For the first time in two years we are pleased to report the Panel was able to meet in person, and we hope that this will continue to be the case going forward.
Over the course of those virtual meetings the spectre of a return of inflation had dominated most of the discussions. We now met with inflation having moved to its highest level in decades and asked where do financial markets go from here? We quickly moved from whether this inflation was a temporary blip (as no one in the Panel had enough conviction to argue that that line) to why the markets did not appear to be pricing the inflation in. Gold is one area the panel felt should have moved more given the increase in inflation. To the panel it looks that the inflation debate has become ideological. If you are a Keynesian you would say there is no link between inflation and the rate of money growth, and would use the last 20 years as evidence of this. This line of thinking believes the increase in money growth does not mean there will be inflation beyond this transitory phase, and in fact the levels of money growth must continue so we can fund post-pandemic stimulus. However the stakes are high as the longer this strategy prevails the stronger the inflation will be, if the link between the two does still exist.
TInflation will also impact politics. Currently it is popular with stimulus and low interest rates. But as the cost of living increases there will be a turning point where it becomes more politically popular to rein in inflation. One should follow the politics for when significant tightening will occur.
Japan was put forward as one market that looks attractive in this scenario. Companies there tend to have strong balance sheets, are relatively lowly valued and it is an economy where there is no inflation. An additional tailwind could be a new Cold War with China, diverting capital and trade flows to Japan.
Peter Hollis, Russell Napier, Ally McKinnon, Glen Finegan and the Kennox investment team.
What would you do to improve the way the global corporate system works?
At Kennox, we see great strength in the current corporate system, which includes the creation, growth and interaction of an enormous range of companies. Whilst there are unquestionably significant problems, these corporates are an essential part of the market-based ecosystem that has steadily increased living standards for so many across the globe for so long.
For this system to continue and to thrive, it is imperative that (enough) investors focus on risks over the long term. Decisions that risk this long-term sustainability should be discouraged, and ones to protect it encouraged. It’s not that every player needs to think in the long term, certainly many won’t. But there needs to be a critical mass of considerate and balanced long-term investors – these are essential to protect the benefits that so many individual companies, and all together the entire corporate and market-based system, bring to society.
What needs changed? Here are a few concrete actions that Kennox would suggest that would encourage this long-term thinking and behaviour:
- Take away the tax advantage for the deduction of interest expense.
- Incentivising more debt increases the likelihood of over-leveraging and destabilising a business.
- Modify the tax incentives so that companies are inclined to increase dividends for shareholders who hold for longer.
- For instance, Air Liquide in France already does so.
- Likewise, increase the voting rights for shareholders who hold for longer.
- Shareholders who are aligned to longer-term decisions should have more say.
- Restructure management remuneration to pay the majority of bonuses in the form of shares that can’t be sold for a decade.
- This starts to align management’s risk focus to match the desired long-term sustainability time frame.
- Make quarterly reporting optional.
- The market should focus on the long term, not the short term.
The corporate system isn’t broken but it could certainly do with improvements. Let’s think ahead and protect it.
Kennox suggests that there might be other ways to view ESG and inflation than the accepted narrative currently in the markets. Maybe it makes sense to consider the idea that wishful narratives are crashing into the inevitability of hard realities.
Perhaps the situation with natural gas in Europe is a good example for ESG. A widely-accepted narrative recently has been that natural gas has no redeeming features, therefore no one can invest in the supply of gas (witness the dramatic drop off in capex across the industry in the last few years – almost a trillion $ at peak down to $450bn pre covid and an estimate of $350bn in covid). That looks like wishful thinking – there is currently no scale affordable alternative to fossil fuels. Obviously, but inconveniently. Does it not look like many investors are assuming that buying a highly-rated ESG fund will solve this prickly little dilemma? The real ESG question is how much pain we want to take as a society, and who should bear that – questions along the lines of can we consume 20% (or 40%) less energy? Should our energy be 20% (or 40%) more expensive? How do our hospitals, ambulances, and fridges deal with intermittent power? Etc. This has enormous societal implications, so let’s at least talk about the real issues – not the distraction of how the rating companies have come up with Telsa as ESG-brilliant and Shell as ESG-uninvestible. It is just a distraction from the bigger question.
