Are you keeping an eye on the long bond market? Even if you’re a generalist or an equity investor, perhaps you should be.
The US 10-year bond has been weak, recently breaching the headline 5% yield threshold. This matters for two reasons. First, it’s the market indicating that a higher cost of capital across the board is not as “transitory” as many had hoped. Second, over the last decade of cheap money, many investors have flocked into increasingly crowded trades and many market participants have taken on ample lashings of leverage. Bond price weakness piles pressure on both – and any uncontrolled rush to the exit would be extremely painful.
Hopefully, the long bond market issues unwind quickly and smoothly. But sometimes it pays to be prudent, not hopeful.
In our latest quarterly report, we note that several of our holdings are seeing a broadening dislocation between burgeoning operations and stagnant share prices – managements are genuinely scratching their heads as to why the market is not marking up their lowly share prices alongside improving outlooks. This dislocation is a powerful indicator of future potential, with Sky New Zealand being an excellent example.
Have a look at the quarterly if you’d like to read more.
We’ve noticed lately that the dividend yield on the Fund has been creeping up and now sits at all-time high levels (3.8% for the Class A and 3.6% for the Class I, net of all fees and notably higher than the gross yield of 2.0% on the MSCI World). This rise comes on the back of increasing dividends from our holding companies matched with the attractive valuations we are finding out in the market.
We bring it up as we find this one metric to be especially helpful, both as shareholders and as managers – it’s a good indicator that we are finding attractive valuations, and it shows that the companies that we invest in are willing to share and are looking out for their shareholders’ interests. It also balances shorter-term returns in the form of cash dividends with longer-term capital growth.
Should investors buy government bonds at present?
Although outside our daily focus (the Kennox Fund only invests in global equities), we appreciate the importance of bonds:
· They represent a huge portion of global savings
· They moonlight as the “risk free rate” (although former SVB management might argue with you here)
· They remain essential to the smooth functioning of governments worldwide
Kennox has long been wary of government bonds and our unease is only increasingly. Global governments (bonds’ ultimate backers) are getting more and more exuberant in trying to absolve the private sector of risk. This drives spending and the plentiful supply of bonds ever higher. Our wariness was reinforced by a few graphs in the excellent BIS Annual Economic Report, such as this one:
Annual Economic Report 2023 (bis.org)
That this ballooning in debt levels has been increasingly absorbed by central banks only adds to the worry – the Fed owns about a quarter of all their government debt, the BOE about 35%, the ECB about 40% and the BoJ an astounding 50% (as shown on the graph on page 52 of the report).
Owning a government bond is aligning yourself and your wealth with this sort of spendthrift behaviour, questionable pass-the-parcel strategy, and monetary wishful thinking. In the short term, this might well not matter. But in the long term, this is a significant headwind, if not an outright trainwreck. We urge caution while merrily sticking to what we know. Back to our day jobs...
PS – we would recommend reading the “Longer-Term Backdrop” section in the introduction of the BIS report (on page “ix”). It’s only a page long but an excellent summary aligned to our view of how we got into this mess.
Opportunities abound for our style of investing. In the Q2 2023 Quarterly Report, we talk through three new stocks added to the Fund in 2023: Youngone Holdings, LG Corp and ODP Corp.
These are differentiated opportunities trading at exceptional valuations. This is inherently attractive in a narrow market that has only become more consensus, as described in the Quarterly:
“Concentration at the top of most markets has increased markedly. Apple, now worth over $3tn and more than the entirety of the Russell 2000, constitutes 7.7% of the S&P 500 making it the largest single stock in the history of the benchmark… The dominance of a few stocks by performance is even more startling than by weight. In the first half of 2023, the largest seven stocks (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla and Meta) produced 77% of returns. The bottom 460 stocks produced negative returns in aggregate.”
We attended the London Value Investor Conference last month, the tenth iteration of this conference and every year we’ve taken something away. This year, two points really struck us.
