When to Buy Value, Second Order Impacts & Geopolitics

The Wrong Shares

Since the two week bear market in early March growth equities have massively outperformed value. I have previously covered why we cannot depend on the normal process of mean reversion that value investments typically rely upon to correct for this bifurcation. Version 1.0 of the equity market response to the pandemic was based on the idea of the V shaped recovery, that a vaccine would be produced within 6-18 months, the economic ship would self-right and we would be back to where we left off in January. The equity market is forward looking by a similar time frame, so buying equities made sense. By following this strategy you would indeed have timed the market recovery very well, but I believe you would have been right for the wrong reason, and would also likely have bought the wrong shares.

Non Dilution is Critical

One of the “value” equities I own is Dignity the funeral services business. I have lost significantly on it over the last 2 years. In their recent H1 results they produced numbers that were broadly in line with forecasts and stated quite clearly that the critical factor for them remains the outcome of the ongoing enquiries into the funeral and pre-paid funeral markets. On this basis I thought the shares would do very little and go back to sleep for another few months. But I was pleasantly surprised when the shares actually ended up 35% on the day. What I later discovered I had missed was the very last line of the RNS stating that the Board didn’t believe any future actions would involve equity dilution (strongly indicating they did not intend to issue more shares). I learnt two things from this. First always read the entire statement, and second, the market is valuing assets in shortage, or at least in relatively fixed supply, above most other factors at the moment, including most traditional measures of value (in fact this tendency seems to be increasing). This is the reason why Amazon, Facebook, Google, Gold and Bitcoin have all been strong. The FANGs are massively over capitalised, are (as a group) buying in their shares and certainly don’t need to issue any more, while government can’t print gold. If I am right here, then the signal to buy value will be when investors can see that the necessary recapitalisation process is over.

Accommodation not Defeat

So what are the circumstances when investors might feel confident the financial consequences of COVID are known? The most obvious scenario and most widely hoped for one is a successful vaccine. However, I am less confident than I was a few months ago about this. Finding a workable vaccine is one thing, manufacturing it in massive volume is another, and finally convincing a sufficient proportion of the population to actually take it, quite another again. These are not easy problems to solve. Increasingly I believe that the way to think about tackling COVID-19 is accommodation rather than defeat.

New Behaviours

The best historical analogy is likely to be the 40 year process of accommodation the World has had with the AIDS virus. The early stages of the AIDS epidemic resulted in a widespread change of awareness of potentially dangerous sexual practices and people took more precautions. Over time we refined our behaviour on the basis of a better and wider understanding of specific risks and new behaviours were normalised, including incidentally a much greater awareness and appreciation of homosexuality in society and the surfacing of issues such as gay marriage.

Asset Reallocation

The impact of COVD-19 will be similar to this, but in regard to social behaviours. Over the longer term as a society we will learn how to better control the spread of the virus, how to deal with the infection when present and how to protect the most at risk groups. We will evolve a new normal and the impact of the total lock downs will become a distant memory. However, this learning process could take many years. As a consequence we will find ourselves with too much of our economic capital allocated to socially intensive activities such as shopping, hospitality, public transport, office work, older unautomated manufacturing facilities etc. Until we have a line of sight over how the owners of such assets can finance themselves (or fail in the task and have their assets re-allocated), the stock of value equities will be unknown and these shares as a group, will not perform.

Digital Accelerates Away from Analogue

As we have seen with so much of 2020 so far, the established trends we all knew about have been accelerated. The move from physical to online retail the US had been moving along at approximately 1% a year since the early 2000s. So far in 2020 the year to date move in this trend has been the equivalent to a decade, this is 20 fold acceleration. Amazon grocery deliveries have tripled year to date and the rate of growth of Prime is accelerating from already high levels of penetration. The other side of this coin is that we are seeing the last gasps of the analogue world happen at higher speed. The BBC looks like its position on the UK license fee is stranded on high ground, but must soon be drowned out. Printed media is now terminal, shopping malls and central business districts increasingly ghost towns. In the US every traditional consumer media company is trying to become Netflix and launch their own streaming service. Meanwhile at Netflix they are moving on and rapidly becoming the World’s broadcast network. Reportedly it is on track to deliver more dubbed content than original language content to its c 200m customers by next year. The point is, our ability to reallocate capital into more modern usage is under intense pressure as the digital world is moving ever more quickly away from the analogue.

Second Order Impacts, Taiwan the New Saudi Arabia

So much for the direct impact of the pandemic on equity investment, in addition we need to consider some of the second order impacts. In essence I think, although it is still too early to know, the impact of lock down policies have largely made things worse, not better. I think that the institutions that failed us were largely the public health agencies from the WHO, The Center for Disease Control in the US and Public Health England here. I think that the countries that will emerge relatively strongly from this period will include Sweden, having chosen not to wreck its economy in its COVID response. I think that the West is already in Cold War 2 with China and data and computing capability have already eclipsed natural resources as the main focus for foreign policy. The main theatre of global tension has decisively moved from the Middle East (we no longer seem to notice that Libya has been effectively divided up between Turkey and Russia) to the South China Sea. While Chinese moves to tighten its grip on Hong Kong offer us the chance to have a dutiful bout of post colonial anxiety, Taiwan remains the real prize with its historic significance in the Chinese Revolution and unparalleled semiconductor fabrication capability. The canary in the coal mine for the US is the harsh reality that Intel has conceded and raised the white flag by outsourcing production of its next generation computer chips to TSMC. If data is the new oil, then Taiwan is the new Saudi Arabia. Things will remain tense,the point about cold wars is that they can turn hot. Maybe Wuhan turns out be China’s Chernobyl or Cuban Missile moment and we have a Hollywood ending, but I am not banking on it.

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