News & Insight • Market Insights

01 July 2023 | Simon King

Thoughts on 2023 - Sailing on the Seven Seas

Regular readers of our quarterly investment thoughts will be more than aware that we have been consistently cautious in our commentary on the outlook for global economies, and in particular the threats and ravages of high levels of inflation.

Our commentary since the beginning of 2023 has been somewhat more positive, predicated on the basis of the world being somewhat closer to the end of this inflation and interest rate cycle.

Our longer-term concerns focus on a lack of growth globally, and these have not abated since we see little evidence of the increased levels of investment by governments or corporates to facilitate the productivity gains required for sustained periods of economic growth. As such we have not changed our view that the next five years will be a period of limited real growth ie adjusting nominal rates of growth for inflation. Essentially this means there will be no rising tide to carry all investments higher. However this does not mean that there are no opportunities for positive returns. As OMD sang in their 1991 hit of the above title, you have to cast your net wide in what will be choppy waters. The following piece seeks to explain how Vermeer Partners hopes to make money in more challenging markets.

Seek Out Growth

We have commented many times previously that when growth is generally scarce, then areas that are growing become even more valuable. In our view, over the long term, there is simply no substitute for investing in companies that grow consistently over time. At times they will be over-valued, at times they will be mismanaged, sometimes their growth will come to an abrupt halt, but ultimately well managed growth companies can overcome these negatives. The growth they achieve need not be spectacular, just steady and sustainable. This does not have to come from a whizz-bang new product or service, it can sometimes be about doing something boring better than everyone else. Growth can also come from very obvious sources such as demographics. Everyone agrees that populations are getting older and unhealthier, yet not everyone invests in healthcare.

No Substitute For Quality

In our opinion quality can only be measured on a subjective basis. There is a tendency in markets to invent a positive narrative around a company that has historically produced good results. Whilst we believe that history has some part to play in predicting the future, it is only part of the process. This is particularly true at present since as we have previously made clear, the next decade will be very different to the previous 15 years. Our own definition of quality is quite clear: a company needs to be able to grow quicker than the overall economy, exhibit superior margins and returns on capital, possess the strength of franchise and balance sheet to control prices and demonstrate strong discipline around investing the excess cash-flows that it will inevitably produce. This latter point is absolutely key. Too many good companies allocate capital in a haphazard fashion, resulting in poor returns to shareholders. We are ambivalent as to where these companies reside or indeed to what they actually do (within reason!).

Although one or two of these companies may fall by the wayside in the short term, most persist for decades and are usually only side-lined by regulatory changes, megalomania, or seismic technology shifts. Our focus is to identify these investments in the first place, purchase them at reasonable valuations and then monitor and hold them until something changes fundamentally. Dislocation in markets can often throw up increased opportunities for us to purchase companies we have previously identified as ones we would like to own.

Leave No Stone Unturned

Investors will have to cast their nets wide to achieve gains moving forward. Previous prejudices will have to be put to one side and a more pragmatic stance will be required. Viewing opportunities on a global basis and accepting that performance will come from both income and capital gain ie total returns, will be very important moving forward.

“Special Situations” is a much over-used term, but it is undeniable that they exist and that they can be very valuable for investors. In an investment world that loves to label and categorise things eg growth vs value, strategic vs tactical, active vs passive, discovering assets that have been put in the wrong box can be very lucrative, because they are often mis-valued. There are many examples of this at present, particularly in the UK market, where valuations remain subdued. We do not recommend spending much time and effort trying to identify catalysts for change. We more take the view that the market gets there in the end.

Japan is a perfect example of this. The country’s economy and stock market have been regarded as moribund for many years and its currency has continued to decline. It faces a different set of macroeconomic issues compared to other developed economies. However, many of the companies in the Japanese market are simply too cheap and are not reliant on the domestic economy. Japanese companies are coming under increasing pressure from their government and certain investors to restructure their very conservative balance sheets. This is leading to an increase in dividends and share buybacks. Investors have been slow to recognise the opportunity but unsurprisingly are becoming more interested as the stock market starts to go up. We have been investing in Japan for some time and as always have been prepared to be patient.

