Logos LP letter for the year ended December 31, 2016; titled, “Three Year Anniversary.”
“The best thing a human being can do is to help another human being know more.” –Charles Munger
Is there a link between intelligence, knowledge and successful investing? At first glance, it might appear as if there is. Wall Street is known for only hiring the best and brightest. However, some of the world’s most successful investors didn’t attend the world’s best universities and don’t claim to have a higher than average I.Q. Read More
When Matthew and I started Logos LP from our apartment in downtown Toronto, we had no idea it would become the kind of firm it is today. Even before its inception it was only a beta version of a pure alpha strategy we developed in Montreal while studying for the bar exam. Oh how far we have come as our firm today has grown assets over 600% in less than 3 years, all the while providing an outlet to share our knowledge globally.
Nevertheless, we still have the same purpose beyond making money to guide us: To empower organizations and individuals to solve meaningful problems and have the confidence and ability to shape their own futures. In the furtherance of this purpose we have two ambitious goals. The first is to maintain a compounding machine that will create transformative generational wealth for our unitholders over the course of the 21st century. The second is to spread knowledge to assist our community in becoming more thoughtful investors but most of all more thoughtful humans. We are proud to say that we are on track in achieving both these goals over the long-term.
Although this has been a journey with highs and lows like no other, it has been a wonderful 3 years and we are excited to see what Logos LP will accomplish in the next 60 years and beyond. Nevertheless, perhaps more so today than ever before we believe that the only truly reliable source of stability is a timeless inner core and the willingness to change and adapt anything and everything other than that core.
What is our core? Our firm is anchored in the timeless values of trust, integrity, resiliency, lowturnover, long-term stewardship, innovation, discipline and continual learning with regards to our investments and the world around us. If cracks developed in any of these core pillars, our fund and partnership would cease to exist. As we move into our 4th year of operation we remain acutely aware of the need to maintain our sense of self in this chaotic and unpredictable world.
“It is better to understand who you are than where you are going- for where you are going will almost certainly change.” –Jim Collins
That is why we want to thank each and every one of our investors who believed in us from the beginning. Without this encouragement and support, none of this would be possible. You were the ones who believed in our vision and kept pushing us to forge ahead during hard times. No amount of gratitude can be explained by this simple letter, but we want you all to know that we have a deep agape (as the ancient Greeks would call it) that is now entrenched in the soul of the Logos LP brand.
Before we get to the fund’s performance in 2016, there are a few things we have learned over the past 3 years that are important for us to discuss. To start we wish to look to a great quote from one of our favorite investors:
“We look for a horse with one chance in two of winning and which pays you three to one.” — Charles Munger
We believe this quote not only represents an investment outlook but an attitude on life. Although we believe our capital allocation strategy has embodied this notion (which we will talk about below) there are a few ideas we have learned about ourselves and the fund since inception.
Lesson #1: Our “Core” Strategy Limits Risk
At a high level, the Logos LP investment process is to use the power of leverage to acquire businesses that have the highest returns on capital coupled with large book value per share growth (i.e. high quality) over a long period of time, using a composition mix of “core” and “peripheral” positions to reduce the volatility that leverage naturally provides. But what does this strategy actually mean to our investors? Although many of you have read our investment memorandum as part of your introductory package, we want to take a moment to provide some details as to what our strategy is all about, where it is going and how we think it provides us with the best balance over the long-term.
The strategy is built around particular stocks that are known to be “core” positions. There are very few of these stocks out there that are potential “core” positions. However, at a high level, these are stocks that the fund would never sell or allocate out of (but may not continuously buy over time, either) because the opportunity cost, volatility and probability of satisfying results over the long-term is too great. Conceptually, these positions must not only have strong book value per share, high returns on equity and stable revenue growth, but they must also have specific qualitative characteristics that are generally difficult to find. They must have what we believe is:
a. A highly sustainable competitive advantage: This not only investigates ‘high-moat’ quantitative aspects like recurring depreciation expense, gross margin expansion and CFROI but also looks deeply in the actual markets the company operates in and the strategic direction the company is taking.
b. Long-term stability: This looks for companies and markets that we believe will be around for the next 100 years. The company should have sound management raised organically within the industry it operates in while consistently looking at the long term. We also evaluate management’s propensity to own shares in the company via open market purchases. This encapsulates a favourable view of other insider ownership such as founding families.
