Ardevora Quarterly Review - First quarter 2018

The technical obsolescence of the couch potato?

Last quarter was modestly loss making for global stock markets, with MSCI ACWI down around 1% (in dollar terms). Loss making quarters happen fairly regularly in stock markets and last quarter didn’t look unusual. It was the seventh losing quarter since the market low in Q1 2009 (29 have been rewarding out of the 36); the -1% loss doesn’t look bad compared to the average of -7%. But somehow it has felt more uncomfortable. There are a couple of plausible reasons why.

First, it has been an unusually long time since the last loss (Q4 2015); we have had eight consecutive quarters of gains. Long consecutive runs of gains tend to polarise emotions among investors. The more experienced of us worry more, the longer the run. We are familiar with the pain of loss and grow increasingly restless in anticipation of the next one. Less experienced investors can feel differently. They (if my recollections of youth are anything to go by) are more tempted to conclude stock market investing is easy and risk free. Eight unbroken quarters without loss is rare, especially since 2008. Before 2015, the rhythm of gains and losses was more along the lines of two or three quarters of joy and one of pain.

Second, stock markets usually hurt when investors worry about new things (or they remember old things to worry about which they have previously forgotten). This time, the worries have been a change from the usual post-2008 flashbacks of the Global Financial Crisis. Investors have remembered times of rising interest rates, inflation, trade wars, and how all long periods of gains in stock markets (the “bull market”) always come to an end, and have worried. The different source for anxiety may explain some of the apparently perverse sector returns last quarter.

Tech was the best performing sector last quarter, and was positive. Tech is conventionally considered risky and is expected to perform badly in a down market. Consumer Discretionary was the next best and was also positive; again this sector usually does badly when anxiety is rising. Financials were the third best and in positive territory. Their performance seems to make more sense, with a bit of creative thinking. Investors were worrying about the prospect of rising interest rates. Rising interest rates usually cause investors to worry about Financials (credit quality), but the long period of very low interest rates has squeezed profitability for banks, so the prospect of an interest rate rise is good for banks’ profitability. The worst performing sectors, leading the market declines, were Telecoms and Consumer Staples. Both are usually considered “safe” and “defensive” and a good place to invest if you are worried about the market.

To make sense of the apparently inconsistent sector moves it is worth exploring two questions.

First, what are the implications of rising interest rates and which kinds of businesses might prosper or suffer? Second, why might Tech be a safer place than Staples (or was the last quarter an anomaly)?

Banks should do well when interest rates start to rise from close to zero. They can rebuild some net interest margin but they shouldn’t have to worry too much about credit quality, having gone through a long cleaning up period for their loan books since 2008. But after the first few rises, more familiar factors come into play: higher rates can choke credit demand and affect credit quality. For Financials, early joy over rising interest rates can be followed by slowly building anxiety.

Interest rates don’t move in isolation. They usually go up in response to changes in inflation (or to be more accurate, inflationary expectations). For the first time since 2008, accelerating inflation rather than deflation looks more likely. In our experience, stock markets don’t like accelerating inflation, but they do tend to give you more protection than most other asset classes. Also, not every stock feels inflation in the same way. How a business operates affects how it is able to cope with inflation; how it copes with inflation tends to impact its stock price. Weak businesses can be bullied by their suppliers, their workforce and their customers, and will struggle with inflation. Their costs will tend to go up faster than their ability to raise prices. Strong businesses need not fear inflation; often it makes growth easier. What a company does (its sector, for example) is far less important than how it does it, in our view. This brings us to the apparently inconsistent recent behaviour of Tech and Consumer Staples.

We like finding ideas in Tech, but we are wary of Consumer Staples. The Tech sector elicits two anchor views from most investors: high risk and potentially fast growth. We think it is common for investors to frame sectors which can contain fast growing stocks as risky because they worry that if one company is growing fast, another must be losing somewhere. The history of Tech is littered with such examples: Nokia wins, Motorola loses, Apple wins, Nokia loses and so on. Success in Tech feels transitory and risky. Consumer Staples have different anchor emotions: comfort and familiarity. Staples seem to have endured forever and success does not look ephemeral.

The Tech sector is diverse, containing businesses as different as Apple, Google, NVidia, Facebook, Applied Materials, Microsoft, IBM, Salesforce and Cisco. They are diverse because the way they make money is so different. In our framework of cognitive bias, we are drawn to sectors that are heterogeneous. We think it is easy for investors to reach general views about a sector and then inappropriately apply them to businesses which are really pretty idiosyncratic. This makes for error from bias. In our view there are plenty of safe, defensive and robust businesses in Tech. If you are worried about the world, there are plenty of places you can hide in Tech – in stocks with loyal customers, pricing power, strong positions with suppliers and seemingly bullet proof balance sheets. Crucially, from a management behaviour perspective, there are plenty of businesses where there are opportunities to grow which keep CEOs’ egos safely inflating. While it is still true there are plenty of Tech businesses that are losing to current winners, the sector has matured, so now losers are just as likely to be found outside the sector as within.