At Last Some Yield!

Since Vermeer Partner’s inception in 2019 we have expended much time and effort in analysing the attractions of fixed income investments. Due to the very low levels of yield available across the market we employed a “barbell” strategy ie a limited exposure to very low yielding government debt, no exposure to the middle part of the yield curve (mainly corporate) and decent exposure to a spread of higher yielding vehicles with a higher level of risk. On the whole, this has produced positive outcomes for our clients. The world is now in a somewhat different place and the interest rates available on a range of assets are attractive. In addition both US and UK government debt ie treasuries and gilts, offer the ultimate guarantee and attractive returns. At present, our focus is on instruments with a short life, since we can be more confident of their returns, but as our concerns on elevated interest and inflation rates abate, we will look at longer dated securities. This is a very different situation to just 12 months ago when investing in fixed interest meant accepting very low rates of return.

Cash Is Not A Dirty Word

We also regard cash as a plausible investment. Often cash is regarded as an admission of defeat or excluded from the mandate of a wealth manager. At Vermeer Partners, we predominantly run discretionary portfolios on a balanced strategy. We believe this gives us the mandate to consider all asset classes that can earn a return. We hold a small amount of cash on a fractional basis ie to meet the day-to-day requirements of moving assets. However, we are very comfortable holding cash on a strategic basis when it is attractive in comparison to other assets. Cash holdings do not have to consist purely of bank deposits, there are a number of alternatives which are attractive and offer the necessary levels of liquidity and security.

Don’t Diversify For The Sake Of It

Diversification is an interesting topic in times of uncertainty. The textbook approach is that investors should diversify, since if you genuinely do not know what is going to happen next, then you do not want to have too much exposure to an area that may suffer and do not want to miss out on things that do go up. The problem is that this can lead to being invested in areas that offer very little in the way of genuine growth prospects. As we have stated above the ultimate risk-free asset, cash, offers an attractive return at present. We do not believe that certain asset classes are offering sufficient prospective returns to compensate for the risks involved in investing them. This is particularly true in the Alternatives space, which continues to be occupied by a series of opaque, inconsistent and expensive vehicles. We will invest in this area but only on a highly selective basis.

No Time To Be Technical

Correlation is another area of heated debate at present. Put simply it is the extent to which different assets perform in a similar fashion to each other. Received wisdom is that generally bonds and equities have a low level of correlation ie when one goes down the other goes up and vice versa. This led to the wealth management industry generally recommending a 60%/40% split between equities and bonds. In periods of strong equity performance, the industry found ways of spicing up the bonds section with geared investments, so the 40% became more of an “other” bucket. From 2010 until 2021 the accommodative macroeconomic background meant everything went up ie everything was highly correlated. Then in 2022 everything went down together. The simple fact is that to construct portfolios on previous methods is no guarantee of future success. It will be important to think outside of the box.

Ignore Market Noise

Resisting the siren calls of market commentators and supposed experts is also important. Vast swathes of the investment industry prosper from meaningless short-term recommendations and tips that simply do not produce returns over the longer-term. In more difficult times this type of noise tends to increase and becomes ever more tempting for any investor. Strong discipline and an unswerving focus on quality, growth and returns is essential.

Opportunity Knocks

Although it may sound slightly perverse, we are genuinely excited about current market conditions. We believe that they will suit more active and fundamental investors who have the ability to sort the wheat from the chaff. The last 15 years have seen a generally rising tide carry all ships, with much success for cheap passive products and poorly constructed thematic based vehicles. Investors have generally become a little lazy, using proxies to gain exposure to loosely defined investment themes. Moving forward we do not believe this approach will be successful. The key requirements will be high conviction, laser like focus and the ability to look forward and not backwards. The Vermeer Partners investment process is based very much on fundamentals, understanding what companies actually do and looking to make money for our clients in every part of their portfolio. Therefore, no fundamental changes to our process are required in order for our clients’ investments to prosper.