On inflation, we at Kennox have neither economists’ nor academics’ biases, so let’s go back to the very basics. What if inflation is too much money hitting too few goods? And what if this money comes from the enormous leveraging that the world has undertaken in the last few decades (the Institute of International Finance global debt data is not a bad place to look here, especially the bounce in the pandemic)? This would explain why all asset prices look expensive, with bonds especially inexplicable in our minds. If this money is all an illusion (or a wishful narrative as per above), then the only two ways back to reality are inflation or asset prices falling – these are the only two ways to realign the financial system and the real world, ie the narrative to the hard realities. So to the key question: is this much global leverage sustainable? That is what the market needs to consider on inflation – and worry a lot less about “transitory” or not, 2% or 4% yoy, CPI or RPI? No one can know the answer, whatever they say, but having all your eggs in the “it’s all fine” basket looks a bit less than comfortable (to us certainly).
What is interesting is that it is possible to position in such a way that can benefit from these situations. In a market that looks very pricey, we can find investments that look very inexpensive. In a world of eye-wateringly high leverage, our portfolio has dramatically less leverage than the market, and very low absolutely, with, for example, half the companies having net cash on the balance sheet or negligible levels of net debt. If there is inflation, some of our companies do well, not simply avoiding being hurt, with energy or gold mining holdings being examples. It is this type of non-consensus thinking, and the stomach to take and hold positions in the face of market pressure and fashion, that affords this type of opportunity (for a bit more colour, please refer to the 3Q21 Quarterly commentary).
Kennox’s investment style is logical, sensible and powerful, built upon fundamental human behaviours. Psychologists and behavioural economists observe that not-entirely-logical traits and irrational quirks slip regularly into human behaviour. For Kennox, key to note are that people:
- extrapolate the recent past,
- don’t like uncertainty,
- and adopt a herd mentality feeling safest with the crowd – which in turn exaggerates the first two points.
This behaviour leads to opportunities where the financial markets overshoot – and where Kennox can take advantage. Judiciously practiced, bargain-hunting value investing exploits these opportunities.
Kennox seeks out the pricing/valuation advantages that arise from these quirks. There are stocks where the market prices in a negative- to terribly-negative outlook but where the much-more-likely outcome is more benign (or even positive).
Most often for Kennox this is exhibited in the form of short-term headwinds. The extrapolating mind of the market views any headwind as an ominous and permanent risk. This gives a price drop. This price movement transforms into a genuine opportunity only when we assess that the headwind is temporary and the long-term risk profile has not changed – or even improved, as survivors face decreased competition. Kennox refers to this as the J-curve, where temporary headwinds turn to tailwinds as the industry eventually cuts backs supply and/or demand recovers.
As these investments involve short term operational risks (ie the uncertainty or extrapolation that gives the price opportunity in the first place), we aim to minimise other risks (buying sector leaders, with conservative management, low leverage, etc). This ends up with very strong risk-adjusted return profile – ie we can have our cake and eat it too.
Lastly, as stewards of our clients’ capital, we view ESG issues as serious long-term risks, threats to the viability of the franchise. Similar to any other risks, these can be misdiagnosed by herd-following investors. Kennox is able and willing to take a stance against consensus where warranted.
This framework sounds simple, but logical and independent-minded decision making, and the fortitude to stick with it, is not easy, and should neither be discounted nor taken for granted. Kennox is able to take advantage of the market’s quirks – quirks such as extrapolation, uncertainty and herding – by being logical and methodical, patient, and most importantly, entirely aligning our investment process with our beliefs in the world around us.
For the third successive meeting the Panel met virtually, in of itself an example of the restrictions that society still faces. The debate focussed on what covid-related impacts will be temporary and which will be longer lasting.
The largest topic for discussion was the possible return of inflation and how best to prepare portfolios if this were to be the case. The increased reach of government into the financial sector was viewed as likely to be a longer lasting consequence of the pandemic (even if the market remains ambivalent, as judged by the state of the bond markets). The historical example of the 1960s was brought up, where inflation reached mid single digits by the end of the decade. As happened then, with increased government influence, central banks may become impotent against political interference and avoid promptly offering up necessary but bitter remedies. At the least it feels worthwhile owning something in portfolios in case inflation were to increase into mid to high single digits once again. For example: historically, indebted businesses with negative working capital have done well during inflationary periods. There was some debate over whether indebtedness would be attractive, as the path through could be quite rocky and leverage adds a risk factor, and all agreed that long-maturity debt with locked-in rates would be by far most preferrable. The ability to pass on price increases is another key feature in this environment.
