Ardevora Quarterly Review - June 2017


Stock prices tend to move on shifting hopes or anxieties about the future. Some companies have more control over their future than others; some are more easily buffeted by the behaviour of their peers, by governments or central bankers, or by the whims of traders in currency or commodity markets. The daily news is awash with speculation on so many of these things. As you sit in your office as a portfolio manager, you attempt to penetrate the noise, deciding which stocks to own, trying to find the ones which might reward you for some insight you think you may have.

We frame our views around two focal points. First we judge how the managers who run companies are behaving. We assume most managers tend to view the future too optimistically and are tempted into taking too much risk; either they chase growth too aggressively or they resist evidence of a more difficult environment too stubbornly. We look for those where their views look realistic, conservative and safe. Our hunt for them helps us form a view on the overall stock market, from the bottom, up: where is risk building, where it is receding, where are management relaxed, where are they seemingly in denial?

Second, we judge how other investors are behaving. We have to take a lateral approach. Investors are a seething mass. We can only attempt to infer how the mass is behaving. We infer in two ways. Initially we look at stock prices in relation to both their history and to attributes of the company they represent (sales, profit, cash flow). Some patterns imply anxiety or scepticism; others imply a feeling of calm or hope. Then we watch how financial analysts are behaving; we can observe them more directly. They produce forecasts and they write reports. Their views can influence investors, so they give us a partial insight into the views of the seething mass. From analysts we can get a sense of where anxiety or hope is building and, where scepticism may be lingering.

For most companies it is getting harder to grow. This can make normal management behaviour risky. In our experience most managers like trying to grow their companies. They can be tempted into risky behaviour when their plans don’t fit reality. A fast growing company can miss growth targets and allow costs to run ahead of new sales. A slow growth company can be too slow to recognise disappointing sales or pricing is not fleeting, but long lasting. They hang on to old plans for too long. The herding of management behaviour can create industrywide problems, like “trapped” capital.

When an industry goes through an unusually benign period, with unusually easy growth, managers can be tempted to chase growth as though it will never end. Some industries can also go through periods of disruption, where growth is pursued by new types of businesses which have figured out better ways of doing the same thing as their old competitors; the industry doesn’t grow much, but new businesses grow rapidly while the majority struggle. Both conditions together can cause problems for older businesses, creating long lasting problems of trapped capital. Capital can become trapped when it flows in easily, but find it hard to get out when returns are disappointing. A lot of the barriers to leaving, in our view, reside with collective management behaviour and denial. Once the excess capacity is stuck it exerts a slow grinding pressure on profitability that can sometimes be lost in the swings of more transient factors like economic cycles. Ultimately, the only way an industry with trapped capital gets fixed is when conditions get bad enough for enough capacity to be destroyed, or if some new, unpredicted source of demand comes along that surprisingly absorbs some spare capacity. In the meantime, investing in stocks in trapped capital industries can be frustrating and unrewarding most of the time. Trapped capital industries create anxiety for investors. Investor anxiety often reveals itself in low valuations for stocks. Cheap looking stocks can be tempting investments. Cheap stocks can be rewarding if they “mean revert” – the future is better than the past, by being less awful. Mean reversion doesn’t work very well in trapped capital industries, however. The trap keeps a lid on things, making improvements rather than poor profitability, transient.

We are attracted to other investors’ anxiety. We think investors can overreact to bursts of intense bad news, and can be scarred by particularly unpleasant experiences. But judging whether investor anxiety is misplaced for stocks in tricky industries with trapped capital is difficult. The debate often collapses down to how quickly a business might fail, rather than how far it might recover.

Since 2013, we have been worried the natural resource industries had become trapped. Recently we have started to worry they are not alone. We now believe there may be three industries where investors are anxious, but where trapped capital makes it tricky to judge whether this anxiety is truly misplaced: energy, media and retail.

Energy is the industry which vexes us the most at the moment. The industry experienced an unusually benign environment from 2000 to 2013. The oil price quintupled, making life easy for almost every company involved in energy production and switching management focus from survival and efficiency, to growth. The oil price collapse in 2009 proved to be short lived, emboldening managers further. As a result a lot of existing companies invested for growth. This is the first ingredient for trapped capital. The second is the emergence of new businesses with new, better ways of doing things. They suck in new capital. With the development of US shale reserves we have this second ingredient as well. Huge strides have been made in transforming previously prohibitively expensive oil and gas reserves locked up in US shale formations into a low cost source of new oil and gas. Once uneconomic below $80 per barrel oil, now large areas of shale reserves make attractive returns at $40 per barrel. Capital has flooded in to take advantage. Meanwhile new sources of demand, like China, are slowing and new demand destroying technologies, like renewable energy, are shifting the previously benign environment. The industry got a nasty shock in 2015, as the oil price fell sharply again. For a short time investors and analysts worried about whether some oil businesses would survive. The industry responded, production was cut and the oil price has partly recovered. But no capital has really left the industry and now capital is coming back in as US shale producers, having cut costs further, begin to grow again. The trapped capital cycle looks set: too much capacity, not enough desire to exit, most businesses locked into non-mean reverting low profitability, with investor anxiety ebbing and flowing around a slowly unfolding trap. The industry can offer opportunity, but most likely amongst the small number of carefully run disruptors or occasionally when investors worry about bankruptcies in the businesses that will survive, but not ultimately prosper.

