.

In response to the US’s plans to introduce tariffs on Chinese imports, China’s Ministry of Commerce said it is planning to place import tariffs on 128 US products representing US dollar 3 billion in imports. Tariffs will be placed on products such as US steel pipes, recycled aluminium, pork, fresh fruit, and wine. To some Beijing’s reaction appears measured, to others it seems meek. In our opinion, Beijing has just made its first cut; it has a thousand more lined up. How many cuts they make depends on Washington.

Ever since Mr Trump abandoned the Trans Pacific Partnership, Mr Xi has taken it upon himself to become the primary advocate of global trade and in turn positioning China to play a greater global role. The measured response is sound politics. Beijing will not want to come off looking aggressive or to take steps that could derail global trade. For seemingly undue aggression from China would push Europe and other American allies to align with the US – something they have thus far resisted in doing.

Investment Perspective

Mr Trump, in our opinion, is not the crazed madman with too much power to wield as some segments of the mass media would have us believe. Instead, we think he has two immediate goals in mind when it comes to China: to shore up his voter base; and to send China the signal that the rules of engagement have changed. The latter goal is something a number of commentators and analysts have pointed to while citing Mr Trump’s interview with Oprah Winfrey in 1988. While we have no reason to doubt that Mr Trump indeed is approaching the situation in the way he described he would to Ms Winfrey three decades ago, we must also accept that the world we live in today is drastically different to the one that existed at the time of that interview. The rise of China is amongst the most far-reaching changes over the last three decades.

Before the rise of China, the US was already running trade deficits – in effect borrowing US dollars – and supporting the internationalisation of leading US companies. These companies invested all over the world and became what today are commonly referred to as multinational corporations. These multinationals used, in effect, US debt to fuel international expansion and generated returns that far exceeded the interest cost the US incurred on its debt. The end result being that the US was able to collect the spread between the return on investment on the multinationals’ international operations and the cost of its debt.

The rise of China has had a profound impact on the above described dynamic. First, it has led to US multinationals earning much higher returns on their international investments. Second, China has as a matter of policy helped reduce the cost of US debt. The end result: the US earned an even juicier spread on its international investments.

As any corporate financier worth their salt will attest to, when such a spread is available to exploit you should continue to add leverage till the point the marginal benefit of additional leverage is zero. And this is exactly what the US did. Wall Street won at the cost of Main Street.

Donald Trump by unleashing a trade war is attempting to reverse this trend. The consequence of which is that the US’s net investment income that has been positive for so long will turn negative. Leverage after all cuts both ways. For his protectionist policies to yield long-term results tariffs may not be enough, however. Mr Trump will need both a much higher interest rate and a stronger US dollar. Given where US debt levels stand and the US Treasury’s borrowing needs for the coming years can the US withstand this policy? We think not.

We do not want to be long the US dollar. Tactical positioning aside of course.

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 Sources: 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)Source: 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)Source: 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 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 IndexSource: Bloomberg

MSCI Emerging Markets IndexSource: 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.

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China’s Governmental Revamp and the World’s Shift Toward an Inflationary Regime

“It is necessary sometimes to take one step backward to take two steps forward.” – Vladimir Lenin

“I don’t mind going back to daylight saving time. With inflation, the hour will be the only thing I’ve saved all year.” – Victor Borge, Danish-American Comedian

A Chinese parliamentary document released this week unveiled a major revamp of China’s central government. As part of the overhaul China will merge its banking and insurance regulators to create the Banking and Insurance Regulatory and Management Commission. Two new ministries to oversee the protection of natural resources – the Ministry of Natural Resources – and ecology and environment – the Ministry of Ecology and Environment – will also be set up.

