Don't let hope get in the way of sound investment decisions

For the last 27 years I have been trundling back and forth on a little commuter train across the iconic Forth Bridge from Fife to Edinburgh on my daily journey to work. There is a soothing familiarity in the routine which allows one to contemplate the day ahead or to decompress on the return journey from another day dealing with the hurly-burly of capital markets. The most observant readers (who should probably get out more) might recall that we featured this exact journey back in 2015 when we observed the changes in the way commuters were consuming media—an observation that helped us make an investment in the company formerly known as Facebook.

In a post-pandemic world, I am now only taking the train three days a week. I also have a small dog who joins me on the journey and has become our de facto office mascot. Life is different now. Equity markets and economies are different too; geopolitics have deteriorated and barriers to trade have increased while the threat of global warming looms ever larger. This short essay is an attempt to bring some perspective to this while giving a view on where we are in markets today and what might happen next.

My train is still filled with people messaging, shopping or consuming media on their phones. But the conversations with other passengers which are struck up because of my four-legged co-commuter are most definitely a welcome change. I recently bumped into a former nurse who had changed careers to work on the railways citing better pay and conditions.

This is a cause for concern. In developed countries, we have many things we need to do over the next decade – we must develop more efficient and lower-emitting power, transport, industrial and real estate infrastructure. We also have a responsibility to provide better healthcare to our increasingly aging populations. Bottlenecks in labour markets could potentially delay progress in these areas and hearing that skilled labour is being forced to quit one in favour of the other is unhelpful. One can only hope that immigration policies become more liberal as politicians act in the long-term interest of their populations rather than simply short-term political expediency. Unfortunately, this outcome seems less than certain if past is in any way prologue.

Returning to markets, as an active investor and an avid fan of one of Scotland’s lowest-ranked football teams, I am more than familiar with the phrase “It’s the hope that kills you”. Currently, there is more than a nagging sense that this could be applicable in markets today. A year ago (in “History rhymes”) we identified that parts of the equity market looked like they were in a bubble. The most speculative and risky assets like Bitcoin and early-stage technology companies subsequently fell dramatically as higher interest rates and tightening liquidity caused previously virtuous cycles to become vicious. High-flying market leaders fell sharply in 2022 with Tesla, Alphabet, Amazon and Meta platforms all declining between 39 and 65%. The downturn in cryptocurrencies and the related collapse of intermediary businesses was also well documented as Bitcoin itself fell 65% during the year. Correctly identifying this likely outcome and avoiding the most overvalued areas helped us weather the storm in 2022 relatively well (though it was still challenging as a manager of growth and quality companies).

Fast forward to Q1 2023 and—if observed in isolation—investors would be forgiven for wondering if 2022 had even happened. The spillover of stresses in the financial system led to the failure of SVB Financial and the bail-out of Credit Suisse through its merger with UBS. Challenges in the regional banking sector in the US continue and look like they will have meaningful ramifications in the commercial real estate sector. Meanwhile, the desire to own defensive quality companies combined with the perception that we are approaching a peak in inflation and interest rates prompted a stampede into the very companies that had fallen the most in 2022. In Q1, Tesla, Alphabet, Amazon and Meta rose by between 17 and 76% in three months. With seven stocks accounting for more than 85% of the market’s advance, (of which we only owned Microsoft) this represented a very challenging period for our strategy. We remain concerned that the top-line growth and future margin assumptions for many of these businesses look too high and it may be difficult for these companies to maintain leadership in the market should earnings and cash flow disappoint. Time will tell but the fact remains that our strategy has not been this wrong-footed in any one quarter since Brexit and the election of Donald Trump as US President.

So, what are we doing now? Well, we are grappling with the following difficult questions…

• Could we be wrong that the hope being placed on FANNMAG stocks (or whatever other acronym people care to shoehorn in) or in AI may be overly exuberant?
• Are markets in the equivalent regime of the LTCM and Asian currency crisis of the late 1990s—the policy response to which (along with the Y2K effect) caused the internet stock bubble of 1999–2000? Might we be only in the foothills of an even greater speculation about to unfold?
• Or are we in the aftermath of the bursting of a psychological market bubble in speculative assets during which we typically see dramatic short-term rallies of between 80 to 100% before the downtrend resumes? This is akin to 2002 post the internet stock bubble bursting and can be seen in a range of downturns from Japanese equities to commodities and emerging market assets at various points over the last 40 years. In this scenario, we are almost certainly facing a recession and the potential for further falls in profits and cash flows.
• If this is 2002 and the tech bubble has burst, what will take up the position of market leadership over the cycle that subsequently follows? Could it be energy transition companies that help us solve the major social and environmental problems we face? Might it be the healthcare sector which must innovate to solve the conundrum of caring for more acutely ill aging people with fewer resources? Could emerging market assets come back into fashion after a decade or more in the wilderness?

While we research these big questions (many of which are imponderable), we remain focused on our search for companies that we feel can improve their return on capital through the cycle. For consumer-facing businesses, we favour those in the service sector where the recovery from the pandemic continues to play out. Travel-related companies, auto parts distribution and food service firms all look to have solid demand outlooks with improving returns on capital. These are the features we like. Similarly in financials, our lack of banking exposure has been helpful, and we continue to be invested in insurers and increasingly in banks with a skew towards emerging markets like HDFC in India and Bank Mandiri in Indonesia.

The lagged effects of the pandemic and the tightening of financial conditions for startup firms have caused some of our healthcare holdings to experience volatility. But as these factors begin to normalise, we are confident in the longer-term prospects for these firms and valuations are looking much more attractive. Equally in industrials, some of our cyclical exposure feels a little early but we need to look over the horizon to what may lead in the next cycle, and we still believe that solving the major challenges of energy transition will represent significant opportunity in the future. The secular trend of reshoring supply chains is also supportive.

Technology remains a conundrum. To expect a sudden increase in internet advertising to justify recent share price moves seems a little naive. First quarter results from Netflix and Tesla suggest some of the Q1 high flyers may have gotten too close to the sun. AI, however, could represent a very large and disruptive product cycle with applications as yet undiscovered. We plan to do more work in this area but in the meantime have added to our position in Microsoft given the potential market share gains they might make in internet search using their ChatGPT platform.

You can probably tell that I did not use AI to write this article—perhaps I should have. Meantime I will continue to take my train to work with Benji searching for companies we believe can stand the test of time. I am looking forward to the conversations we will have along the way: there is something uniquely human about that which is in itself soothing and a source of comfort which I am not sure AI or a fleet of robotaxis could provide. Now if only my train driver would show up for work more regularly…

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The future return on investment and the growth of a company's cash flows are key focus points. Iain's team seek companies where the future is not reflected in today's valuations. 

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