1st June 2016

It should be noted that we met before the EU referendum, but are writing up these notes after the UK voted to leave. We can’t claim to have predicted the outcome of that vote, but the comments remain pertinent, and the subsequent performance of some of the sectors mentioned has been interesting. The discussion (unusually) revolved more around opportunity than risk, looking for where best to search for ideas that fulfil our valuation criteria without assuming unacceptable levels of risk for a concentrated portfolio. It is not hard to find stocks that trade at enticing valuations (high street retail, car manufacturers, banks), nor to find those that have moats that offer operational resilience (consumer brands; high quality industrials). The challenge is to find companies that offer both. We cover a couple of the areas that we discussed below.

“Chicken Cyclicals” versus Deep Cyclicals

We have noticed an increasing share of the value opportunity set being taken up by cyclical companies. We are always fascinated by sectors where the supply side reaction to a downturn in a sector is quantifiable. A contraction in capital expenditure will lead to a reduction in supply which will lead to a reversion in pricing power (and consequently profitability). The outcome of this cycle is predictable, the timing is not. With this in mind, we are exposed to gold (where expenditure fell 5 years ago and only now can we see supply contracting) and oil (where expenditure fell sharply 2 years ago but supply has not yet contracted). Other commodities look more difficult, with supply expected to continue increasing for some time to come.

This difficulty in predicting the timing and the level of pain that will be experienced at the bottom of the cycle leads commodities (including energy) to be known as “deep cyclicals”. Companies exposed to these same cycles but with a more muted exposure (due to their market positions or other structural reasons) are occasionally referred to as “chicken cyclicals” – attractive to investors not brave enough invest in deep cyclicals. In that bracket we would put high quality oil service companies (Slumberger et al), other high quality industrials (Flowserve, Donaldson, Pentair) etc.

Currently the “chicken cyclicals” are priced to reflect their quality rather than to reflect their cyclical headwinds. There will be a time when the opposite is true, and at that point they will be interesting.

Banks

Banks have been much maligned, and therefore are automatically of interest to value managers. We have a natural bias against their intrinsic leverage and complexity. Never the less, we wonder if there are equivalents in the banking sector to the “chicken cyclicals” of the commodity world. Asset (and deposit) gatherers versus investment banks; better capitalised US banks versus somewhat stretched European equivalents; Handelsbanken versus Royal Bank of Scotland.

It is fair to say that at Kennox, we are some way away from being comfortable buying banks. We are concerned that most will be bankrupt at the bottom of their cycle. Whilst this may only be theoretical bankruptcy rather than technical bankruptcy, the risk is uncomfortable.

Postscript: subsequent to our discussion, despite our lack of exposure, it was difficult not to notice the sharp discrepancy in performance of Handelsbanken (down 5% in sterling terms) and the UK banks (down between 25% ad 35%) since the referendum.

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