c. Visionary corporate culture: In “Built to Last” Jim Collins compares visionary companies with regular companies on the stock exchange and found that companies that are truly visionary have specific qualities (i.e. timeless core values and a purpose beyond just making money, Big hairy audacious goals, cult-like cultures, home-grown management etc.). These companies have done significantly better over time than the broader market and we look for companies that we believe have this visionary culture.
d. Small enough to become a “bagger”, big enough to have a chance: Companies with high profit margins and growth will eventually encounter slowing growth because new entrants will eventually seize the opportunity to compete against these companies, especially if these companies are small with smaller moats. We look for companies that are small enough to become a “bagger” (more on this later) but big enough to be able to attack a market without getting completely crushed by the competition. The sweet spot would be companies under $10 billion (could be upwards of $15 billion depending on the market) as we believe based on our studies these are large enough companies to make a potential footprint in the global economy while having the growth runway that we find desirable.
We analyze the above qualities in conjunction with a probabilistic analysis and an overall quantitative assessment into the business to see if it would have the potential to be a “core” position. Here is a brief example of a core position that we own:
One of the largest positions in the Logos LP portfolio is a company known as Church & Dwight (NYSE: CHD). The company is a producer and distributor of various consumer packaged goods (CPG), with 80% of its revenues in North America. Over a 10 year period the company has compounded at a rate of over 31% per year and over a 20 year period has compounded at 125% per year (over 2500%) which is about 25x excluding dividends whereas the S&P 500 has only done 271% excluding dividends. We have concluded, based on qualitative, probabilistic and quantitative analysis that CHD was attractive as an investment “core” a little over than a year ago due to the following reasons:
a. Wide-moat capabilities and potential in the CPG industry
b. Large runway in the market it operates in (by comparison, Procter and Gamble is a competitor that is more than 20 times the size of CHD)
c. Focus on niche markets with low competition (recently acquired a shampoo company solely focused on thin hair)
d. High returns on equity with high growth in earnings per share
e. Multi-generational management focused on the long term
f. Recession proof portfolio
g. Focus on innovation and disciplined portfolio management (the company’s top 4 brands did not exist prior to 2000)
Currently, CHD has a market cap of around $11.6 billion. The question we have to all reading this letter is this: Could CHD eventually grow to become the size of its competitors operating in similar or identical markets?
Consider the following competitors:
a. Colgate-Palmolive – market cap of $60 billion
b. Proctor & Gamble – market cap of $230 billion
c. Reckitt Benckiser – market cap of $60 billion
d. Unilever – market cap of $125 billion
e. Clorox – market cap of $16 billion
In a stable growing market like CPG and with the acquisitive nature of CHD’s management is it
- CHD could reach $17 billion in market cap (a little bigger than what Clorox is today) over the next 3 years, which would be a near 50% premium at current levels?
- In 40 years, with the CPG market reaching well over a few trillion, CHD could be worth more than what Proctor & Gamble is worth today?
Since 1976, CHD has done over 217x unlevered and excluding dividends meaning a $500,000 investment would be well over $105 million today in capital alone. We do not know if this will occur in the future, but even at half that return over the next 40 years in our levered strategy and including dividends, you have a core investment in favorable long-term market conditions that we believe would make us the exact opposite of a horse’s patoot, barring any irrational decisions on our end. As a comparison, real estate in Toronto’s core (one of the hottest real estate markets globally), both residentially and commercially had done roughly (depending on the location) 8-12x in 43 years (excluding agent fees of 5%, legal fees, LTT of 5%, maintenance fees of 1% annum etc.) which is less than 4.8% of the capital return of CHD excluding those aforementioned fees.
We do not know where CHD will be in the next 10, 20 or 50 years and we don’t even know what it will do next year. However, evaluating a range of probabilities coupled with an interdisciplinary investment approach over the long-term (i.e. looking at consumption levels, economic growth, geopolitics, societal and demographic changes, environmental changes etc.), we believe the chances of our investment being worth more tomorrow than it is today is fairly high, and much higher than other investments in the stock market in addition to other investment classes like real estate or gold.
