15th April 2015

The discussion started with everyone agreeing that the investment environment was not easy at present with high prices for assets and significant risks. However, we have also all felt this has been the case for quite some time now. A good way of judging market exuberance is to collect anecdotes of the herd doing irrational things. There were more in the tech bubble of 2000 and in the IPO frenzy of 2007, but the “covenant-light” debt model now regularly seen in the US is up there. We are reminded of the well-known Buffett quote that “forecasting rain doesn’t count, building arks does”, as we looked for areas of the market that might hold up in a potential market fallout. To that end, we touched on insurance companies that would benefit from a hike in interest rates, on Indian tech companies and Singaporean banks, but as the notes below show that we focused on some of the things make life difficult.
Living with disruption

The increase of internet availability and the rapid growth of download speeds has created a boom in start-ups disrupting long-established businesses. We questioned whether a rise in interest rates would slow down the phenomenon (traditionally a lack of available cheap credit makes capitalising new businesses more challenging), but for once we really do believe that this time it’s different. A large number of disruptors are now focussing on taking existing assets and making them more efficient. Think of Uber disrupting the status quo in taxi ranks worldwide, or Airbnb’s impact on the holiday let market. So many of the recent “disruptors” follow a capital light model that makes them low risk, high gain businesses to establish.
The problem from an investment point of view is that there are very few areas of the market not being disrupted (so there is more risk in those investments), and the vast majority of disruptors are priced to win (even though only a small percentage will actually go on to be the dominant player). In other words, there is no value in the “disruptors”, and traditionally safe-haven market leaders have become “disruptees”.
Will China provide the answer to the inflation vs deflation debate

We are watching China’s ongoing commitment to the currency peg with interest. The fact that two thirds of all foreign currency (US dollar) debt has been taken out by the state-controlled banks implies that the official policy is still to support the peg. In 2008, the policy felt supportable as any deficits in the capital account were more than offset by surpluses in the rampant current account. This is no longer the case. The exodus in capital is so significant that the sum of the capital and current account is now negative. This makes it very hard to support a stable currency, certainly in the longer term. Just about all indicators point to the Renminbi being significantly over-valued absent external support. Should the Chinese currency fall, that would weigh heavily on prices globally. Sounds like deflation…

Peter Hollis, Russell Napier, Angus Tulloch and the Kennox investment team.

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