The Panel met up once again following a fascinating but equally precarious six months in the financial markets.

Since the regime change that began during the pandemic, the Panel had been in agreement about inflation being on the horizon and not being ‘transitory’. Now that it has arrived, there was disagreement over whether we are living through a cost of living crisis or entering an inflationary boom period. Nor is there much clarity on the paths of a steep rise in rates now or for a decade of financial repression. With the amount of debt around, a government forcing up rates would induce a recession. Therefore there is a political balance between dealing with inflation and minimising defaults. It may take many years (as in the 1970s) before there is the political will to fully extinguish the inflationary flame, due to the harsh recession that would surely follow. If we are in an inflationary boom, why would the government instigate a recession? And if we are in a cost of living crisis, it feels likely as soon as the recession hits and inflation temporarily comes down, the political will for high rates will evaporate. It is worth remembering the inflation of the 1970s was only tamed when rates remained at high levels even during a recession.

As noted above the Panel does believe there has been a regime change in the financial system. Therefore it was generally agreed we should look to own what has underperformed over the last decade. This includes telcos, if we believe markets will become more rational and governments will allow a reasonable return on capital. Additionally, the next decade could well be defined by a Cold War with China and increased government intervention in the economy (both of which would cause the regime change to continue for longer). Consequently it follows to look for businesses that have been hurt by outsourcing to China and/or those that will benefit from increased government expenditure.

Angus Tulloch, Peter Hollis, Russell Napier, Ally McKinnon, Glen Finegan and the Kennox investment team.

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.

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.

Fuelled rather than deterred by the disruption and uncertainty of Covid-19, the Advisory Panel conducted its second remote meeting in December.

The disruption caused by the pandemic has produced plenty of talking points and diverse opinions as to where the best opportunities might be.  Central to this was a discussion as to which radical changes the world has undergone have been permanent, and which changes have been temporary.  Permanent changes to an operating environment create the mirage of a value opportunity (or a “value trap”, where a price fall accurately reflects the change in the likely fortunes of a company), whereas temporary changes create genuine value opportunities (where price moves reflect the short term position, and under-value the long term opportunity).  Companies in this second group are likely to experience the “holy grail” of compounding price increases with volume increases as the market recovers.  Identifying these opportunities before the rest of the market remains the challenge facing all investors.

Here are a few ideas that the panel discussed: the UK has had a difficult time through the pandemic, with Brexit adding to the uncertainty, but as one of the least loved major stock markets it looks inexpensive; housebuilders were mentioned as a possible source of opportunity, especially if there continues to be pent up demand and high savings across the population; banks, airlines and pubs (at least those that survive) also look interesting as areas that have suffered, but are likely to remain relevant regardless of how the pandemic is resolved.

This led on to one of the most important issues for global markets: the possible return of inflation.  Most economists have so far thought that a significant rise in inflation is at best a distant possibility, having laid dormant for so long.  Governments’ increased activity – in the markets, in the monetary system, in the size of central banks’ balance sheets, and in directing and guaranteeing lending through the commercial banks – means that times may be changing.  The Barber Boom of the early 1970’s might be an interesting case study for the future.  Most on the Panel agreed that it is certainly worth being prepared – holding some assets that will thrive in an inflationary environment.

Peter Hollis, Russell Napier, Angus Tulloch, Ally McKinnon, Glen Finegan and the Kennox investment team.

Due to the lock down, the Advisory Panel met for the first time not in person but over video link, to discuss a changed and turbulent world.

Energy and the fossil fuel economy, the future of global transport, the likely comprehensive change in the world’s perception and understanding of debt, the resilience and/or susceptibility of different emerging economies and their currencies, sources new and old of taxation to finance the enormous economic bill of government intervention, the likelihood of a return of inflation, the timing and shape of any recovery, the possibility of capital controls – all these and more featured in an especially wide-ranging discussion.

A major topic of conversation was the role of government in the global economy and corporate landscape, at present and in the future. The moves of the government have been extraordinary as well as widespread. The Panel felt that the reach of government into the economy was unlikely to retreat at any time soon, even after the ebb of the pandemic, and governments’ changed relationship with the banking system is especially noteworthy. This is an area where governments might find enormous attraction in keeping a finger in the pie (or should we say keeping a major influence on strategy and on lending committees). This is a step change compared to the investment landscape over the last four or more decades and requires a fundamental change in mentality.

On micro-economics, we discussed some of the current conundrums of investing – should a company’s very long term value be affected if it had to shut operations for a year? Which ones will survive and which fail? At least part of this was down to who makes that decision – the markets via emergency financings and rights issues, or government via considerations of national strategic importance. Rights issues and other capital raisings are the current rage and it is worth watching the winners and losers, but also especially the duration and scale of the capital needs of the market. The Panel will continue to monitor developments, which promise to be fascinating even if potentially discomforting.

