Ardevora Annual Review – 2017

I like Hawaiian shirts, but only on Fridays

There is always plenty to see. We fall into bias when we only see what we want to see. Sometimes it happens when loud, or garish information drowns out more nuanced, relevant information. 2017 was like a Hawaiian shirt convention.

We, like many in our industry, rely on Bloomberg for our news. Our Bloombergs blared Bitcoin, Brexit and Trump all year; Trump the most, as he tweeted and tweeted and tweeted. He was the late Sixties, swirly patterned, neon coloured Hawaiian shirt. So, so loud and confusing. Between the psychedelic Trump came Bitcoin. And bubble. Bitcoin obsession came seemingly from nowhere. At the year’s start, crypto currency was hardly heard of. By Christmas, I was cornered by a dentist from Toronto, desperate only to talk about Bitcoin. Interlaced between these two wild extremes was Brexit. Every month, headlines dribbled on stalled negotiations, falling London house prices, and the impending exodus of finance jobs. This exhausting cacophony did not matter, it did not help to understand what drove markets last year. Barely noticed, but highly impactful, was surprisingly strong global growth. Sifting through small pieces of duller information suggests the surprise came mainly from China, its seeds in the partially obscured traumas of 2016.

We look for information which can help us understand the behaviour of three groups of people: company managers, financial analysts and investors. Once a year we take stock, sift through the information we think is important and try to understand why markets behaved the way they did. The first thing that jumps out to us is error.  Financial analysts, who make forecasts for companies’ profits, were unusually wrong last year. A strangely large number of stocks delivered surprisingly strong profits in 2017.  The pattern of financial analyst error looked unusual, through time and across sectors.

In 2015-16 there was a major shock. A very large number of stocks suffered a lot – poor stock price performance fed by disappointing profits, which reached its crescendo in the first quarter of 2016. A complicated mix of overzealous management behaviour in natural resource industries and government driven changes in the Chinese economy may have been the cause. When we look at the pattern of financial analysts’ error through time, it looks like we walked into a global recession in late 2015 – lots of economically sensitive stocks had profit warnings.  The pattern since early 2016 looks a lot like a post-recession recovery. We have been trying to figure out what drove this pattern and why it seems to have gone largely unnoticed. We think it was all about China.

We think the stutter of 2015-16 was caused by the Chinese desire to shift their economy away from “old” style heavy industry. We think a centrally driven push to restructure poorly performing, inefficient old industries and the pursuit of a tighter environmental agenda caused a break in economic growth,  growth which had previously spilled out of China to the benefit of a wide spread of non-Chinese companies. The stutter, we think, caused the hidden recession of 2015-16 and judging by the pattern of financial analyst error, most people didn’t see it coming.

But after the first quarter of 2016, it looks like the changes started to work. Apparently gloomy news on Chinese debt and zombie old economy businesses struggling was really a symptom of positive change. The Chinese economy was shifting into new industries and the nature of Chinese growth was changing. This explains the marked shift in analyst forecast error after March 2016. There was a rapid jump in the number of emerging market stocks beating profit forecasts, spread across almost every sector, both industrial and consumer facing.  But the way it spread out to the rest of the world looked different in a number of subtle ways. For us, it explains the surprises of 2017.

First, industrial technology stocks felt the benefit quickest and the most. Tech companies tied to industrial investment, not to the consumer, have seen explosive growth and surprised the most. China is investing aggressively in automation, production efficiency and R&D heavy industries. Second, outside a few notable exceptions (autos and luxury), consumer facing non-Chinese stocks did not benefit much. This has been especially obvious for powerhouse consumer branded companies. They benefited from the early phases of Chinese growth but now look increasingly locked out. They are struggling to grow. We detect a deliberate shift in Chinese priorities to drive the development, wherever possible, of domestic consumer brands to supplant non-Chinese ones. Third, there have been old economy beneficiaries but not from demand per se; more from the shift in Chinese priorities to efficiency and environmental protection. Vale, Rio Tinto and BHP Billiton have overcome tepid steel demand by offering a superior quality product, supplanting less efficient alternatives; a wide range of industrial chemical companies have seen their profitability surprisingly boosted as Chinese competitors have struggled with new environmental regulations. Fourth, Chinese companies are beginning to leap-frog overseas rivals, turning their attention to competing outside of China. ANTA is pushing hard in athleisure, Geely in cars.

It looks like China has successfully rebalanced its economy, but it looks like the US is trying to unbalance theirs. Trump only managed one thing last year – to get a tax reform bill passed. It looks like an exercise in fiscal stimulus, applied when there isn’t much slack in the US economy. Wage pressure is building, the Fed is tightening. China looks safer than the US from here.

China seems to hold the key to relative success for stocks. It seems to be driving sustainable growth, yet our sense is its importance is still down played. Another year of surprising growth looks in store.