The merger of the banking and insurance regulators will be accompanied by the transfer of authority to draft and issue banking and insurance regulations to the People’s Bank of China (PBoC). The overhaul of the financial regulatory infrastructure comes at a time when Mr Zhou Xiaochuan, governor of the PBoC, is expected to retire after 15 years at the helm of the Chinese central bank. The Chinese banking system has grown by an order of magnitude since Mr Xiaochuan’s appointment as governor in 2002. At the end of 2017, Chinese banking assets amounted to RMB 252 trillion and China’s total debt reached 257 per cent of GDP.

During the Communist Party of China’s 19^th National Congress last year, Mr Xi Jinping identified containing financial risks as one of the government’s priorities for the next three years. In November last year, not long after the National Congress, Chinese financial authorities took the first step towards a more unified approach to regulating the financial sector by unveiling new draft regulatory standards for the issuance of asset management products by all types of financial institutions.

The new guidelines will bring the Chinese asset management industry under a single regulatory regime for the very first time and are aimed at closing the many regulatory loopholes that exist in the current setting. Under the new rules, any financial institution issuing asset management products will face a number of new regulatory constraints. Most notably, financial institutions will be unable to pool assets raised through “wealth management products” or roll over these products indefinitely. The ability to pool assets and roll over products indefinitely provided a loophole that allowed investment losses in legacy wealth management products to be covered through the issuance of new products – resulting in a pyramiding of financial risk within the system. The new rules will now expose investors in wealth management products to a greater possibility of incurring losses. While the rules do increase the risk of suffering losses on investors, they are a much needed step toward reducing the systemic risk wealth management products pose to the Chinese financial system.

The authorities, in recognition of the potential disruption a wholesale change in regulations can cause, have proposed a transition period till 30 June, 2019, for existing asset management products to become compliant with the rules under the new regulatory regime.

The plans announced in this week’s parliamentary release are one more step towards bringing the Chinese financial sector under a unified regulatory regime. The transfer of authority to draft and issue banking and insurance regulations to the PBoC, in particular, is a bold move. Under the proposed set up the Banking and Insurance Regulatory and Management Commission will effectively become the PBoC’s oversight and enforcement agency.

In the current setting the PBoC is one of four financial regulators in China. Given the unprecedented growth of the Chinese financial system, a disjointed approach to managing the financial sector is no longer feasible and should have been done away with many years ago. The increased authority of the PBoC and the existence of only one oversight and enforcement agency, we believe, should lead to a more proactive approach to controlling the risks within the financial system. The days of unlicensed peer-to-peer lending – the Chinese equivalent of US wildcat banking in the nineteenth century – are, in our opinion, over. And the toughening of financial regulation that started in 2017 is a theme that, we think, will continue over the course of 2018 and quite possibly 2019.

Mr Xiaochuan’s, during his reign as governor of the PBoC, went to great lengths at reforming and liberalising the Chinese financial system. His contributions, albeit very gradual, were instrumental in the transition of the renminbi from a fixed to a managed float exchange rate, the growth of private sector banks, and the liberalisation of interest rates. The reforms, however, have come at a cost: a banking system that is unparalleled both in terms of scale and complexity. We therefore think that the Chinese government, and by extension the PBoC, will put any plans to further liberalise the system on hold in favour of defusing financial risks.

The Chinese government’s geopolitical ambitions and the success of the Belt and Road Initiative will at a point greatly depend on the PBoC’s ability to transition to a liberalised capital account, which in turn will require the renminbi to be switched from a managed to a floating exchange rate. The opening up of the capital account, and by extension the ambitions of the Chinese leadership, cannot be achieved with an unstable financial system. The Chinese have no choice but to increase control over the financial system in order to diffuse systemic risks.

Mr Zhou’s successor is more likely to be a conservator as opposed to a reformer.

Investment Perspective

The Chinese leadership under Mr Xi’s reign has increasingly come to emphasise the importance of social wellness. So much so that social wellness now sits near the top of the Chinese government’s priorities – the creation of an “ecological civilisation” has been added to the government’s goals as part of the most recent round of amendments to the Chinese constitution.

