As we predicted last month…. in an article titled Hugh Hendry Bet Big On Chinese Futures Ahead Of Crash
Below is Hugh Hendry’s larest letter to investors.
Hugh Hendry’s CF Eclectica Fund commentary for the period ended June 30, 2015.
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Discretionary Global Macro
The investment objective of the Fund is to achieve capital appreciation, whilst limiting risk of loss, by investing globally long and short mainly in quoted securities, government bonds and currencies, but also in commodities and other derivative instruments.
Hugh Hendry’s CF Eclectica Fund – Performance Attribution Summary
- A late sell off in European and Chinese equity markets saw the Fund book a loss of -1.2% for June.
- Equities gave back -3.2% in aggregate with European stock holdings across pharma, property and telecoms accounting for the majority of losses.
- Italian index futures also suffered as the Euro Stoxx 50 dropped -4.1% towards the very end of the month as the Greek PM called for an impromptu referendum on the adoption of proposed bailout conditions.
- Chinese index exposure, reduced by half from the mid-April high following a tremendous run, cost the Fund a relatively modest -0.8% as a sharp sell off (the specific catalyst for which was less apparent) triggered the widespread liquidation of leveraged margin positions.
- Losses from the long equity book were partially offset by shorts on oil services companies as a further fall in the price of oil, prompted by the prospect of increasing crude shipments from Iran, added to the general negative sentiment.
- The overall loss for the month was significantly pared back by gains from fixed income positions which returned a combined +1.8%.
- Our short on Italian BTPs was particularly profitable as yields spiked on concern over the apparent deterioration of the situation in Greece and additional gains were to be had from our Mexican interest rate receivers, Eurodollar call spreads and European inflation swaps.
Hugh Hendry’s CF Eclectica Fund – Manager Commentary
Our enthusiasm for a shift to a global policy promoting higher wages has proven contentious. Nevertheless, the UK has become the latest advocate of such a demand boosting initiative with the newly re-elected government announcing plans to raise what it terms the “national living wage”. By 2020 British businesses will be mandated to pay at least $14 per hour for employees aged over 25, a rise of almost 40% which affects at least 20% of the distribution of wages in the country. Despite prominent businesses such as Ikea, the large Swedish retailer with 9,000 UK employees, announcing its intention to adopt the plan, the initiative set off the usual chorus of alarm bells that such policies run the risk of destroying jobs and investment in the UK.
Phrases such as “economically useless and intellectually empty…” tend to be the customary riposte to a controversial vision of the future and yet they say nothing to counter the Henry Ford notion that if workers have more money, businesses have more customers. And it conveniently sidesteps the evidence from America where the highest rate of job growth by small businesses is occurring in those states and cities with the highest public mandated minimum wages. As I write New York seems set to become the latest US city to enact a $15 per hour minimum wage for fast-food workers versus the current rate of $8.75. Henry’s insight, it seems, is spreading like a rash.
The recent experience of the UK economy is also insightful; the country has never employed more people than it does today with jobless claims at the same low level as they were pre-crisis in early 2008 and the unemployment rate is now only 0.8% higher than in 2005, when it was probably close to full employment. And yet despite such achievements, economists tend to fret over what is perceived as an enduringly low level of productivity and the menace that, with the tightening of the jobs market, the central bank will be forced to hike interest rates.
This perpetual phantom, the speculation that central banks will have to hike rates and produce a rout in stock prices (in Japan the fear stretches as far back as 25 years) reminds me of the sad case of Steve Feltham who gave up his job, house and girlfriend 24 years ago to live in a van and devote his life full-time to looking for the Loch Ness Monster. Reality dawned last week when he gave up his whimsical pursuit concluding that he had probably been duped all along by the rather more prosaic theory that the images most likely captured large catfish first introduced to the area by the Victorians for sport fishing.
The great mystery of the UK’s curse of low productivity, its likely debilitating effect on domestic corporate profitability and the perceived need for British rate hikes are all like the mystery of “Nessie” probably made obsolete by recourse to more humdrum explanations. To us, the path to British recovery owes much to the early initiative of the previous government to boost wages for low income groups by increasing the tax-free allowance by 54% from £6,475 to £10,000. This dramatically increased the supply of labour – both from those previously willing to abscond and accept generous welfare payments as well as non UK residents lured by this effective take home after tax pay rise of c.11%. The blossoming British recovery therefore probably owes much to this boost in wages which also explains the spectacle of an economic recovery that has been dismissed as job “rich”/productivity “poor”.
What nonsense. Britain’s “productivity problem” seems to owe its existence more to the semantics of economists insisting that it be measured on a per hour worked basis, than the evident reality that having people sit idle receiving state benefits is perhaps the ultimate drain on total productivity. Thankfully, with British public policy initiatives having widened the reach of the labour market to better capture this lower paid and inevitably less productive workforce it seems inevitable to us that we should have recorded a stagnation in the productivity growth of the average British worker. Who really cares? This de-facto wage boost has increased the total production of the British economy, generated fewer transfer payments and allowed a younger generation to enter the workforce, something which is sadly lacking in other parts of the European economy. And by enriching consumers, corporate profits are rising and the economy is expanding without threatening an uptick in inflation.
This helps explain our current enthusiasm for the recruitment sector where share prices are breaking out of a long fifteen year bear market relative to the broader stock market. Such businesses are an excellent play on improving and tightening labour markets globally as they are only just starting to recover from a savage downturn. Consider that in 2014 the staffing market in France was 32% below its 2007 high, the UK/Ireland 30% and Japan 42%. Source: Adecco Investor Presentation
The stocks remind me of our positive experience back in 2004 investing in the oil services sector when share prices were just breaking out from a long bear market. The better companies had managed their downturn well and as a result traded at valuation levels which seemed to exclude the prospect for large price upside; instead one had to believe that the oil price was going to triple – something that no analyst would ever dare to publish in their valuation model.
With the global jobs markets recovering we believe the dynamics of the recruitment industry are set to change positively in a manner yet to be captured by DCF models. These companies double dip – they get paid their fees as a share of higher wages, and then if the job market strengthens sufficiently, staff turnover goes up as workers become willing to forgo job security, tenure and safety from the tyranny of ‘last in first out” style job cuts in order to chase more lucrative salaries elsewhere. This is the golden period when the recruitment agencies get to have their cake and eat it. The real gearing therefore comes in the companies exposed to the permanent hiring end of the industry; in Europe, that is PageGroup, Hays and Robert Walters.
And it is this latent additional kicker that is typically excluded from investment banks’ research. Say it quietly, but if things really improve, in the manner that we can envision, and clients want to turn more temps into permanent staff, the staffer receives a fee which provides an incremental income stream which is very high gross margin and comes with minimal additional cost.
The UK names are perceived as low growth cyclicals where margins seem to have fallen structurally since the mid-2000s. It is exactly the same argument I heard time and again ten years ago as British pension funds shunned the commodity mining sector; plus ça change! Hays used to make 10% profit margins but are forecast to make just 5% and the stock sells for 0.6x sales whilst PageGroup, which made 18% margins at the peak but now reports just 8-9%, trades on an EV/Sales of 1.4x. Source: Company Annual Reports
As I said in my introduction, it seems the market has been reasonably efficient at pricing these businesses. But from experience I am willing to bet that as the tide turns the extreme profit gearing to economic cyclicality will make a mockery of analysts’ modest expectations and with the stocks enjoying very strong balance sheets and 2-3% dividend yields the sector seems ripe for lift off.