Investors should acknowledge the inherent biases within their portfolios and try to reduce them to avoid making unintentional bets, according to CRUX Asset Management’s Jamie Ward.
Some growth investors may be making assumptions without even realising it, the TM CRUX UK Core fund manager explained, adding that it is his job to identify where there may be an implicit bet based on the construction of the portfolio and remove it.
“If you are in the growth bucket, typically most of the businesses you are finding are going to be – to some extent – short interest rates, so growth investing is to some extent a call on short interest rates,” Ward (pictured) explained. “This is due to the fact that growth businesses, by their very nature, are high duration because the value of them is based on their future earnings stream rather than something more recent or tangible.
“Therefore, if you are just a pure growth investor, you are – I believe – taking a bet that interest rates are going to be lower and lower, unless you bring in some kind of nuance that tries to lower that implicit short interest rate bias.”
Another example he made was the idea that businesses outside of the commodities sector are short energy, because energy is an input for their business.
He said investors can use stock selection to find a company that can benefit from higher energy prices, so that the construction of the portfolio is not an accidental bet on lower energy prices.
“If you place yourself in a bucket you end up making these bets, and you may not even know that you’re making those bets,” he said.
“I’m trying to be very specific in recognising when the portfolio is making these biases. If you are purely bottom up, you will inevitably end up with biases”.
One area in particular that he is trying to avoid betting on, is a call on lower inflation rates.
“I’m making sure the portfolio isn’t making a specific bet on lower inflation rates because I feel I can see a mechanism [where] inflation goes higher,” Ward said.
He said he is trying to make sure that parts of the TM CRUX UK Core fund are beneficiaries of higher inflation, as much as there are parts of the portfolio that are beneficiaries of lower inflation.
This is partly due to the fact that for the last few years, Ward has been of the view that the key risk in markets is that the cost of capital is too low.
He argued that the monetary response for the last 10 years has been an “over-reduction in the cost of capital” and “a covert financial repression” whereby it has become difficult to generate an income without taking risk.
“Now it’s impossible to the point where if you are taking ‘no risk’ you are destroying value in real terms,” he said. “If you took a look at the UK, the five-year breakevens are implying a real capital destruction of 2.5 per cent per annum.
“For the last 10 to 12 years, quantitative easing has fixed a problem that was true in 2008; it has sort of become the nail the central banks are trying to hammer.”
He said there will likely be a political backlash where new capital is not finding its way into the real economy.
Ward added: “Issues that seemed were considered on the fringe 10 years ago are now so mainstream that they have already happened, Brexit is an obvious one or Donald Trump being elected.”
One outcome he anticipates is a sort of overt funding of government expenditure via central banks, effectively becoming the political solution.
“What that will mean is the new liquidity that keeps getting created rather than going into capital markets and inflating more and more asset prices, will go into the real economy,” the manager said. “If that happens then you end up with a real risk of inflation, not totally dissimilar to what happened in the 1970s.”
In this type of inflationary environment, Ward said there has been a resurgence in people interested in more capital-intensive businesses, specifically those with high, fixed capital intensity.
“With fixed capital, you start thinking about replacement costs,” the CRUX manager explained. “If you assume the economics of a business remains relatively static, then in an inflationary environment, the cost to build a large fixed capital asset will be much higher in 10 years today.
“So as an owner of an asset today, you’re effectively getting an inflation in the value of your asset, but you don’t see it on the accounting standards, and because you don’t see it on the accounting standards it makes it look like the business gets better and better.”
One business that has high fixed capital intensity that he likes in this type of environment is the London-listed quarry business Breedon Aggregates.
“As you can imagine, selling rocks out of the ground is not super-high returns on capital, but where its capital is employed is in the ownership of quarries,” he explained. “It’s almost impossible to open a new quarry.”
He said the economics of quarries are interesting because what they sell are very heavy, and very cheap, and because the cost of transport is so high, you cannot import from Spain, Africa or China.
“So, if you own quarries in a local area you have pricing power, and because it’s a fixed capital-intensive business, it means it benefits from that inflationary impulse that goes through the replacement cost,” he added.
He said we could be headed to an environment similar to that of the late 1960s and early 1970s where investors known as ‘asset strippers’ would buy business with large fixed capital assets that were not trading on high multiples on their equity, and just selling the assets off because the assets were a lot more than the balance sheet value.
Commenting on Warren Buffet, who made his biggest acquisition in four years last week purchasing Dominion Energy’s gas pipeline network for almost $10bn, Ward said the economics of that sort of business is not that dissimilar to that of a quarry.
“You can’t replace it. You can’t build a new one, there’s huge amount of fixed capital in it,” he concluded. “And if you are buying it at balance sheet value or less and you end up with an inflationary environment, then the real value of that asset goes up and up – it doesn’t get reflected in the balance sheet – and therefore the return on capital goes up and up.”
Performance of fund vs sector over 5yrs
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Source: FE Analytics
The £59m UK Crux Core fund has returned 22.86 per cent over five years, compared with the average IA UK All Companies peer’s 9.84 per cent return. It has an ongoing charges figure (OCF) of 1.01 per cent.