Currently, the portfolio has 4 “core” positions that make up around 55% of the portfolio. Our analysis of CHD was also done with the other “core” positions even though they are in different industries entirely. Over the past 3 years, we have learned that the main benefit of having these “core” positions is that they tend to stabilize any systemic market volatility (these core positions all have manageable volatility levels) while allowing us to manage risk effectively in our “peripheral” positions (more on this below). Although any portfolio will be subject to declines over the very long term, despite our use of leverage we have been able to weather major declines (such as the oil crisis in October of 2014 and the China sell-off in January of 2016) without selling a single share of our “core” positions. Together, they provide the perfect mix of enough upside with strong risk control given the long-term fundamentals of these businesses.
Lesson #2: Our “Peripheral” Positions May Capture Significant Upside
The second part of our strategy is focused on our “peripheral” positions, which are stocks that are categorically described under 2 distinct camps:
a. Stocks that we believe are potential “baggers”
b. Stocks that have a catalyst attached to them leading to a depressed valuation
We have no rules as to how much of the other 45% of the portfolio is in the first or second camp, but we are more interested in companies that are potential baggers, and even more interested if they are potential baggers at depressed valuations.
What are "baggers"?
In 1972, Thomas W. Phelps (1902-1992) wrote a book called “100 to 1 in the Stock Market: A Distinguished Security Analyst Tells How to Make More of Your Investment Opportunities” which looks at the characteristics of stocks that do 50x, 100x, 200x, 300x and even 1000x or more in the stock market over a period of time. The term “baggers” was first coined in Phelps’ book and these are the kinds of companies that can generate explosive wealth, turning small investments into very large ones. Arguably, a company like CHD (a 217x stock since 1976) and some of our other “cores” could be considered “baggers” since they have already provided strong returns to investors (although we believe there is much more room for growth in our current core positions), but our “peripheral” positions take a twist on this definition by looking not only at what have been baggers and will continue to generate outsized returns, but also potential baggers. Generally speaking, we look for companies that are smaller than $2 billion in market cap (ideally smaller than $900 million in market cap), have explosive revenue (sometimes more than 200% per annum), have explosive book value per share (sometimes 20x or more in less than 5 years), high management ownership levels, usually have not been public entities for more than 20 years and have very high ROIC and ROE (sometimes over 40% unlevered).
A potential bagger usually has a specific associated catalyst that the market is not fully realizing yet (such as a new business model in an established market, a new model in a new and growing market or a brand new product in a new market) and there is real risk that the company may not ever become a bagger or the market is not yet convinced it may become one soon (these kinds of names are usually uncovered, more illiquid or have sold sold-off for a number of reasons). These are generally extremely difficult companies to find as the majority of these kinds of companies tend to be in biotechnology, pharmaceuticals and other science based sectors (which we do not usually invest in) but there are companies out there that do fit this mold in the non-biotech field.
The problem with investing in these “peripheral” positions is that because they are usually small and fast growing, entering into the name at a proper price point is extremely difficult and they are also much more volatile when major economic swings or platonic shifts occur. An example would be an enterprise technology company growing at over 20% per year with no debt but large exposure to foreign currencies but a limited client base. An event like Brexit or the Trump election (which significantly impacted global currencies) can shift the stock from high flying performance to a 40% decline in a year, despite having (potentially) strong long term fundamentals and a perceived economic moat.
On rare occasions, many of the potential baggers on our watchlist start becoming value plays (which has happened in 2016). On very rare occasions, we are able to find a name that not only has explosive growth but has the signs that it may eventually become a stable cash flow generator (i.e. large cap) due to the fact that the market it operates in grows at a predictable rate, there is very little competition and it is on pace to capture significant share. These are very difficult to find and we aspire to build large positions as (if) we find these kinds of companies over the years.
Aside from potential baggers, we also look at stocks that have fallen victim to an opportunistic event leading to a depressed state, which can mean a variety of things and can alter what we do with that stock over time. These companies tend to be highly cyclical in nature and thus being able to capture them at a great price can turn out to be an incredible opportunity to hold a volatile stock without getting burnt. Sometimes certain depressed names become stable operators with a shift in their business model and management, leading to a high quality compounder.
We are certainly on the lookout for such scarce opportunities yet we are careful to avoid falling into a value trap. On the very rare occasion that we are able to find a stock that has fallen victim to a specific catalyst unduly depressing its price we catch an entry point into a potential bagger. These are excellent opportunities to test our patience and discipline. Typically, we find names that may be depressed for a particular reason that we believe is unjustified and may initiate a position. These kinds of investments make up a fairly small portion of the portfolio.