Media is an industry as old as oil. People have wanted to consume information and be entertained for a long time; by reading, by listening, by watching, by playing. And people have been prepared to be diverted by marketers and advertisers as they have consumed. Like oil, the demand for media has for so long seemed insatiable. And, like oil, recently there has been a wave of new businesses, using new media, to deliver information and entertainment. Old media originally viewed new media as an opportunity for further growth. How wrong they were. Newspapers have been the first to experience the reality, and their refusal to succumb has trapped them into ever declining profitability. CDs and books, DVDs and now TV are all struggling along the same path. Media companies are reluctant to leave, for capital to exit. The new media companies like Facebook and Google are supremely profitable and fast growing, but the rest are seemingly trapped. Occasionally other sources of bad news converge and create sharp spikes in investor anxiety; recessions temporarily accelerate the pressure. But most media companies are slow to die and so these transient periods of acceleration can cause investors’ anxieties to expect a more rapid demise than is likely. But outside these periods of extreme stress investors’ anxieties are often too hopeful of mean reversion, and they are disappointed.

There is a lot of stress in retail at the moment. Retail is an old, old industry. It has been through a range of significant changes, from the rise of general stores like Sears Roebuck, to the invention of department stores, “super” markets, shopping malls and category killers. All seem to have played out into a forgiving environment of mass materialism and consumerism. People have wanted to buy more stuff and have seemingly absorbed each new store format as it has arrived. The latest iteration, however, may be tipping the industry into trapped capital. Investors and analysts have long worried about western economies becoming “over-stored”, they have also worried about the disruptive influence of online shopping. Neither seemed to have mattered until now. Amazon has destroyed most conventional retailers in books and CDs; capital has left. Now it is threatening almost every other store format, but no capital has left yet. In food retailing, own brand discount retailers are encroaching from below, home delivery from above. In clothing, once thought to be immune from on-line models, consumers are embracing free delivery and easy returns to shop at home. The change has been surprisingly rapid, the response from most retail managers still surprisingly slow. They seem to have made the same mistakes as traditional media companies, mistaking online as an opportunity to grow, to gain new customers, not as an existential threat to their businesses. Profitability is coming down, investor anxiety is building, and stock prices are falling. But management behaviour still looks mainly in denial. A powerful “death of the store” narrative is taking hold, but it does not apply everywhere. Also, for those retailers who accept their plan should be survival rather than growth there is a lot they can do to improve their competitive position and slow their demise (Best Buy is a credible example). The majority, however, looked trapped.

Opportunities amongst the damned do arise in trapped industries, but sporadically. When investors fear for the survival of companies, their anxiety can be misplaced for perverse sounding reasons: trapped industries remain trapped because it is difficult for capital to leave, so many of the companies are surprisingly slow to fail. If a bout of “failure” anxiety coincides with some generally bad economic news (which affects demand) investors can also be tempted to believe companies will fail quickly, when in reality they limp on and survive. In the three industries we have talked about in only one can we sense any investor anxiety over whether companies will fail soon (energy), in the rest anxiety still looks to be building. But successfully investing in any trapped industries is always likely to be challenging.


The UK stock market is an oblique window on the world. It contains many of the world’s largest mining companies and a few of the largest oil producers. There are companies selling booze and cigarettes, cough medicine and treatments for asthma. And in the undergrowth, only marginally influencing the path of the FTSE 100 Index, are businesses buffeted by the UK economy.

As previously mentioned, for most companies it is getting harder to grow, making normal management behaviour risky. In our view, a fast growing company can miss growth targets and allow costs to run ahead of new sales. A slow growth company can be too slow to recognise disappointing sales or pricing is not fleeting, but long lasting. They hang on to old plans for too long. We see evidence of both in the UK.