Peter Hollis, Russell Napier, Angus Tulloch, Ally McKinnon, Glen Finegan and the Kennox investment team.

Given elevated levels of global equity markets, the panel expects returns from the equity asset class to be muted compared to recently, and especially in the US where stocks look most expensive. Should one readjust one’s investment style for this? Good growth managers should still look for good growth companies, and value investing will still work where good stock picking avoids the companies that will not recover. Based purely on headline valuations, emerging markets look to be the cheapest, but the panel was sceptical that these would necessarily provide the best returns. There are a preponderance of state owned or directed firms, and without confidence in either property rights or the rule of law, promising returns can evaporate quickly. In addition, higher quality companies in emerging markets are often commanding a significant premium to the market as a whole.

The panel felt that the more focus the industry gives to ESG investing, the less meaningful it is becoming as a tag. It is perhaps more useful to reclassify funds into impact funds (which only buy companies that are focused primarily on having a positive impact), sustainability funds (whose fund managers believe in active engagement), and others (many of which will effectively incorporate ESG into the research in any case). There was an interesting discussion as to whether there was a potential sacrifice of returns for investors in these funds, or whether they might in fact outperform. An increasing demand for ESG funds has driven a differential in valuations of firms that are considered to be ESG positive or ESG negative, and this effect on its own has impacted short term performance. Whether this will have a meaningful positive effect in the longer term, or whether tighter investment restrictions will inhibit returns will only be known with the benefit of hindsight.

The panel also discussed a variety of points around building a culture at an investment company. Should employees be able to deal personally, even if they do so within the usual compliance guidelines (no front running, for instance)? Some view it as a dangerous distraction, or even as a conflict of interest if employees start to change their behaviour around stocks they own. Others see it as a vital pragmatic learning opportunity, in that you only really get experience when your money is on the line. Another question is how to get diversity in the investment team? An interesting observation from Rory Sutherland in his book Alchemy was that teams will be more diverse if the company hires in batches – if you hire one a year, you end up with the same mould. If you hire five at once, you can take some risks and might therefore hire some more differentiated candidates. On decision making, there will always be lots of conflicting voices, internally and externally, so part of the investment process is to absorb all the points of view, but still be able to act, even in the face of some opposition.

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

The Advisory Panel met with the backdrop of markets that have risen 14% in the first 4 months of the year, and a clear return to “risk on”. Information technology once again tops the sector charts (up 25%) and the more “defensive” sectors of Utilities and Health Care are up 7% and 3%. Rising markets imply that investors are feeling relaxed, but should they be? We do not live in ordinary times. There are record levels of debt being held privately and on corporate balance sheets, we have yet to ween markets of quantitative easing fully, interest rates remain at un-realistically low levels, and there are more than $10 trillion of bonds trading at negative yields. What else is on the panel’s collective mind, and what (if any) opportunities does that present.

The ugly face of protectionism: there are increasing tensions between the US and China, and this has potential to be a “trade war” of a size that will not leave any global markets untouched. China has been exporting deflation globally for many years (as the rest of the world benefits from cheap Chinese labour, and seemingly limitless output). A surprising number of people are suggesting that “low inflation” is set to last forever, but should the US impose trade restrictions on China, this will almost certainly result in inflation, and put pressure on interest rates. Japan is the biggest direct competitor for a large number of Chinese exports and could, in the longer term, be a clear beneficiary. Relatively cheap equity markets make this a rich hunting ground for potential ideas. Asset heavy companies (long out of favour with the popularity of the asset light business model) are also likely to benefit from a return inflation as the replacement cost of those business increase with a return of inflation. These are investment ideas for those with a long time horizon though, as if the RMB depreciates in the short term, this trade gets tougher before any tariffs bite.

The rise and rise of the US: Since the bottom of markets in March 2009, the S&P 500 has delivered over 400% returns (416%) in sterling terms. The MSCI World excluding the US has delivered less than half of that amount (196%). The information technology sector has delivered a staggering 555%, whilst energy has delivered less than 100% (94%). These discrepancies in fortunes are remarkable, and inevitably lead value investors to look at those sectors that have underperformed (relatively) to seek havens from what feels like a universal re-rating. The Kennox portfolio already has a significant weighting in energy names. Remember that these are oil and gas companies (no longer just oil companies), that that the world will likely need more energy over the next 20 years and not less, and that we must rid ourselves of coal (which makes up 20% of the world’s energy supply currently) before we reduce our dependence on the other fossil fuels. Remember also that switching to what currently are more expensive alternative energy sources disproportionately hurts the poorest members of society, so is not the political “no-brainer” that it is often portrayed to be. The panel also thinks that the UK market (the weakest of the major regions) may well offer some opportunities. The FTSE 350 trades at around 14x PE (excluding those with negative earnings), compared to over 18x for the S&P500 and over 22x for the Nasdaq. Whilst Brexit is causing uncertainty, it is unlikely (again in the longer term) to quite so detrimental for all of the businesses as the discount implies.

