Investment Management

Curve Ball

Quarter 2 2018

After a protracted period of rising equity markets, the stock market has finally cracked. A perfect storm of bad news: a diplomatic row with Russia, a Facebook-related data breach, threats of trade tariffs between the US/China and the usual nonsense from the White House all provided the excuse for equity markets to sell off in style. Should we be worried?

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A curve ball or a storm in a teacup?

In months and years gone by, events such as these would have been anaesthetised by the US Federal Reserve Bank in the form of lower interest rates. No more. After a slow start, the US is all but sprinting towards a ‘normalised’ interest rate setting, with one rate rise in the bag already this year and the promise of a further 3 or 4 quarter-point rate hikes to come. This will move short-term dollar rates to just shy of 3%, probably by 2019, and then on to 3.5% in 2020. A world apart from the zero-rate, equity- friendly environment promoted by the Fed in the aftermath of the 2008 crisis…and all entirely consistent with a normal stock market cycle.

Investors will not need reminding that, in all other major markets, interest rates remain either very low or negative. Some may even remember that high street banks used to pay interest on overnight cash deposits. This probably won’t happen in Europe or Japan for some time, but US dollars are now earning something meaningful (admittedly still below inflation) for the first time in a long while. This growing interest rate gap with the rest of the developed world suggests that the dollar should be soaring. In the informed world of foreign exchange, however, exactly the opposite has occurred. The dollar Index has now lost around 10% of its value over the last 12 months. As short-term rates have risen, long bond yields have barely moved. The yield curve has, therefore, flattened considerably, to its narrowest point since 2008. According to this one important metric, the US is heading inexorably towards recession. This goes some way to explaining the behaviour of the equity market and the dollar over the last few months. It really has nothing to do with Stormy Daniels.

It is unlikely that higher interest rates will be the sole preserve of the Fed. The Bank of England has already hiked rates by a quarter point and looks increasingly likely to tighten in May (to 0.75%) with further rate hikes expected as the year progresses. European rates will remain at rock bottom, however, as they will in Japan where Prime Minister Shinzo Abe’s promise of higher inflation remains just that. We are light years away from the economic horrors of the 1970s and accompanying economic collapse. Central bankers have read their history books and will be acutely aware of the perils of keeping interest rates lower for longer than is absolutely necessary. Investors should welcome a policy of normalisation, not worry about it.

The inevitable but predictable upward swing in monetary policy, therefore, hardly suggests impending doom. But what about protectionism? The economic impact of trade tariffs is hard to predict, not least because the US administration keeps changing its mind about the exact numbers involved. The main target is China, which imports around $50bn of steel

and aluminium into the US each year. Although this is a significant number, it represents less than 3% of total US imports and only around 10% of China’s imports to the US (less than 0.25% of China’s GDP). Even if imports stopped overnight (which is extremely unlikely), the ultimate impact on China is likely to be very small. China’s response – to impose tariffs on $3bn of US imports – is so tiny as to be almost patronising.

There are good reasons to be concerned, nonetheless. Trade tariffs are a problem as much for what they represent as much as the numbers themselves but, predictably, the original threat is already being watered down (by the White House’s exhausted Watering Down Department). The market’s reaction is probably a little worse than usual simply because there are so many moving parts. Last year, investors had also become used to rising stock markets as the norm, so perhaps some complacency had crept in as well. An excuse to take some trading profits, maybe, but nothing more.

Short-term investors and traders now face a dilemma. Inflation is still higher than cash and government bond yields. Uninvested cash is, therefore, losing value in real terms and the cost of staying out of the market can quickly become expensive. Thankfully, longer term investors have less to worry about. The last quarter’s correction provides a good entry point for new money, but for mature portfolios, provided that dividend income continues to flow (it will), capital values will eventually catch up, regardless of short-term market fluctuations.

Investor patience is typically in abundance when markets are rising but is often tested during periods of market declines. If your patience is being tested, or you are a regulator, remember this. The latest Barclays Equity Gilt Study of long term returns shows that since 1899, after inflation, a £100 investment into ‘safe’ government bonds would now be worth £493, cash even less. Quoted equities would be worth just over £2.6 million.

