Commentary
Overview
In 2010, Carmen Reinhart and Kenneth Rogoff wrote an influential paper titled “Growth in a Time of Debt”. The paper argued that when gross debt reaches 60% of GDP a country’s annual growth fell by two percent and when it exceeded 90%, growth was cut in half. Today not a single large, developed country has a debt to GDP below 60%, with the average in the Euro area being nearly 90%; the United States, 120% and Japan a staggering 255%.
Governments have run large deficits for the last 15 years which has led to this indebtedness. As debts have risen, interest costs have grown to a dangerously high portion of government spending. In the end these deficits will have to come down and there are only three ways to reduce a deficit: growth, spending cuts or tax increases. Inflation has often been seen as means to reduce deficits but, in reality, inflation is merely a way of masking a real terms spending cut or tax increase.
Falling birth rates, aging populations, increased immigration controls and high indebtedness makes growth the unlikely route; although a productivity boom led by artificial intelligence is a small possibility. Spending cuts also seem unlikely given the state of public services in the developed world. That leads us to the probable outcome of higher taxes; whether on corporates or households, this scenario will not be positive for corporate profits over the coming decades. Given this outlook, we find it odd that global equity indices are trading on 21x (potentially peak margin) earnings.
There has historically been a clear relationship between valuation and subsequent returns. For example, in 1962 the S&P traded at 20x price to earnings and the subsequent real return over the next two decades was negligible; in 1982 it traded at eight times, and the subsequent return over the following two decades was 15% per annum (12% real return).
The S&P 500 is currently at nearly 25x price to earnings, so we would expect the medium-term outlook for returns of large US companies to be low. However, unlike 1962, there are many areas in the world that are not trading on high multiples but instead are lowly valued compared to history. This is particularly true of small and medium sized businesses in Europe and developed Asia, and this is why this strategy trades on just eight times earnings. We therefore believe the outlook for returns for this strategy remains good, even though we do not expect high returns for the overall market.
Latest Quarter
It was a strong quarter for equity markets and for the strategy. Inflation continued to fall around the world led by lower energy prices feeding into goods deflation. Wages in most developed countries comfortably exceeded inflation helping the consumer and corporate profits. The two weakest performers were NOV and Pason Systems on the back of lower energy prices. NOV had been performing well following good results in July with a solid order book, higher margins and strong free cash flow; however, since the results, lower energy prices have negatively impacted its share price.
The best performer in the quarter was HelloFresh following the release of its second quarter results. The meal kit business is still seeing near double digit declines, but this has been offset by strong growth in the ready-to-eat segment. Dominik Richter, founder and CEO, bought €10m worth of shares which is the first time he has bought shares since its listing in 2017. In addition, an activist shareholder has acquired a 7% stake in the business.
New Positions
We initiated a position in two new holdings: Dream International and ZIGExN.
Dream International is a leading manufacturer of plush stuffed toys and plastic figures with a Vietnamese manufacturing base. Founded in 1984 by the current CEO/Chairman who retains a 68% ownership, Kyoo Yoon Choi, the company has established a strong market presence enjoying long-standing relationships with major global toy brands including Disney, Hasbro and Mattel. The company has an impressive track record of growth with sales tripling over the last decade, driven by expanding product lines and entering new markets. As Dream has grown, it has benefitted from economies of scale with SG&A falling from 14% of sales a decade ago to just 3% today, resulting in net profit growing seven-fold over the decade. The valuation is clearly attractive at four times earnings, a discount to book value and a 13% dividend yield, but in part this reflects the increased political risk for Hong Kong listed stocks.
ZIGExN is a Japan-based technology company specializing in online platforms that connect consumers with various services, primarily in the real estate, job, and travel sectors. The company was established in 2006 by Jo Hirao (53% owner) and has grown to become a significant player in the Japanese internet industry. The company has an impressive track record of profitable growth with a successful track record of disciplined M&A. The founder is young and excited about the current M&A opportunity set in Japan. The valuation is attractive, trading near its historic lows.
Outlook
The dividend yield on the strategy is now the highest it has been in its history; the price to earnings ratio is near its lowest and the upside to our target prices remains elevated at over 90%.
Organisational update
At the firm level, during the quarter, Richard Garstang has been appointed Managing Partner. Richard Oldfield has returned to the firm in a part-time role on the investment team, providing support and perspective, and has resumed his role as Chair of the Board. Whilst these changes have no direct impact on the running of the strategy, they are an example of our careful, long-term succession planning to continue to position the firm for sustained success and innovation.
