The Weekender

JULY 8, 2023

Fighting in the gaps

From B.H Liddell Hart’s Strategy:

“Only 2% of all military victories were a result of a direct attack on an enemy’s main army. Most success came from attacking the flanks, from the untraditional, or from fighting in the gaps.”

So where might there be “gaps” for allocators and investors? Where are the scarcities, the value opportunities, and the uncrowded trades?  Well, I travelled to Monaco last week for the annual Fund Forum to try and find out. I find Fund Forum a great venue to test theories, ask awkward questions, and listen to both what’s said as well as what’s unsaid or overlooked. It’s often in these gaps where the biggest opportunities lie. And where were the gaps this year? Weaker bonds/higher yields, value, the UK, Japan (surprisingly), Emerging Markets, and commodities. They love AI and loath Bitcoin. Few had heard of Conway’s book Material World, even fewer of the Yale paper suggesting current ESG incentives are counterproductive.  And not one person had heard about Space Solar. Or knew a spot welder. 

“All I want to know is where I’m going to die, so I’ll never go there.” – Charlie Munger

Many I spoke to last week seem to have attached themselves to the idea that rates and volatility are heading lower, and that pre-pandemic programming is returning: long bonds and long duration. Now, volatility matters here, since a lot of marginal liquidity is being run on platforms and by “machines” that use vol-targeting risk frameworks. This means they deploy more capital (often with leverage) as volatility falls. Momentum builds around the trend, contrarian views get rolled, shorts cover, and a positive feedback loop envelops. With VIX at 14 and Nasdaq at 52w highs as I write this (5 July), that may describe the current tape. However, although these periods can last for a long time, when they reverse thy often do so quickly, and  the damage can be brutal, even existential. And so, I believe it pays to question this narrative as I expect a key trigger is about to be pulled – a break-out in the risk-free rate – a destination many might wish to avoid. In advance. 

Invertiere, immer invertiere!

“Invert, always invert,” was the quote made famous by German mathematician Carl Jacobi and adopted by Charlie Munger. It seems appropriate within the context of the risk-free rate – the 10y – for it seems posed at a critical juncture. Now, despite all the focus on the Fed, inverted yield curves and so on, it’s the risk-free rate we use to discount future profits. Get this right, get equities right. And what’s price signalling? Well, despite an incredibly bullish context (falling inflation, recession fears, Chinese debt-deflation, two of the largest bank failures in history) the 10y hasn’t budged. Could this forewarn of an alternative view where recession morphs to resilience or even growth? Could this be why the equity rally is broadening to include more cyclicals, small caps, and even transportation stocks?  As I’ve discussed previously, the homebuilders continue to defy the naysayers, with home prices in the US now up for a third straight month. The stock market is often the best economist. And if she is right this time, this new narrative should support areas like the UK, Japan and Brazil. Regions you could purchase a lot of with Apple’s market cap (which now buys you the FTSE and most of the IBOV). But for this change to occur, it needs a new narrative. And I know just the bloke to deliver it: John Maynard Keynes. 

The impacts of Military Keynesianism

Ashtead is a UK-listed stock with the majority of its business in the US. They just reported full-year revenue growth ahead of expectations, at 24% (!). Open their slide deck. Take a look at slides 16-19. Here they talk of $2T in likely stimulus over 3 or so years – a manufacturing super-cycle. On slide 16, note the sectors they expect to be impacted. It makes sense, I think, to over-index the suppliers and regions that feed into those sectors. Not only are many of them deep value (UK, Brazil,) some are undergoing reform (UK, Japan) and will benefit should a new narrative form around ESG that favours engagement/abatement. The UK, EU, Japan, South Korea, and Australia are all part of the US State Department’s Mineral Security Partnership. And the UK is a very “special” friend, it seems, being deemed a “domestic source” under both the Defence Production and Inflation Reduction Acts. So, closer economic ties may one day be reflected in closer valuations. This with a starting multiple of 14x CAPE in the UK v 28x for US. Now that’s a massive gap. One I would happily be fighting in.

Resource wars, nothing new

The race to secure critical materials for geo-strategic purposes is nothing new. Indeed, the West’s restriction of GPU chip exports and China’s reaction with its own curbs on gallium and germanium is a well-run playbook. During WWI, for example, the UK had to lobby the Swiss to persuade Germany, their enemy, to send them precision optics to ensure they had enough binoculars and telescopic sights to assist with range finding, a prerequisite for military success. Thanks to state largesse and muscular industrial policy, Germany had cornered the precision glass market, scaling what was before then a niche industry via huge subsidies. Sound familiar? What’s fascinating about this story is how it ended. As Ed Conway writes in Material World, the Germans actually gave the Brits the binoculars! But only in return for something they were short of, but that the Brits had cornered: rubber! So, where are the scarcities in this arms race? Where are the gaps? Well, as discussed, it may no longer be in the ephemeral. But it might be in the material world: in atoms not bytes, in things not ideas, in hands not heads, and in welders not coders. Software can’t eat that world, although it’s critically dependent on it. And this at a time software is now eating software. Yes, “AI will build AI,” so says Jensen Huang. And he should know. He’s the CEO of Nvidia.  

The trade of the decade?

As you know, I believe the UK could be an extraordinary opportunity on a 10 year view (as is Japan and Brazil). Not only is it ludicrously undervalued, but it’s also about to undergo significant reforms which could unlock the 2^nd largest savings market on the planet. This when it’s attracting foreign capital. According to the UN World Investment Report it’s the number 1 destination for FDI in Europe and number 3 in the world, and it’s already a centre for AI.  Just pausing on AI for a second, a limiting factor for successful application is access to data. Well, in the field of biotechnology and health science, an area the UK excels in, who has the largest patient data set on the planet but the NHS?  Could this be one reason why Open AI have chosen London as their first non-US location? And Palantir are coming too. Might they have been in discussion with the government as to our defence capabilities? I wonder. But back to capital markets. Yes, reforms help: think less red-tape, tax-incentives for home bias, lower reg-cap requirements (Solvency 2) and boosting research coverage/sponsorship by reversing aspects of MIFFID 2 (unbundling?). But often, the most powerful incentive to money flows is price. And if the world becomes more open to the importance of the material world, the UK stands to benefit. We might see a large value transfer from the ethereal to material, from the US (on 28x) to the UK (on 14x). Next week we will hear more from Jeremy Hunt at his Mansion House Speech (Monday). And ou might remember my comment after the Atlantic Declaration; I think Sunak may have negotiated a free trade agreement with the US but just hasn’t told us yet. Perhaps he was waiting for Biden to visit before announcing it? If he is, he won’t wait long, Biden is scheduled to be visiting next week. For more on this read Change.

The biggest gap, in Space

We’ve discussed space-based solar as a potential solution for the energy transition. Unlike wind and land-based solar it’s continuous (think baseload), offers energy density closer to that of nuclear than other renewables, but at a lower cost and without the issues with waste. CalTech recently demonstrated the ability to wirelessly beam power from satellites to Earth (so no technology impediment) and the UK (and Saudi) have committed capital to build a facility in an area considered the centre of the previous energy revolution: the North Sea. Now, I never seemed to get much interest on the topic. That might be about to change thanks to two other blokes (well, their business) by the name of Oliver Wyman, who have actually done some research on this topic. You can see their findings here. But clearly, the biggest gap of all, one few seem to be fighting in, is space.

“I don’t believe in astrology; I’m a Sagittarius and we’re sceptical.” - Arthur C Clarke