Faster growth slowing down is most obvious in healthcare. There are a few global speciality pharmaceutical companies quoted on the UK stock market. They have found it easy to grow for many years. Both Shire and Hikma do a lot of business in North America. Until recently they have been able to grow easily through a combination of new drug launches and higher prices. But it isn’t so easy now. Growing by pushing prices up, in particular, has become much more difficult. We have seen some very high profile businesses in North America run into trouble as the tougher environment has evolved and their company’s managers have pushed on with old growth plans regardless; Valeant and Endo for example. Usually when economic risk is rising, investors are tempted to buy healthcare stocks because demand for drugs is usually left unscathed. They look safe. We don’t think Hikma or Shire are safe now though.

Growth disappearing altogether is most obvious in two quite different areas: retail and mining. Most UK based retailers are admitting that growth is harder. However they have mainly been blaming fickle or pressured customers, who they expect to return to their old ways. Food retailers seem to believe austerity minded shoppers will become more relaxed. Clothing retailers seem to believe that political convulsions around Brexit have temporarily neutered spending, or millennials shifting priorities towards eating out will settle down. Both areas of blame look dubious to us, and cover up an unwillingness of company managers to accept that growth is slipping away and not coming back soon. Many of the UK’s retailers have been behaving like the UK is in a recession, but many other businesses, which rely on the UK’s populations’ desire to spend money, have not. Aldi and Lidl are prospering. So are ASOS and BooHoo. Carnival Cruise fills its cruise ships. BMW seems to sell all of its Minis. There isn’t much evidence of a recession (yet). Instead, what is going on is more competition (not less demand). So when Next or M&S complain about disappointing sales and blame the economy they are, in our view, in denial. People are spending their money differently with businesses which give them what they want better or more cheaply. This isn’t going to change quickly. We are not in a recession yet, but if we are heading for one, life is going to get a lot more disappointing for those retailers that are already losing.

Miners are also having a tough time. Demand is still there for what they produce, but new demand hasn’t been quite up to expectations for five years now. The people who run these businesses have gone through a period of blaming others for missing their targets, blaming their peers for behaving irrationally, until finally accepting conditions are not going to get easier quickly and running their businesses accordingly. Unlike UK retailers, who still look in denial, miners like Anglo American and Rio Tinto look like they have accepted the world has changed, and are now thinking more about risk than opportunity.

How company managers are behaving is only one part of the puzzle that drives stock prices. The other is what other investors believe, or how they feel. If investors are anxious and managers are behaving in a risky way stock prices tend to keep going down, in our view. Anxiety, if you like, is not misplaced. If investors are anxious but management is taking action to reduce risk then anxiety is more likely to be misplaced and the stock price can rise, despite apparently bad news. Hence we argue that investors are anxious about UK retailers and speciality pharmaceutical businesses, but not anxious enough given management behaviour. Whereas investors are anxious about miners and sceptical about a recovery, but managers are behaving sensibly, reducing risk, so investors scepticism is more likely to be misplaced.

There was a burst of widespread anxiety a year ago, when the vote for Brexit was passed. Instinctively investors believed that Brexit was bad and a recession would ensue. A year later and we are not in a recession. The housing market has not collapsed. But this does not mean these things will not come to pass. For the first time in a long time the agenda for monetary policy (controlled by the Bank of England) and the agenda for fiscal policy (controlled by the government) are diverging. Inflation is building, the currency is weak. This puts upward pressure on interest rates. But most people are struggling and unhappy and want the Government to spend more (and tax more). This makes for a stressful economy. The impact on the UK stock market is complex. Many large UK based companies are unaffected by the UK economy and are helped by a weaker pound. Their influence on the FTSE 100 Index is greater than those tied to the UK economy. This makes for an unusual situation. Bad news is not necessarily bad for the UK stock market, especially if you avoid risky management behaviour.

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This material is for distribution to Professional Clients only, as defined under the Financial Conduct Authority’s (“FCA”) conduct of business rules, and should not be relied upon by any other persons. Issued by Ardevora Asset Management LLP (authorised and regulated by the FCA). Registered office: 6 New Bridge Street, London EC4V 6AB. Registered in England No. OC351772. Tel: 020 7842 0630. Past performance is not a guide to future performance. Care has been taken to ensure the accuracy of this document’s content, but no responsibility is accepted for any errors or omissions herein. The views expressed do not constitute investment or any other advice and are subject to change. In particular, we are not recommending or expressing an opinion on the merits of buying or selling any securities mentioned herein.

Previous Commentaries

Quarterly Commentary Period ending March 2017
Annual Commentary Period ending December 2016
Quarterly Commentary Period ending September 2016
Quarterly Commentary Period ending June 2016
Quarterly Commentary Period ending March 2016

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