Russell Collister CHIEF INVESTMENT OFFICER - APRIL 2018

Pushmi-PullyuSometimes on our travels there are little things which belie the more traditional stages of the adventure - client meetings, seminars, the weather, the food, the hotel. There are fleeting idiosyncrasies which no-one really thinks to raise in a public forum; being utterly inconsequential and yet remembered by the traveller for years to come. Whether it might be the approach to central train stations (graffiti, industrial estates, overgrown verges) or airport taxi drivers taking your hotel transfer as an opportunity to provide you with the full Nürburgring experience. In my case it was one trivial little problem encountered on my recent trip to Switzerland. No, it wasn’t the dominance of veal and pork on menus (or perch from the Zurichsee), nor the armies of street-cleaning machines we had to dodge of a Sunday morning. It was my Swiss-induced door-opening-dyslexia. These evil (but very clean) contraptions always seemed to open in the wrong direction. Neither was this solely my burden, as my husband faced the same dilemma. Toilet doors swung out rather than in (which makes sense anyway), while hotel doors swung in, not out. Not helped by my lack of German (give me “poussez” over “drücken” any day, bitte schön) I tussled with doors, language and luggage, like some kind of groaning Pushmi-Pullyu from Hugh Lofting’s “The Story of Dr. Doolittle”. Thankfully, the Swiss don’t speak camel, as swearing occasionally ensued.

Once calmed (bags abandoned, gin and tonic in hand), I had the leisure of reflecting on the metaphorical and financial pushes and pulls we sometimes encounter in business; a sure path suddenly blocked, marked by indignation and, often, embarrassment. Doors which should have been opened easily were not, while others we expected to remain closed, opened so quickly that we fell into a crowded room. At FIM Capital, we only buy shares in companies we believe are on the path to growth, right? Well yes, of course, but sometimes there are doors to investment which need to be opened slowly, others which should remain closed and those which might slam in our face. Our entry point could be marked by a prudent and transformative acquisition or perhaps a change of management team. Sometimes our clients’ investments have to withstand a boardroom coup, the equivalent of galloping across a bridge before a portcullis thunders down on top of us. Sometimes it’s a takeover where a hatch opens above our heads and bestows us with a pile of cash (and the whole process of finding a good replacement investment starts all over again).

If you are really having a bad market day, there are neither “drücken” nor “ziehen” signs on a glass door which you walk right through, experiencing death by a thousand cuts. There have been a few of these recently in the UK and the US (must we really mention Carillion and General Electric again, groans the rest of the Investment Committee?) Like a snooker player, perhaps the trick here is to have one foot on the ground at all times and to walk a little slower with your eyes wide open. We call this diversification, patience and experience. There are also those lovely Helvetic doors I encountered in Zürich, where one doesn’t really know how to approach them until you simply have to. Sometimes making an investment decision can feel very uncomfortable and having 100% conviction towards any idea involves rushing in

where angels fear to tread. Occasionally, a 75% assurance can feel more like 50%, or being stuck in a revolving door with a small child riding a ‘Trunki’ suitcase. That said, revolving doors were invented by a sensible German to repel wind, rain, snow and what the Victorian age might label as “noxious effluvia” (street pollution). Best of all, you can only push. What might seem like a chore at the time, may yield significant longer-term rewards.

I finally confronted my own “Pushmi-Pullyu” dromedarian nemesis at the end of last year, buying shares in Visa Inc. for some of my US dollar-based client portfolios. Am I going to tell you that we’ve made a killing in the space of a few months? Well hardly, but despite the best efforts of Zuckerberg and Trump, they still trade at a modest unrealised gain and are trading over 3% higher, year-to-date. The decision to buy was as torturous as travelling with a Russian trying to get through passport control at Gatwick Airport on a Friday evening, only to find that the scanner doesn’t work and sniffer dogs are eyeing up his briefcase. Uncomfortable. Visa’s shares are expensive by general standards, they are a global brand name (covered by too many analysts) and thanks to ‘blockchain’ technology, shortly after we started buying them, Visa was corralled unceremoniously into a group called ‘disruptable’ industries; the rich hunting ground of entrepreneurs like Elon Musk. Not in our opinion, however. Visa represents excellent value at 28 times forward earnings (yes, gasp). We opened that particular door because Visa has remarkable metrics: huge profit margins, high returns on equity, supporting double-digit annual dividend growth and, perhaps ironically for a credit card company, zero debt. As far as fintech is concerned, Visa is more likely to lead advances in payment technologies than to be disrupted by it. We may have to be patient to see another triple-digit gain from these shares over the next decade but it will be worth the wait. Step into to the fast-track queue please, Madame and can I take your luggage? Oh and…yes of course we have automatic sliding doors at this hotel.