With the focus on the environment it might seem that the Chinese leadership is attaching less importance to economic growth. With the government announcing target economic growth of “around 6.5%” at the start of this year’s National People’s Congress, however, such an assertion would be far from the truth. In addition to a continued commitment to strong economic growth, the government also highlighted cutting production capacities as one of the goals for 2018.

If we take the Chinese government’s stated goals at face value then we think the world may be entering a profoundly different economic environment to the disinflationary one we have lived through over the last three decades. Consider the scenario that the Chinese government is proposing:

Chinese credit growth will be regulated to the extent that certain types of corporate borrowers may no longer have access to any form of additional credit;

Production capacities of industrial commodities, such as steel and coal, will be reduced and there will be negligible amounts of new capacity additions;

Industries and households will be weaned off coal and other polluting fuels and shifted to more environmentally friendly yet more expensive alternatives such as natural gas;

Government officials will not only be judged on the absolute level of economic growth achieved but also on the environmental cost of that growth; and

Chinese growth will continue to be above economic potential despite environmental and financial constraints.

At the same time the world is at the cusp of an infrastructure spending boom. China is moving full steam ahead with the Belt and Road Initiative and the US government is concurrently pushing for congressional approval for a USD 1.5 trillion infrastructure investment plan.

A world with growing demand for industrial commodities combined with lower Chinese capacities is bullish for industrial commodities. Once we throw the fact that the developed world has all but lost its industrial manufacturing capabilities and is unlikely to be able to make up for lost Chinese capacities into the mix, we find ourselves considering the possibility of a wildly bullish outlook for industrial commodities over the medium-term.

Coupling this outlook with the fact that US financial institutions hold over USD 2 trillion in excess reserves, and that US companies’ attitudes toward capital spending are more positive than they have been in a decade, we find ourselves considering the possibility that commodities may well serve as a better hedge for equity market risk than US Treasuries at this stage.

Trade Wars: Hedging for Tariffs

“You realise that all the lines on the maps really do not exist. You can’t even tell where one country starts and the other one stops. All those things that create conflict just melt away, and you can see our planet as one home for all of us.” – Anousheh Ansari, Iranian-American astronaut’s reflection upon seeing the earth in its entirety

“No nation was ever ruined by trade.” – Benjamin Franklin

“The whole is more than the sum of its parts” – Aristotle

“We can only see a situation with true clarity when we take the time to carefully consider the interests at hand. And we understand it even better when we consider how the situation might be different if the underlying interests were different.” – Excerpt from Pebbles of Perception: How a Few Good Choices Make All the Difference by Laurence Endersen

The government of Israel has for many years placed a complete ban on trade with Iran. In fact, Israeli law stipulates the penalty for violating the ban on Iranian imports can be as high as imprisonment of up to two years. Despite this, Iranian marble, it turns out, is a notable feature of some of the most prominent buildings in Israel.

A complex adaptive system is a system in which a complete understanding of the individual components does not directly translate into a comprehensive understanding of the system’s behaviour as a whole. The global trade system that enables the cross-border exchange of goods and services is a type of complex adaptive system. It is the adaptive nature of this system that enables the availability of Iranian marble in Israel.

President Trump and his posse of international trade warriors is, by unveiling their first wave of import tariffs, attempting to change the dynamics of the global trade system. How the individual and collective components of the system mutate in response to the Trump Administration’s policies is anyone’s guess. What is an almost foregone conclusion, however, is that system’s response will include second and third order effects – the so called unintended consequences – that US policymakers will not have anticipated.

Our rudimentary attempt at diagnosing some of the potential unintended consequences of the Trump Administration’s protectionist theatrics is based on identifying how the prominent players within the global trade system are incentivised. The European Union is one of the major players within the system we consider to be trapped by a complex web of incentives. The predicament faced by the bureaucrats in Brussels is of an existential nature. Existential threats activate the most basic of human instincts – the instinct of survival. And the thing about basic human instincts is that they can cause the most rational of agents to behave irrationally.