Commentary
Overview
In 2010, Carmen Reinhart and Kenneth Rogoff wrote an influential paper titled “Growth in a Time of Debt”. The paper argued that when gross debt reaches 60% of GDP a country’s annual growth fell by two percent and when it exceeded 90%, growth was cut in half. Today not a single large, developed country has a debt to GDP below 60%, with the average in the Euro area being nearly 90%; the United States, 120% and Japan a staggering 255%.
Governments have run large deficits for the last 15 years which has led to this indebtedness. As debts have risen, interest costs have grown to a dangerously high portion of government spending. In the end these deficits will have to come down and there are only three ways to reduce a deficit: growth, spending cuts or tax increases. Inflation has often been seen as means to reduce deficits but, in reality, inflation is merely a way of masking a real terms spending cut or tax increase.
Falling birth rates, aging populations, increased immigration controls and high indebtedness makes growth the unlikely route; although a productivity boom led by artificial intelligence is a small possibility. Spending cuts also seem unlikely given the state of public services in the developed world. That leads us to the probable outcome of higher taxes; whether on corporates or households, this scenario will not be positive for corporate profits over the coming decades. Given this outlook, we find it odd that global equity indices are trading on 21x (potentially peak margin) earnings.
There has historically been a clear relationship between valuation and subsequent returns. For example, in 1962 the S&P traded at 20x price to earnings and the subsequent real return over the next two decades was negligible; in 1982 it traded at eight times, and the subsequent return over the following two decades was 15% per annum (12% real return).
The S&P 500 is currently at nearly 25x price to earnings, so we would expect the medium-term outlook for returns of large US companies to be low. However, unlike 1962, there are many areas in the world that are not trading on high multiples but instead are lowly valued compared to history. This is particularly true of small and medium sized businesses in Europe and developed Asia, and this is why this strategy trades on just eight times earnings. We therefore believe the outlook for returns for this strategy remains good, even though we do not expect high returns for the overall market.
Latest Quarter
It was a strong quarter for equity markets and for the strategy. Inflation continued to fall around the world led by lower energy prices feeding into goods deflation. Wages in most developed countries comfortably exceeded inflation helping the consumer and corporate profits. The two weakest performers were NOV and Pason Systems on the back of lower energy prices. NOV had been performing well following good results in July with a solid order book, higher margins and strong free cash flow; however, since the results, lower energy prices have negatively impacted its share price.
The best performer in the quarter was HelloFresh following the release of its second quarter results. The meal kit business is still seeing near double digit declines, but this has been offset by strong growth in the ready-to-eat segment. Dominik Richter, founder and CEO, bought €10m worth of shares which is the first time he has bought shares since its listing in 2017. In addition, an activist shareholder has acquired a 7% stake in the business.
New Positions
We initiated a position in two new holdings: Dream International and ZIGExN.
Dream International is a leading manufacturer of plush stuffed toys and plastic figures with a Vietnamese manufacturing base. Founded in 1984 by the current CEO/Chairman who retains a 68% ownership, Kyoo Yoon Choi, the company has established a strong market presence enjoying long-standing relationships with major global toy brands including Disney, Hasbro and Mattel. The company has an impressive track record of growth with sales tripling over the last decade, driven by expanding product lines and entering new markets. As Dream has grown, it has benefitted from economies of scale with SG&A falling from 14% of sales a decade ago to just 3% today, resulting in net profit growing seven-fold over the decade. The valuation is clearly attractive at four times earnings, a discount to book value and a 13% dividend yield, but in part this reflects the increased political risk for Hong Kong listed stocks.
ZIGExN is a Japan-based technology company specializing in online platforms that connect consumers with various services, primarily in the real estate, job, and travel sectors. The company was established in 2006 by Jo Hirao (53% owner) and has grown to become a significant player in the Japanese internet industry. The company has an impressive track record of profitable growth with a successful track record of disciplined M&A. The founder is young and excited about the current M&A opportunity set in Japan. The valuation is attractive, trading near its historic lows.
Outlook
The dividend yield on the strategy is now the highest it has been in its history; the price to earnings ratio is near its lowest and the upside to our target prices remains elevated at over 90%.
Organisational update
At the firm level, during the quarter, Richard Garstang has been appointed Managing Partner. Richard Oldfield has returned to the firm in a part-time role on the investment team, providing support and perspective, and has resumed his role as Chair of the Board. Whilst these changes have no direct impact on the running of the strategy, they are an example of our careful, long-term succession planning to continue to position the firm for sustained success and innovation.