Staples may look safe, but many do not have crucial properties which can insulate them from impatient management behaviour. Some of the reasons why they have looked safe are being eroded; some are starting to lose to Tech. Staples rely on the habituation of their customers. They have successfully used the commercial application of psychology (advertising) to bombard their customers, using traditional media (print and TV), with messages designed to convince them to be lazy and disregarding of price. But technology has systematically attacked a number of these previously successful strategies. Technology now makes it much easier to search out reliable alternatives and to compare prices. Technology has weakened the power and influence of traditional media in shaping customers preferences. Technology has weakened the habitual patterns of consumption. Conventional retailing, conventional media and conventional branded staples are all part of an ecosystem which captures and manipulates customers. Technology is attacking conventional retailing and media; in our view this weakens the businesses built on its foundations. Consumer Staples companies look lazy and lacking opportunities to grow. In our experience this can often lead to risky, destructive management behaviour.

Hence, we do not believe the last quarter was an aberration: if you are looking for long term safety, you are better off hunting in Tech than in Consumer Staples.

Global Review

Depending on your currency, we either lost a little (in £) or gained a bit (in $) last quarter. Whichever currency you chose we did manage to squeeze out a bit of outperformance over MSCI ACWI. Most of the outperformance came from picking enough good stocks, but as always we had plenty which did not perform so well. This is usual for us and why we hold a lot of positions (around 200); we know from years of experience, investing is a game of probabilities, with lots of noise and plenty of opportunity to be wrong. While it might be fun to gloat about our successes (our purchases of Sartorius and Twitter looked particularly smart last quarter), there is always the uncomfortable list of stocks sitting in the smelly bottom twenty contributors to remind us we are not quite as smart as we would like to believe.

We were helped by our attraction to Tech: a modest overweight added around 20bps to our performance which more than offset the drag from owning stocks in the Materials sector. Being dubious about the merits of Telecom and Energy stocks also helped (although the latter doesn’t look so smart this month). All are low impact though, as our performance still tends to come from the accumulation of lots of small bets rather than a few whoppers.

The two aforementioned successes of the quarter – Sartorius and Twitter – nicely illustrate the eclectic outcomes of our approach. First, we have to be convinced a business makes sense. We need to be convinced it is worth trusting the managers of a business to behave in a sensible and potentially rewarding way. Trusting management is risky and we are risk averse. We are prepared to trust management in two general situations.

One is where we think a business has got into trouble, but can be fixed if its managers focus on the right things. This is how we would frame Twitter. Twitter is an unusual business with some attractive attributes. It has millions of users, who habitually use it. Once persuaded, a user is relatively cheap to keep engaged and there is plenty of potential to make money from their usage. The problem, until recently, is that the managers of Twitter have been pretty bad at working out how to turn habitual use into good free cash flow. Luckily for us they were particularly effusive and overconfident about their plans on IPO. Their overconfidence puffed up the hopes of investors and forecasters, only to be quickly dashed by disappointment. A long period of disappointment and concurrent stock price falls tend to build pressure on managers of a business to do something sensible and view opportunities a little more realistically. Management can get boxed in and are forced to concentrate more on risk than opportunity. We like that. We have seen enough similar situations to believe the discomfort of a previously ugly stock price and deep forecast misses are worth a closer investigation. But we also know it’s an odds game, and Twitter could be sitting in the smelly list of poor performers when we next write about our performance.

Sartorius is an example of the second type of situation where we are prepared to trust management. We like businesses with an unusually benign environment for growth and where their ability to achieve growth should be pretty easy, if management behave sensibly. Sartorius has lots of opportunity at the moment. It makes equipment used in the research and production of biosimilars. Drug companies around the world are very interested in the potential for biosimilars and are keen to conduct research into them. There are only a handful of companies making the equipment needed. The equipment also requires servicing and disposables, which generates good money for a company like Sartorius. To us, Sartorius’ management seem to be taking advantage of their current good fortune in a reasonably unhurried, sensible way. Businesses like Sartorius often turn out to be good investments despite their attractive qualities being quite obvious. We think it is surprisingly easy to forget how unusual the combination of good business, good management behaviour and easy growth can be, and for how long it can go on for a company. When a stock is sitting amongst thousands of others who are all shouting for attention, somehow investors and analysts can get surprised at how long such a business stays “good”.

We made similar convincing arguments for Minth (a Hong Kong based maker of car parts) and Navistar (an American truck maker), but they didn’t perform well last quarter. Sometimes the market doesn’t care and sometimes we are wrong. Fortunately, we were slightly more right than wrong last quarter and we outperformed despite it being a tricky quarter for global stock markets.


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