The bureaucrats in Brussels are unelected officials. Their only claim to legitimacy comes from the existence of the European Union. These bureaucrats it leads are incentivised to ensure the survival of the European project. This survival depends on the union members maintaining their memberships. It is therefore in this context only rational for the bureaucrats to heavily punish any wantaway member even if said wantaway member happens to be running a huge trade deficit with Europe. The bureaucrats in Brussels, we believe, want to severely punish the UK for the British populous’ decision to exit the European Union.

We fully expect the leaders of the European project to continue to drive a hard bargain in the negotiations on the terms of UK’s exit from Europe – at least in the short-term. The bureaucrats may or may not realise it but the protectionist turn in President Trump’s policymaking has tilted the balance in the UK’s favour and the British government now has the upper hand when it comes to the Brexit negotiations.

The Trump Administration placing tariffs on steel and aluminium imports will increase cost pressures faced by US auto manufacturers – making their vehicles, in all likelihood, uncompetitive in relation to imported vehicles. German automakers exported more than half a million vehicles to the US in 2016 and Germany runs, what we suspect to Mr Trump’s international trade warriors is, an unpalatable level of trade surplus with the US. Should the metal import tariffs be successfully enacted by the Trump Administration, we suspect that German automakers will find themselves at the centre of the next round of Mr Trumps’ protectionist theatrics.

In 2016 the UK ran a GBP 82 billion trade deficit with imports from EU representing 54 per cent of the UK’s imports during the year. German automobiles represented a not so insignificant share of those imports.

Now consider the incentives for the German government. After months of uncertainty Germany has a new government with the Social Democratic Party of Germany (SPD) finally agreeing to a coalition with Chancellor Angela Merkel’s Christian Democratic Union of Germany (CDU). Chancellor Merkel in a bid to secure a fourth-term had to relinquish control of the finance ministry to the SPD. For the SPD the coalition offers an opportunity to position itself as a viable alternative to the CDU for the next election. The CDU on other hand does not want to lose any further ground to the SPD. Collectively the parties want to stop the rise of the nationalist Alternative Party of Germany party. The closure of factories operated by German automakers serves neither party’s objectives. The rational course of action for the German leadership in this context is to reach an amenable trade agreement with the British.

What the bureaucrats want and what Germany needs may test the cordial relationship that may exist between Brussels and Berlin today. The fact, however, remains that there is no European project without Germany and the Germans will eventually get their way. For this reason, we expect Brexit negotiations between the UK and Brussels to turn decidedly in the favour of the British.

Investment Perspective

The time, we think, to buy UK stocks is coming. Exporters benefited at the cost of domestically focused companies as the British pound fell sharply following the Brexit referendum. The tide, in our opinion, is turning and we favour more domestically focused British companies over exporters. We also think the sterling should strengthen relative to the Euro.

Domestically focused British companies may, in our opinion, be amongst the best available hedges to the rising level of protectionist rhetoric coming out of the US.

On the European front, we favour domestically focused automakers in France and Italy over the more export oriented German auto manufacturers. The domestically focused automakers, we think, should benefit from lower steel and aluminium prices as non-US based steel and aluminium producers redirect their supply toward Europe and Asia.

Currency Markets: “You can’t put the toothpaste back in the tube.”

“When you strip away the genre differences and the technological complexities, all games share four defining traits: a goal, rules, a feedback system, and voluntary participation.” Reality is Broken: Why Games Make Us Better and How They Can Change the World by Jane McGonigal

“The dollar used to be a gold standard currency. And the dollar is really good in the last century, I mean in the 19^th century.” – John Forbes Nash Jr.