The Panel also discussed the government stimulus as the start of wealth redistribution, with higher corporate taxes and universal basic income perhaps becoming more prevalent. This already looks a trend across the globe, with examples such as the Biden administration’s stimulus measures, to be paid for with increased taxes of corporates and the rich, or the recent political upheaval in Chile, which has led to the left wing writing a new constitution. The impact of this would be an improvement in living standards for the poorest, an unquestionable positive for society, but must be factored into any assessment of investment holdings. One impact we are already seeing is labour shortages.
The Panel resolved to meet again before the end of the year to continue the discussion.
Peter Hollis, Russell Napier, Ally McKinnon, Glen Finegan and the Kennox investment team.
Intractable societal problems are complex, and any solution will involve painful trade-offs with no easy answers. “Ethical” issues such as diversity, climate change, inequality across groups or genders are especially complicated – if simple and easy answers existed, surely the problems would have been solved by now.
To make it more complicated, ethics are inherently subjective. Individuals can and do hold enormously differing views to each other. Which one should prevail? Groups across geographies, religions, and societies actively disagree with each other’s ethical views. And society’s ethics regularly evolve or change outright (ie opium used to be legal, US’s prohibition of alcohol, the legality of homosexuality, euthanasia).
Any solution therefore must consider a multi-ethical framework, ie there are no universally-accepted ethical absolutes.
Even in ambiguity, Kennox can have a sensible and logical framework. We lay out our thinking as follows:
Kennox & Sustainability
Sustainability lies at the heart of all Kennox investment decisions and we are signatories to the UN supported Principles for Responsible Investment.
The basis of our entire investment process is analysing the core issues for a company, both strengths and weaknesses, to best understand the sustainability of its earnings and its franchise. As long-term investors, ESG-related factors are a key ingredient in this assessment, affecting as they do the future sustainability of the company.
Start with the big picture/Is the whole industry investible or not: We will invest only in companies that bring overall benefit to society. Aligned to the 17 UN Sustainable Development Goals, if we assess that a company or an industry causes significant net harm to society at large, we will not invest at any price. This assessment is viewed as the widest balance of all its activities and interactions with stakeholders, including employees, customers, suppliers, the environment, and other aspects of society at large. For example, under this framework we will not invest in gambling, tobacco, pornography or armament companies.
Kennox must be willing to take contrarian positions: Kennox is willing to take a stance against views in the marketplace if we assess that consensus to be misguided. For instance, if we assess that a company or industry provides a service that is suboptimal on one measure in the view of the market, but overall necessary to the smooth functioning of our society at large, Kennox will judge this industry to be investible. The case for fossil fuels falls into this at present – exclusion on ethical grounds is inconsistent with absolute dependence today.
Any assessment is complex and subjective: In essence, our assessment is to consider the strategic issues that a responsible and sensible company director faces to ensure the sustainability of the business franchise, as measured over decades, not quarters. By its nature this is a complex, often qualitative assessment, and always involves trade-offs and balancing a wide range of interests. In this area, Kennox’s view is that pragmatism is worth more than idealism.
Once we assess an industry to be investible, it is important that our investee companies be responsible and progressive, especially in the difficult areas (ie fossil fuels): Once Kennox assesses an industry to be investible, Kennox will seek out the leaders and engage with them to improve as much as possible, encouraging them to be progressive.
ESG should be fully integrated into the investment process: Our investment team is fully responsible for both the Kennox ESG policy and its implementation – there is no better way to ensure that ESG is fully integrated in all aspects of our investment discussion and decision-making.
OBJECTIVES, VALUES, AND ADVANTAGES
There are times in every investor’s career when the values that drive their approach are brought into particularly sharp relief. Now, as markets become increasingly distorted, is one of these times. Geoff and I have been managing the Kennox portfolio for coming on 14 years now. We have 100% of our equity investments in our Fund and are pleased to have been joined along the way by co-investors able to identify with our approach – our long-term objectives for both risk and return, where we think we have an advantage over the market and the values we adhere to as we go. (Summed up: think long term; our edge is in the unloved; enact sensible decisions; be a true steward of capital).
A few points on this:
We care about the very long-term result (10 years+) and our very long-term objectives are around the absolute not the relative. We are not distracted by short term benchmarks, i.e. the “neighbours getting rich” risk. We do care very deeply about preserving and growing our clients’ capital, in that order, and the risks we undertake to do so.