Global review

Winners kept winning last year. This tends to be stressful. When a stock has won for a long time, by a lot, it is easy to worry it has become too loved. Trying to gauge this is hard. It is the trauma of success. We had a successful year last year. Many of our stocks went up, having already gone up a lot. Towards the end of the year we decided to sell some of them. We think growth can still be easy for them, but we want to see how they behave through the first half of 2018, to see if we notice something different when we don’t own them (we have learnt from experience, the endowment effect can be a source of bias).

Our stock selection leans on our views of the behaviour of three groups of people: company managers, financial analysts and other investors. First we take a view on a stock’s management behaviour. We think company managers can be over-confident and mistake risk for opportunity. We look for situations where it is harder for them to get overconfident, or where the damage they can do is curtailed (perhaps without them realising). Our approach can give us a paradoxical looking attitude to growth. We like growth companies if we think the availability of growth is easy. When growth is easy, company managers can pursue growth without having to overreach (and create risk). We think most growth companies get into trouble when growth gets harder; we think company managers are not good at recognising when growth is getting harder and so pile on risk at the wrong time. Last year, growth got easier for quite a few companies. As a result, we had a good year.

We are usually pretty bad at forecasting where growth will get easier. Instead we try to gauge how company managers are reacting to what they see now, and how their behaviour is unfolding through time. We take cues from accounting information that provides insight into capital allocation decisions and its effectiveness, and we look for clues in management statements about how they are feeling about their environment. We like either stability and calm, or hints that life is getting easier. Once we have spotted stocks where this seems to be true, we try to work out whether they have anything in common; why things seem to be improving. It is a complex and messy task and there can be a lot of noise to cut through.

We did a bad job at cutting through the noise in the energy sector. We were slow to recognise the industry was on a diverging path from mining. We compounded our error, by working out we were wrong at about the worst time.  When we think we are wrong we get twitchy and are drawn to mea culpa; we like to recognise our error and move on. Our timing was poor, we locked in losses just before the oil price bounced.

We were bad at cutting through the noise in the global car industry. We were diverted by the obvious anxiety over car loans and allowed this to swamp other information. Otherwise, we were quite good at capturing the opportunity for owning growth stocks with easy growth. We found plenty in technology, generally in those serving other businesses (rather than making products for consumers), healthcare, where fearful flare-ups over Obamacare repeal helped create anxiety, and unusual industrial businesses that found growth easier as the year unfolded. We captured some extreme looking anxiety in US retailers in the second half of the year, but as we mentioned earlier, we got in a tangle over energy businesses and so missed a second half opportunity there.

We suspect this year will unfold similarly to last, but it is easy to be wrong on such assertions. Trump continues to confuse and the recent tax reform is likely to create difficult to forecast consequences (good and bad). We think growth is still quite easy if you are in the right areas. Prior gloom over oil, or the death of conventional retailing, has dissipated. Investor anxiety seems focused, once again, on 2007-09: an implicit worry the market cannot keep going up, the economy cannot go on uninterrupted. We worry most about inflation, but this is a slow creeping beast. For now it still seems to sleep.

UK review

A tricky year last year; Brexit fog and a volatile exchange rate created a lot of noise. The UK economy got tougher as the year wore on, with signs of stress emerging in businesses more sensitive to the UK economy. In UK Equity our stock selection was reasonable. We were most rewarded for growth with Dechra Pharmaceuticals, our top contributor. Holding our nerve in global miners also helped; despite a poor first half, anxiety ultimately receded again and they performed well. Shorts in retailing and outsourcers gave a boost to the short book. But some misreads in stocks such as Merlin Entertainments and Tesco hurt us, as well as our short in Sports Direct which held us back. We have admitted defeat in all these positions and moved on.

We still believe the UK market is a curious mix of opportunity and risk. We continue to run shorts in UK retailers and outsourcers. We also distrust some of the more acquisitive healthcare stocks. On the longs, we still like miners and growth companies which aren’t tied to the UK economy.

In UK Income our stock selection was reasonable, but our larger position sizes in stocks with higher dividend yields swamped us; our performance was dragged back by larger positions in stocks such as GlaxoSmithKline and Imperial Brands weighing more heavily than our lower yielding successes such as Dechra Pharmaceuticals. We have held larger positions in higher yielding stocks to keep our overall fund yield up. This is the second year in a row where our successful growth stocks have been swamped by our sluggish yield stocks. We think it is time for a slight change in approach. We have decided to meet our income constraint by buying a few large, “safe” FTSE stocks with above average yields. This has released some money to increase our position sizes in some of the lower yielding growth stocks we like, and should give us a better balance to the fund.

Important Information

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 September 2017
Quarterly Commentary Period ending June 2017
Quarterly Commentary Period ending March 2017

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