“The thought experiment of Adam Smith correctly takes into account the fact that people rationally pursue their economic interests. Of course they do. But this thought experiment fails to take into account the extent to which people are also guided by noneconomic motivations. And it fails to take into account the extent to which they are irrational or misguided. It ignores the animal spirits.” – Animal Spirits by George A. Akerlof

When US Treasury Secretary Steven Mnuchin uttered the words “A weaker dollar is good for trade,” at Davos in January, he broke rank and became the first US Treasury Secretary in almost three decades to talk down the US dollar. And in one fell swoop he ended the cooperative monetary policy game major central banks had been engaged in since the renminbi devaluation scare in January 2016 and transformed it to a competitive game.

Mr Mnuchin’s comments sent President of the European Central Bank (ECB) Mario Draghi and Governor of the Bank of Japan (BOJ) Haruhiko Kuroda into a state of frenzy. Both were quick to react and proceeded to talk down their respective currencies – Mr Draghi hinted at the ECB delaying its exit from monetary easing while Mr Kuroda‘s language became decidedly dovish.

Capital markets, to state the obvious, do not like volatility. Markets like boring. The cooperative monetary policies of the last two years have been exactly that, boring. As central banks sucked volatility out of currency markets, capital markets of all forms became buoyant. Tech stocks climbed higher. Emerging markets came out of their prolonged slump. Cryptocurrencies soared. Even the much maligned commodity markets rallied. Coincidentally, most markets peaked soon after the détente between global central bank was broken by Mr Mnuchin.

Should we be surprised that a member of the US administration led by President Donald Trump has done away with the niceties of a globally coordinated détente and unleashed competition amongst global central banks? Mr Trump is nothing if not competitive and he is doing his part in stoking global competitive spirits as he did in announcing his plans to impose tariffs on steel and aluminium imports.

One man voluntarily abstaining from the competitive game it seems is newly-appointed Federal Reserve Chairman Jay Powell. Chairman Powell, by striking a hawkish tone during his inaugural testimony on 27 February, extended an olive branch to his fellow central bankers and they gladly obliged. Mr Kuroda this morning suggested that the BOJ could exit from its easy monetary policy as early as next year. The central banks, it seems, want to return to the comfortable climes of a cooperative game world.

The market appears to be giving Messrs Powell and Kuroda due credit with the dollar moving sharply higher after Mr Powell’s hawkish comments and the yen strengthening following Mr Kuroda’s remarks. While the central banks will do their utmost to re-establish a cooperative regime, the reality is “you can’t put the toothpaste back in the tube”. The major central banks of the world are now in a competitive game. While markets may enter an interim phase where the Fed’s hawkish posturing leads to a strengthening dollar, this phase, in our opinion, is likely to be short-lived.

The line in the sand beyond which we would consider our view to be invalidated is a sustained move above 96 on the US dollar index.

Investment Perspective

One major central bank that has conspicuously remained on the side lines during the recent sharp moves in currency markets is the People’s Bank of China (PBOC). The PBOC rarely, if ever, publicly expresses its desired direction for the renminbi. Its statements are generally limited to reaffirming its commitment to promoting a stable exchange rate regime. The PBOC, however, has been known to actively intervene in markets to influence the direction of its currency – such intervention too has been absent recently.

The PBOC, we think, finds itself at a difficult crossroads with respect to the renminbi. Much like the one the BOJ was at with respect to the yen in the late 1980s. The BOJ, in hindsight, favoured short-termism and opted to keep monetary policy far too easy, which sent Japanese asset prices rocketing higher. The Japanese boom, as well known, was followed by an all-mighty bust. The Chinese Communist Party (CPC), it is said, thinks in decades not years – so one would think that the Chinese will not follow in the footsteps of Japan. Short-termism, however, can afflict anyone and there is, we think, a non-zero probability that China goes down the path of too much easing, which would send Chinese asset prices sharply higher. For this reason we would maintain some allocation to Chinese equity markets.

The more probable scenario, we think, however, is that of the PBOC opting to strike a balance between tightening and opportunistic easing and the PBOC may even let the renminbi strengthen some more – especially if said strengthening is driven by US dollar weakness as opposed to PBOC’s interventions.