Lesson #3: New Capital Will Be Focusing on the “Peripheral” Positions
Given that our portfolio has weathered certain major economic headwinds despite our prudent use of leverage, we have learned that particular positions should never exceed a capital threshold (i.e. certain “peripherals” should never become “cores” due to volatility and leverage), certain “cores” should be much smaller positions and that certain “peripheral” positions should be a bigger portion of the portfolio. Current market conditions, the potential for continued economic growth globally, the percentage of “core” positions within the portfolio and specific opportunities that are arising within the market, provide us with an environment to continue to build certain peripheral positions we already own or to add new ones that we have been watching. This not only gives us the opportunity to dilute our “core” positions from 55% to less than 40%, but to also give our current “peripheral” positions, some of which have risen substantially over the past year, the ability to smooth out market risk that we may incur with new positions.
Why do we want to dilute our core positions and why are we focusing on these “peripheral” positions?
As noted above, the purpose of a “core” position is to smooth out the volatility in the portfolio while giving the portfolio the ability to compound at double digits for the long-term. Peripheral names can give these core positions a boost leading to a high double digit portfolio for the longterm. Over time, new capital may grow more slowly than the returns these positions provide, meaning they may make a larger portion of the portfolio sooner as compounding begins. For example, if CHD were to rise 50% over 3 years (~18.3% annualized including dividends unlevered), CHD would be a much larger portion in our portfolio than it is today.
To offset that growth and to take advantage of the very low volatility that this position provides, new capital added (or re-allocated and consolidated from other peripherals) will have to be deployed into new or other current peripheral positions in order to take advantage of the growth these baggers may create and sustain within the portfolio during a bull market. In other words, since our ship is fairly well prepared for smooth sailing, adding more horsepower will give us the speed we need without rocking the boat too much in the event of turbulent waters. Over time, as our peripheral positions start to compound, they may outpace the growth in our core, leaving us with either a new core or an opportunity to re-allocate to a peripheral. If growth in our peripherals organically dilutes our core positions below a certain threshold, we may look at adding more to our current core positions at the right price, turning a peripheral position into a core position (which has recently happened), or adding a new core position to smooth out any potential risks.
With these lessons learned and with an understanding of our strategic direction in capital allocation, let’s move on to our fund’s performance.
Performance and Activities
As of December 30st 2016 on a total return basis, Logos LP has done 22.9% in CAD whereas the S&P 500 has done 11.67% in USD and the TSX has done 21.11% in CAD. On an unlevered cumulative basis, Logos LP has done 52.88%, with price-per-unit in the fund standing at $19.15. At our initial offering of $12.52 on March 26th 2014, an investor would have earned an unlevered annualized net return of 19.22% in CAD, outpacing both the S&P 500 and TSX composite indexes during that time span in their respective currencies.
Over the past year, we have shifted the portfolio towards peripheral positions but we have also been building one of our core positions, Lassonde Inc. (TSE:LAS.A). We believe the future is bright for Lassonde as we believe it has the very unique quality of being a bagger minus the volatility. Another core that we purchased during the January sell-off has been our Mexican airport operator Grupo Aeroportuario dl Srst (NYSE: ASR) and Teledyne Technologies (NYSE: TDY), which was a peripheral position that grew into a core. We do not mind having an industrial name as high quality as Teledyne creeping into a core as the company still embodies the values of the great Harry Singleton, one of the greatest CEOs of our time. We had the opportunity to purchase this company during the oil crisis when it was unfairly punished, since a portion of its revenue is tied to energy producers and refiners.
The portfolio reduced exposure in a couple of very large caps stocks that we still hold (Accenture and Anheuser Busch, which were former core positions) and we have been building on enterprise technology names with international exposure. Our most promising peripheral positions include Rocky Mountain Dealerships (TSX: RME), Enghouse Systems (TSX: ENGH), Luxoft (NASDAQ: LXFT), Dorman (NYSE: DORM) and Home Bancorp (NASDAQ: HBCP). We are most bullish on Enghouse and Luxoft given how beaten down they have been in 2016 despite incredible growth, excellent returns on capital and no debt. Luxoft especially has the chance to propel higher over the next 10 years, which may lift this peripheral position into a core that we must either accept or re-allocate. Despite their size and industry, these names have had surprisingly low volatility as we made most of our purchases in these stocks during periods of large declines which saw their multiples contract to very low levels (Luxoft for example is trading at lower price to sales multiple than CHD, which experiences significantly slower growth).