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

Max Ward (former head of UK equities at Baillie Gifford and current manager of the Independent Investment Trust – the best performing Investment Trust in the UK in 2017) joined the Advisory Panel for our November meeting. As a self-confessed perma-bull (“because it’s just more fun”), even Max was interested to explore whether or not there were any “safe havens” remaining after nearly a decade of quantitative easing has inflated global markets to a series of record highs. Rumours of a reversal of this long-standing policy, or “quantitative tightening” have left market participants feeling jittery in the 4th quarter of 2018. Below are a number of areas that the panel felt might offer some safety should jitters turn into anything more serious:

The Kennox house view: companies that have solid balance sheets (i.e. those that have benefitted least from QE and the abundance of cheap credit) for the most part have underperformed recent bull markets, and remain on reasonable earnings multiples. As such, these businesses should be well placed to outperform global markets for two reasons. First, their earnings should be less impacted by rising interest rates (as this benefits cash savings and penalises leverage) and second, they should be less susceptible to a reversal of inflated earnings multiples (as their starting multiples are already more palatable).

UK Businesses: The UK market has its own set of concerns currently. Over the last 5 years, it is flat in USD terms (against global markets that are up over 40%) as the market considers the risks of Brexit. Whether or not it will be a “hard Brexit” remains to be seen, but that it will be poorly managed now seems a racing certainty. These concerns have weighed on company valuations, but for an investor with a long enough timeframe to look through the inevitably volatile transition, this may well be an excellent opportunity to invest in world-class companies that are sure to survive.

Challengers to lazy incumbents: Many markets are dominated by one or two giants. In some cases, size and longevity of success leaves these giants as “lazy incumbents” ripe to be toppled. Max Ward has had notable success in his investment in Fever Tree, that has shaken market leader Schweppes to its core. The panel discussed several areas where there might be other similar opportunities. Small and nimble players in the telecoms markets for example, or within the Kennox portfolio Neopost (competing with Pitney Bowes) or M6 (competing with the TF1 the state-owned French TV broadcaster).

Family owned business: We also revisited the main topic from the last Advisory Panel. Many family run businesses are conservatively managed, shun leverage and often make sensible decisions on a longer timeframe than those run by management with remuneration that is dominated by short term performance rewards.

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

In a break from our usual format, Alastair MacLeod joined the Advisory Panel to bring a fresh perspective and keep the usual faces on their toes. Alastair has spent over twenty years in investment and hedge fund management, in London, Edinburgh and North America. We outline a couple of the topics discussed during the meeting below.

Diversified Holding Companies – aligned with long term investors
One of the topics that the Advisory Panel focused on, was why it is that diversified holdings companies (often large family-owned businesses) have outperformed over the last 20 years. John Elkann (CEO of Exor, the holding company controlled by the Agnelli family which owns Fiat Chrysler, Partner Re, CNH, Ferrari and the Juventus football team amongst other holdings) highlights some of the reasons in his excellent letter to shareholders after the 2017 year:

• They tend to be prudent in how they are run, particularly in relation to financial matters, which means they remain robust when they face downturns, crises and unexpected events;
• They have the patience not to act when action is unnecessary and resist the pressure to do so. As Charlie Munger says, “Success means being very patient, but aggressive when it’s time”;
• They are aware of changes in the world and are able to adapt when those changes require it;
• They have strong cultures, clearly defined purposes and a sense of responsibility. Their cultures, rather than pay, help them to retain talent and to grow leaders internally.

While Kennox are not (currently) invested in the holdings companies, we agree with the analysis that for fund managers with a long investment horizon, family owned businesses are likely to be well aligned. The S&W Kennox Strategic Value Fund owns several companies with large family or founder shareholders: almost half of all the companies we have ever owned have a significant shareholder (i.e. one that owns more than 25% of the float). Many of these are family owned or controlled.

A couple of other noteworthy points

On dividends: We are not an income fund, and whilst we enjoy being paid to wait, there are often times when companies should hold onto their cash. In the long term, equities have been able to make double digit returns on equity, is there not therefore a case for re-investing all of the cash at a 12% return, that is better than fund managers have done, and more tax efficient. At Kennox, we favour companies that balance shareholder returns with investment, and at times encourage management to cut dividends if we feel they would be better investing in their own business (sometimes to pay down debt, but at other times to invest in growth)

On measuring investments against book costs: Marking individual investments against their historic book cost (i.e. what the Fund paid for the investment) is pervasive in the investment industry, but is perilous and illogical. It encourages managers to hold companies that are below book cost, even when they have become poor investments, and It encourages managers to sell companies that have made a good return to “bank” the profits, when holding is often a better decision. At Kennox, we measure our portfolio against our estimate of their sustainable earnings (i.e. look at the multiple of Sustainable Earnings at which the investment is trading) to gauge whether an investment is a good one today, regardless of sunk costs or profits.

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