As we argued in our piece on China in January, China wants to increase its influence in Asia and that stability is a necessary condition in order to achieve further influence. Therefore, given China’s global ambitions, we think it is unlikely that the PBOC repeats the mistakes the BOJ made in the late 1980s. And if this indeed turns out to be the case, given the current differential in US and Chinese interest rates and bond yields, the Yuan carry trade may be amongst the best trades to put on today.

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 (%)

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 Ratio

Source: Bloomberg

Silgan Holdings Trailing Price-to-Earnings Ratio

Source: Bloomberg

Bemis Co Trailing Price-to-Earnings Ratio

Source: Bloomberg

Tredegear Corp Trailing Price-to-Earnings Ratio

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.

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LNG Shipping

“A war of ideas can no more be won without books than a naval war can be won without ships. Books, like ships, have the toughest armour, the longest cruising range, and mount the most powerful guns.” – Franklin D. Roosevelt

“There are no rogue ships; there are only rogue shipowners.” – Maritime Double Shots by Barista Uno

“Twenty years from now, you will be more disappointed by the things you didn’t do than those you did. So throw off the bowlines. Sail away from safe harbour. Catch the wind in your sails. Explore. Dream. Discover.” – P.S. I Love You by H. Jackson Brown Jr.

Buy what the British government is selling. Buy what the Chinese government is telling you to buy. These are two pieces of sage advice we received from a certain Mr Wang, whom we had the good fortune of being introduced to early on in our investing careers. Mr Wang is, in today’s parlance, a private equity investor. To us he is both a mentor and an enigma.

Mr Wang speaks the Queen’s English, read mechanical engineering at one of the elite American universities, and started off his career in merchant banking in the City of London during the Thatcher years. Mid-career he packed up his bags and moved to China to set up his proprietary investment practice, which he continues to manage today.

Over the years we have turned to Mr Wang for advice on investment matters related to China and he, to our collective memories, has never failed to tell us to buy what the government is telling you to buy. What does that mean? What is the Chinese government telling us to buy and how?

Mr Wang attributes much credit for his, by almost any standard, very successful track record in China to always following the Chinese government’s lead. The Chinese government uses the National Congress – held every five years – as a platform to communicate it strategic and economic priorities. The National Congress, Mr Wang says, is where and when Communist Party tells the whole world where and what to invest in in China.

At last year’s plenum, Mr Xi Jinping emphasised that pollution control is a key priority for the Chinese government. Going forward, China will pursue a development model that fosters, in Mr Xi’s words, a “harmonious co-existence between man and nature”. Somewhat predictably, the authorities hired environmental inspectors from around the country following the National Congress. These inspectors were swiftly dispatched into the China’s industrial heartland in a rush to meet year-end air pollution targets. Thousands of polluting factories were forced to shutter or curtail capacity. Officials in their desperation even forced households to switch from coal-fired to gas-based heating without ensuring the ample availability of natural gas for the freezing winter months. Natural gas prices duly doubled.

Natural gas is not easily transportable over long distances. Where natural gas cannot be delivered by land, it must be liquefied and delivered by ship in the form of liquefied natural gas (LNG). Basic economic theory dictates that for shipping of LNG to make economic sense natural gas prices at the point of delivery must be sufficiently higher than prices at the point of dispatch to compensate for the costs involved in liquefaction, transportation, and regasification. The Chinese crackdown on air pollution and coal-based heating resulted in a sharp increase in the differential between Henry Hub gas prices and Asian gas prices. For example at the peak of the Chinese winter in December last year, the differential between the Japan-Korea Marker and Henry Hub reached three-year highs at USD 8.11 per MMBtu. Well above the USD 4 to 5 per MMBtu differential estimated to make LNG transportation between the US and Asia economically viable. While the spread has come off the highs, it has on average remained more than 50 per cent higher through 20 February this year as compared to the same period last year and also remained above the economic viability threshold for LNG transportation.