The fund is currently sitting on significantly more cash than usual and we do not plan on purchasing anything in 2017 unless a major opportunity arises. Our current plan is to hoard all net new capital as we wait for certain names to compound, and purchase peripheral names on a major sell-off that we believe provide the best opportunity for growth. Currently, the market is at the upper limit of fair value and things are getting expensive, as financials and small caps are usually the last to rally in an extended bull market. Although we believe this bull market still has legs, we are patiently waiting for the right opportunity to come which may come sooner than we think.
“The Worst Start To A Year Ever!”- Everyone
Perhaps as humans, but certainly as investors, we all suffer from hindsight bias. After an event has occurred we have an inclination to see the event as having been predictable despite there having been little or no objective basis for predicting it. This is one of the reasons we remain skeptical of providing an “outlook” for what we believe the following year will bring.
Instead, we can say with relative certainty that we will stick to our sphere of competence: our core investment strategy. We can also say that we will remain self-aware and alert as we take the “temperature” of the market and ask: what are the implications of what’s going on around us? As such, our outlook for 2017 should be thought of as more of a humble “reflection” on where economies/markets are and where they may be headed.
To begin, we will consider where we began in 2016. You may remember statements like the one above putting a dampener on the year. In fact, last January was the worst start we had to the year ever in the history of the stock market.
There were several moments in January in which we were told that a poor January was an excellent indicator of a bad year ahead.
Yet as it goes, 2016 was confirmation that the way a year begins tells us ABSOLUTELY SWEET NOTHING about how it will end. In fact, if you had listened to these “expert opinions” you would have “gone to cash” as many in the punditry advised and perhaps missed out on a few interesting developments in 2016:
1) The S&P 500 (SPY) returned about 9.54%
2) The Dow (DIA) returned about 13.42%
3) The Russell 2000 (IWM) about 19.48%
4) The Dow Jones Transport Avg. (IYT) about 20.86%
5) The Energy Select Sector SPDR (XLE) about 24.87%
Not a bad year to remain fully invested despite the chop we witnessed at the beginning of the year. And all of this in spite of an absence of help from the Fed, an “earnings recession”, Brexit, the surprise election of a man who was deemed as “disastrous” for the stock market, more disorder in Europe, rising populism and nationalism, an emboldened Russia, a few terrors attacks and whatever other disturbances the media told us we should worry about.
What we can glean from this reality is well put by George Soros:
“If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring.” -George Soros
Trying to decide which way the market will turn when someone gets elected, or how exactly it will price in a policy change is entertaining. It gives us all something to talk about. Something to feel smart about if we just so happen to get it right. But it isn’t a sustainable strategy for excellent long-term investment returns.
Instead we may find ourselves jumping in and out of the market. As Peter Lynch has cautioned:
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” - Peter Lynch
If you are in the stock market you have to know that there will be declines. In fact, in roughly the last 90 years the stock market has gone up almost 75% of the time and down 25% of the time…yet the gains in positive years produced more than double the losses in the negative years. So should it come as a surprise that virtually every strategist surveyed by Bloomberg is predicting that the S&P 500 will be higher next year?
These are the boring facts…Time appears to be on the side of the resilient investor. Nevertheless, that’s just how things have played out in the last century or so. Past returns are no guarantee of future returns as it is all together possible that some form of systemic risk could change the way we think about investing and portfolio strategy.
So having reminded ourselves about the unentertaining and somewhat predictable side of the stock market, what “general observations” can we make about 2017?
1) Markets And Economies Will Go Through A Transition Period
Voters on both sides of the Atlantic delivered a decisive repudiation of their political establishment and shifted the fault lines of Western politics from left vs. right to open vs. closed. Globalization, liberalism and democracy are decreasing in popularity as they have become short hands for a rigged system that benefits only a self-serving elite. Nationalistic selfinterest bolstered by outright populism will continue to upset the world order in 2017 with populists amassing power in the French, Dutch and German elections. Thus, a climate of political and economic uncertainty is likely to persist for the foreseeable future. As such, one of the key questions in 2017 will not be whether big new trade deals are concluded but where the anti-globalists will succeed in further eroding the rules that facilitate international trade and investment.