Firstly, there are a range of opportunities that are very, very inexpensive. There are companies out there that have fallen far out of the market’s favour – examples include: selected situations in the US especially smaller companies (where the Russell 2000 index of smaller companies is worth less than Apple by itself); separately each of Hong Kong and South Korea came across as extraordinarily inexpensive but with strong investment cases; and even commodities as an asset class (certainly relative to the wider US stock market). Presenters highlighted a variety of companies. Some are trading on a fraction of book value (as low as 0.2x), others on earnings multiples less than 5x, or with stacks of cash on the balance sheet, or paying dividend yields over 10%, or companies embarking on buy backs that represent a substantial proportion of their entire enterprise value. Extraordinary. As always, each situation needs to be analysed for its own merits and nuances, but the gist of these narratives aligned with what we are seeing in our own holdings.
Secondly, most investors are still looking the other way and have little or no exposure to these inexpensive areas, having done so well out of growth and momentum in the past decade. For short term speculators, this doesn’t matter as flows and momentum will dictate prices. But over the longer term the stock market aligns to where attractive opportunities lie.
Our impression of the market is that it is stretched to quite extreme levels, with the fashionable/consensus/growth so much preferred over the unfashionable/non-consensus/value. At these levels, even investors who have a strong bias against value should have some exposure – say 10-20% of their portfolio – just in case they’re wrong. Those with more of an inclination to value should scale up from there, comforted by the magnitude of the opportunity.
The difficulties in the US banking system rumble on, with First Republic succumbing earlier this week and PacWest teetering even as we write this. The most sensible commentary we’ve seen on the situation is from Richard Bookstaber in the FT, who points out the weakness of a rules-based approach, or “oversight based on unnumerable detailed rules”. He notes: “we don’t fail because of mismeasurement at the second decimal point or a poorly drafted subsection. We fail because our regulatory approach misses material risks wholesale.” As our financial and regulatory systems have barrelled a long way down this overly prescriptive and flawed route, and following the period of perhaps the loosest money in history, sadly we feel this might rumble on for a while yet.
Experiencing risks unseen in decades (such as the return of inflation) or never before (the climate change transition, the hangover from the period of the easiest money in history), investors will have to be more imaginative in managing risk and opportunities, thinking beyond merely what has happened in recent times.
“Opportunities arise when a wide gap opens between reality and appearance…. Current markets offer many opportunities, coming from over- and under-investment in various industries in the global economy, from the market’s crowding and herding, from the authorities’ monetary actions of the last few decades. This is what allows Kennox to be fundamentally optimistic about the prospects for the Fund, in the face of, or even because of, the challenges facing investors at present.”
Our risk focused quality value portfolio has a track record of strong performance in difficult markets – if you’d like to discuss our strategy, please do not hesitate to be in touch.
The Fund was flat (up 0.1%) in February 2023.
Investors wrestle with uncertainty in the global markets at present: what does Quantitative Tightening mean and will central bankers and politicians hold their nerve in the face of continuing adversity? Will inflation go up, down or sideways, in which order and for how long (interest rates likewise)? Will there be economic hard, soft or no landings? What is the impact of the ongoing war in Ukraine, the trade tensions with China (it remains the world’s largest exporter of goods, by the way), the energy transition alongside climate change? And so on.
Facing these unknowable quandaries, investors should be wary of paying up, especially for a rosy consensus. For instance, the US, on average, is expensive and priced to deliver sub-par returns – well laid out recently in this Hussman Funds article. It’s not that the US can’t perform, but it is fighting an uphill battle.
Rather, Kennox has the portfolio strongly tilted towards the inexpensive and unloved, trading at a significant discount to US and global markets. This simple but powerful advantage over the market significantly improve investors’ chances of producing positive returns even in tough markets. In times of headwinds and uncertainty, this can be invaluable.
Following a strong year in 2022 (up 13%), the Fund was up 1.6% in January 2023.
The investment landscape changed markedly late in 2021, and the key question on every investor’s mind since then should be whether it will flip smoothly back again, or whether this new landscape will prevail. We noted the following in Ruchir Sharma’s article of the 29th January 2023 in the Financial Times: “Combined stimulus in the US, the EU, Japan and the UK, including government spending and central bank asset purchases, rose from 1 per cent of gross domestic product in the recessions of 1980 and 1990 to 3 per cent in 2001, 12 per cent in 2008 and a staggering 35 per cent in 2020.”
With government spending appearing to be one way traffic, a quick and painless switch back to the old investment landscape looks less and less likely. Please see the Portfolio Positioning section of the factsheet as to why Kennox feels this suits our style well.