Chinese imports of LNG during the fourth quarter of last year surged 54 per cent in a scramble to meet fuel shortages amid peak winter demand and the drive to decrease coal use for household heating.

Chinese Monthly LNG Imports China LNG Imports Source: Bloomberg

While the surge in demand was unprecedented, Chinese demand for LNG will only continue to grow. Already, 40 per cent of its gas needs are fulfilled through LNG imports. The country understands its reliance on LNG imports and has plans to construct new LNG import terminals and develop pipeline infrastructure to be able to transport gas further inland. At the same time, globally 100 million metric tonnes of liquefaction capacity is projected to be added annually from 2018 through 2020. Chinese demand is coming at a time where the world is flush with LNG supply and the supply is only going to increase. LNG producers have every incentive to ship their product to China, none more so than US producers.

The US Department of Energy projects that US LNG production capacity will quadruple by the end of 2019, making the US the world’s third largest producer of LNG, placing it behind only Qatar and Australia. Moreover, the International Energy Agency expects the US to become the world’s leading LNG producer within a decade.

US Monthly LNG Exports

Source: Bloomberg

The natural gas and liquefaction production capacity to be delivered over the coming years, particularly in the US, means that there could potentially be a global LNG supply glut. In such a scenario US natural gas prices and by extension LNG prices are unlikely to sustainably re-rate to the upside. Low Henry Hub rates and high Asian demand, however, are the perfect combination for a sharp pick-up in the demand for LNG carriers.

We think LNG carriers are one of the ways to play the Chinese pivot towards cleaner energy.

Investment Perspective

Spot charter rates for benchmark LNG carriers averaged USD 46,000 per day during 2017, a 37 per cent increase over average rates achieved during 2016. And in December, driven by the surge in Chinese demand, spot rates averaged approximately USD 70,000 per day – the highest level reached in over three years.

Last year was also the first time in over three years that LNG carrier supply growth trailed demand growth. Demand growth is expected to outstrip supply growth once again in 2018. Despite the improving supply and demand dynamics, absolute carrier capacity still significantly exceeds absolute LNG shipping demand. This, however, could reverse by as early as 2020. Some analysts even estimate that available capacity could be as much as 30 per cent below demand in 2020.

LNG carriers are highly specialised and complex tank ships that are designed to store LNG at -160 degrees centigrade. Typically, LNG carriers require two and a half years of build-time. Meaning that charter rates are the only means by which the market can rebalance until such time that new vessels are delivered. Given that new vessel orders, as a percentage of the existing fleet, are at around five-year lows, vessel orders would quickly have to gather speed to avoid a supply deficit during 2020 – assuming demand expectations are reached. Compounding the problem is the 30 per cent decline in global shipyard capacity since 2011 – a meaningful pick-up in new vessel orders – LNG carriers or otherwise – could result in much higher build costs and longer build-times.

LNG Tanker Order Book (Percentage of Total LNG Tanker Fleet)Source: Bloomberg

One of the major challenges LNG carrier operators have faced during the recent period of excess capacity is the unwillingness of charterers to commit to time charters – a time charter is the hiring of a vessel for a specific period of time. As demand for LNG shipping, particularly between the lucrative US-Asia routes, picks up, the supply surplus shrinks and new liquefaction capacity comes online, charterers – in this case likely to be LNG producers – will increasingly want to commit to time charters, which would not only reduce the financial risk for carrier operators but also drive spot rates up to much higher levels.

The LNG carrier industry is relatively concentrated – the top ten operators control 49 per cent of total capacity. If the larger players are able to show some restraint in ordering new vessels, they could reap the rewards of much higher daily rates for many years.

We are closely following LNG carriers such as Golar LNG ($GLNG), GasLog Limited ($GLOG), and shipping broker Clarkson PLC $CKN.LN to potentially add them to our list of long trade ideas.