Sluggish growth will remain the new normal for the global economy. In 2017, world output measured at market exchange rates will increase by less than 3% for the sixth straight year extending what was the longest stretch of weak growth in more than half a century. Weak demand and poor productivity growth will continue to keep sustainable growth elusive as weak investment and overregulation continue to take their toll.
As such, the world’s overstretched central banks will remain in the spotlight as growth drivers. Expect rates to remain lower for longer. Nevertheless, the U.S. Federal Reserve’s importance and impact will start to fade in 2017 as real interest rates rise, market volatility resumes and the US Dollar continues to strengthen.
On the bright side, an on balance pro-growth Trump administration looks set to establish a more business friendly environment (lower taxes, lighter regulation, significant fiscal spending) in the U.S. which may provide a much needed tailwind for corporate earnings and U.S. stock markets. In addition, President-elect Donald Trump plans to put into effect a onetime tax holiday on cash that U.S. firms bring home from abroad. Both would mean more excess cash on companies’ balance sheets, which could lead to more share buybacks but ideally to capital expenditures, increased R&D and perhaps ultimately to productivity growth.
Despite the prevailing climate of political and economic uncertainty causing global stock market volatility, look for regional banks (NYSEARCA: KRE) to outperform the S&P. These banks have further upside to EPS forecasts and already have solid loan growth, improving margins and will enjoy the strengthening path of wage inflation in the U.S. workforce. In fact, the Financials sector is expected to lead all groups with an 11.6% EPS growth rate in 2017.
Earnings and free cash flow for the S&P 500 index are also expected to grow at double-digit rates in 2017. Yet it is interesting to consider that to get where bulls think earnings are going, the economy would have to pull off a push that is unprecedented since at least 1937. Specifically, on the three occasions the U.S. has gone 7 1/2 years without a recession, earnings have never grown 10 percent this late in the cycle.
Thus, there are reasons to be prudent. Equity valuations have widened this year as prices rose and profits atrophied. Using data on CAPE ratios provided by Yale University’s Shiller, stocks are more expensive now than 96 percent of the time since 1871. Currently at 28, the multiple has held at least one standard deviation above its historic average every month since July 2013.
Investors are indeed confident and thus you should be cautious entering 2017. If the U.S. economy is not as close to full employment as we believe it to be, the multiplier effect resulting from Trump’s proposed fiscal policy choices could be significant. In addition, the prudent longterm investor should remember that demography and sluggish productivity will make it very difficult to push economic growth up to the 3-4% hoped for by the Trump administration. After all, neither fiscal nor monetary stimulus has done much to lift Japan out of its rut.
In addition, in 2017 the steady flow of monetary stimulus from the U.S. Federal Reserve will be curtailed as it is now tightening policy. This won’t be easy and it is unclear that the baton will be smoothly passed from monetary policy to a Trump administration’s fiscal policy. Especially at a time where the hunt for yield has driven record demand for corporate debt issuance, the
proceeds of which have in turn propped up stocks via buybacks…
Finally, and more fundamentally, the populism that has gripped the developed world feeds on its own failures. The more business tries to cope with uncertainty by delaying investment or moving money abroad, the more politicians will interfere with them distorting their operations. As economic stagnation encourages populism, so pandering to the popular will reinforces stagnation. Thus, a Trump administration is no panacea and the prudent investor will remember that the devil will be in the details especially while growth expectations and valuations sit at all time highs…
Prepare for a possible reckoning as the pendulum swings back...
2) The Macro Backdrop Will Favour Value Based Management Styles
2016 may prove to be an inflection point for markets and perhaps for management styles as well. This year growth strategies embodied by the (NYSEARCA: IVW) index seem to have begun to give way to value strategies embodied by the (NYSEARCA: IVE).
Before 2016 investors were prepared to pay just about anything for secular growth stories and thus we saw the relentless rise of FANG (Facebook, Amazon, Netflix, Google). What has changed? Interest rates look set to rise along with inflation.
In September 2015, Barron’s published an article looking at the relationship between value and interest rates. The article focused on the findings of Jonathan Lewellen, a finance professor at the Tuck School of Business at Dartmouth College who, at the request of the magazine looked, at the returns data for both value and growth strategies compiled by Kenneth R. French and Eugene Fama.
Fama and French’s work on value investing and its relationship with growth investing is widely respected and considered to be some of the most robust research on the subject.