It is imperative that any investor knows their advantage over the market. Ours is to look at areas that are behaviourally difficult for a lot of investors. Many are looking for the shiny new thing, but there is great opportunity at the other end of the spectrum, in the areas that are unloved or overlooked because the outlook is obscured, where companies are facing temporary headwinds. We spend our time assessing if these headwinds are temporary or permanent. One is a fat-pitch opportunity, the other a disaster. That this is very different to what a lot of the market does (particularly at present when growth and winners have been so richly rewarded) is especially attractive to us – being fundamentally different means our style can perform even in difficult markets, the timings of which are near impossible to predict.
We spend a lot of time on research but we understand that our competitive edge isn’t going to come from knowing more about a company than anyone else. Rather, it’s how we use the knowledge. It is about being able to differentiate the woods from the trees, the important from the noise; how to balance an understanding of huge numbers of moving parts (inherent in any company in the world), mix that with the uncertainty of change in the future, take an independent view, and distil down into clear-headed decisions.
We are able to look dispassionately at the world and willing to back our convictions when we see a disjoint between the prevailing market narrative and the likely real world outcome. Our opportunities will come in the mismatch between Ben Graham’s weighing machine and voting machine. This is our advantage.
Lastly, as long term investors (our turnover is c.10%) we see ourselves as true stewards of the opportunities we find: we need and want to be responsible owners. We have no interest in micromanaging management but will speak up and challenge on the strategic and material, forcefully if necessary. We are very clear, ownership rights bring responsibilities.
We welcome all investors who share these values to invest alongside us. In the long term we are certain that these behaviours and values will be fruitful in financial terms and, we certainly hope, have a positive impact on society as well.
Charles L. Heenan, Investment Director
Kennox Asset Management
WHY SHELL IS AN ESG INVESTMENT
There are times when there are “fat pitch” opportunities available in the market, opportunities arising when the prevailing narrative in the market doesn’t match up to the likely practical outcomes in the real world. The market’s narrative can become beguiled by enticing but ultimately false promises, by misdirected thinking that is likely to be significantly different to the path of operations and these “real world” outcome. The wider this disjoint becomes, the “fatter”/greater the opportunity.
At present there are several such opportunities in global stock markets, but one of the biggest that we’d highlight is the current situation for energy. Energy share prices are suffering from crushing combination of two narratives: a terrible operating environment running into an ESG view of energy producers cast as inexcusable villains. This narrative looks misdirected, on both sides.
On the operating environment, there are good reasons to believe that the current operating environment headwinds are short term and will not be permanent. Fossil fuels provide about 80% of global energy needs and we do not have a scale, affordable and reliable alternative at present. It will take decades to solve the problems of finding the best new technologies, ironing out intermittency and reliability issues, and creating new infrastructure on a global scale.
The difficulties of 2020 were driven by weak energy prices due to a lockdown-induced demand shock. Lockdowns will end and the temporary dampening effect on demand will at least abate. At the same time, mentalities on the supply side have changed, and capex spend to maintain output has been savaged. Estimates of close a $1tn spent on upstream in 2014 halved after in the late teens, and was about $300bn in 2020, a third of the peak. This does not look sustainable when demand is off 5%, and that in a pandemic year. The outlook for strong players well positioned versus the rest of the industry is nowhere near as difficult as the market is assuming.
On the ESG side, climate change is a complex issue with no easy answers nor pain-free options. There certainly isn’t just one “right” answer: it will take many different approaches and angles, and it will involve a wide variety of players (including all of corporates, government, and consumers). There will be a transition in global energy provision over time, but evolving away from this 80% of our energy supply, with no clear solution even visible at present, will take decades.
In this context, we feel it is entirely responsible, indeed commendable, for companies to continue to provide a product that is essential to modern life, until this transition is complete. To deny this interim period where fossil fuels are needed is to be deluding oneself that the cost and reliability of energy is not core to modern society: heating houses, growing food and transporting it to the table, powering hospitals and ambulances, enabling clean water. If in doubt, check in with someone who has lived with a persistent or prolonged blackout recently. And it is easy to forget how much of an impact on quality of life inexpensive power can make, in the form of transport or heating or cooling or cooking, to anyone trying to live on a meagre income.
In this world, a company like Shell looks extraordinary. Shell is working to be part of the solution, and we feel it is one of the best at balancing all the issues involved. At the same time, even in the pandemic-induced distortion, its operations continue to generate robust returns. Providing the energy to power our society, playing a core role to finding the solutions of the future, at these valuations and this level of scepticism in the market, the opportunity is enormous.