Lewellen looked at five periods of increasing rates from January 1983 to the present, and compared the returns of high book to market stocks (value) to low book to market stocks (growth) during these periods. The professor found that:
When the Fed was raising interest rates, value stocks had an average return of 1.2% a month or 14.4% year versus growths return of 0.7% per month or 8.3% year. However, over the sixmonth period leading up to rate increases, growth outperformed value with a return of 1.6% a month versus 1.5%.
Look for this trend to continue in 2017 as managers go back to basics and stock performance becomes differentiated by company fundamentals.
3) Certain Emerging Markets Will Have An Excellent 2017
Certain emerging markets performed very well in 2016 with Brazil and Kazakhstan leading the way:
Fears that the Trump Administration’s policy approach will bring down the entire emerging world are overblown. Domestic strength in the U.S., a strong dollar and rising inflation will be favorable for certain emerging markets. Look for strength in Brazil, Canada, Russia, South Africa, India, Indonesia and perhaps even China. Stay away from Turkey and other countries that are vulnerable to external shocks arising from higher U.S. borrowing costs and Trump’s policy changes.
4) The Elite Will Remain Disconnected With Reality
As hinted above, perhaps the biggest trend this year has been the disconnect between the commentators’ analysis and forecasts and what actually happened.
Brexit and the American Election were analyzed wrongly yet funnily enough, this trend continued even after those big events, as the popular commentary repeated that there was a great deal of uncertainty whilst if you look at data such as consumer confidence in the U.S., it hit the highest since 2001.
Why? Perhaps one of the biggest risks facing the world today is how out of touch the elite is with the rest of the planet. Brexit, the U.S. election and other populist anti-globalization movements around the globe have placed the spotlight on the gross amount of class cluelessness that exists today. Growth and productivity in the rich world are stagnating and the fruits of what growth remains are getting captured by an ever narrower section of society. If we don’t take steps to bridge the class culture gap, when Trump or other populist movements prove unable to bring prosperity to those left behind the consequences could turn dangerous.
Ironically, in a year when populist voters reshaped power and politics across Europe and the U.S., the rich just kept getting richer ending 2016 with $237 billion more than they had at the start. The politics of profits matters. Corporate profits rebounded quickly and robustly after the 2009 recession which has underpinned the outstanding performance of equity markets despite a sluggish economic recovery.
Yet the other side of the coin of a high profit share for investors, is a low share of GDP for workers as companies have kept their labor costs low. This lack of real wage growth has proven to be a key reason for the political unrest that has griped the developed world.
Thus, investors or “the elite” find themselves in a bind. The kind of real wage growth that would calm political risk would have a negative effect on profits and thus share prices.
The stage is set and sadly, 2017 looks primed for more fireworks…Expect more volatility and unfortunately more animosity.
Stepping back and looking at the big picture, cracks in liberalism/capitalism’s foundation are starting to show. This economic/political system began as a world-view premised upon the businessperson as a hero: one who dreams of a better world and who brings that world about through hard-work, discipline, compassion and craftsmanship.
Societies flourished with open borders and the free exchange of goods, capital and ides. Today, the anti-capitalist intelligentsia (created by capitalism) dominate our classrooms as politicians decry open borders, open markets and even open mindedness. The problem is that people are loosing faith in progress. Liberals included.
Today, many in the developed world feel that progress is what happens to other people. Progress is what past generations had the pleasure of enjoying. If liberalism/capitalism is to make a resurgence it will need to address this growing malaise. It will also need new ideas and new champions.
Will we see forward progress on this issue in 2017? Unfortunately, we think not. Especially given the fact that 2016 heralded the beginning of the “post-truth” era. Our system of governance was always premised on reasoned debate regarding mutually agreed upon facts yet the combined effects of addictive and “entertaining” social media, shameless politicians and a weakening traditional media has made truth simply a matter of one’s own personal “feelings” or “perspectives”. We are each the “unique”, “special” and “correct” stars of our own shows as we Facebook, Instagram and SnapChat our way through life trapped in our personal echo chambers. Indeed, it is always darkest before dawn.
Nevertheless, on a more personal note, as you move into 2017 take a moment to ask yourself: who am I? Instead of simply: where am I going?
You may find that the former holds more importance than the latter.
“One must find the source within one’s own Self, one must possess it. Everything else was seeking – a detour, an error.” –Hermann Hesse, Siddhartha
All the best for a 2017 filled with thoughtfulness and contentment,
Chief Investment Officer
Head of Strategy
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