Mary Tait INVESTMENT DIRECTOR

Quarter 2 2018

“Great decisions often take no more than a moment in the making” (unless you are stuck in a doorway with luggage, Mr. Lofting).

Core Strength

Towns and cities across the globe have been uniquely developed over generations to accommodate evolving cultures and economies, transforming themselves time and again either to prepare for something new or to celebrate something old. Since the beginning of the industrial revolution the pace of change has accelerated, and our infrastructure has to facilitate ever-expanding and longer-lasting populations in addition to increasingly sophisticated technologies which change the way we interact with the world. While our ability to connect and trade globally is an undeniable advantage, in our efforts to keep up the pace of change, our capital cities risk becoming bland collections of uninspired tarmac, designed for quantity and efficiency over appreciable and characteristically visual quality.

Throughout cultures and societies, towns and cities are often built from a centre which inevitably influences how infrastructure develops and expands around it. This is often the case even if the original justification for that centre (i.e. trade, defence, agriculture, religion) is no longer as relevant, even if it might be to the overall detriment of the region’s long-term efficiency. Understandably, no-one would live in a town designed from a blank canvas for efficiency alone (this may explain why some places, such as the City of Peel, are so nice to visit, despite not being well suited to accommodate growing numbers of cars).

This natural evolution is a key element sorely lacking in many areas of our creative media. The film industry offers a great parallel, since tremendous care is needed when creating an organic and unique world without it falling flat when observed on-screen. Ignoring the process completely is worse; creating a product where it’s hard to care about the world being constructed or the characters within it. Films subsequently stick to the tried and tested; generating predictable returns by pairing off the latest that Hollywood can offer in order to fill out the latest year of film releases. Sure, it’s an efficient way of making money, but the best in the industry always seem to provide more. These appear to be growing less frequent, which isn’t surprising in a time where the budget for summer blockbusters can easily exceed $100m; a lot of money to risk when the ‘tried and tested’ works so well. Meanwhile high barriers to entry mean that small and independent projects can be over before they begin.

This is why literature truly excels. The story to be told is limited only by the author’s imagination, which is free from committee or budget, made evident by the fact that some of the best films are often heavily inspired by an author’s work, which has already found great success in its own right. The gaming industry has found some middle-ground between these two mediums and although there is the same mixed bag when it comes to big-budget endeavours, the cheapness of computers means that barriers to entry within the film industry do not exist to the same extent here. Valve has created a distribution avenue for the more modest game developer through its digital platform, Steam, whereby gamers pay for early access to a game which is still in its development phase,

Something old, something new…St. Vitus Cathedral Minecraft Project (Planet Minecraft).

Looking back on my visit to Prague a number of years ago, I am still in awe at the idea that St. Vitus Cathedral took between 600 and 1,000 years to build (depending on which start date you use). It must have taken considerable vision to see it through to completion. Of course, such infrastructure is not entirely unique to Prague.

leaving feedback on ways it can improve. This allows for constructive input from a relevant audience while providing funds for its ongoing development. The nature of this cycle means that a game won’t really attract a following unless there is more personal input in the central design, which shows in the final product. For example, ‘The Binding of Isaac’ was a game developed over a three-month period and released on Steam with modest sales expectations; since then, it has gained such a following that it has now been remastered and re-released on all major platforms. Similarly, ‘Minecraft’ was released to the public in 2011 as a developmental release (not through Steam) for a low fee and it is now perhaps one of today’s most widely recognised gaming brands.

By contrast, large gaming corporations which have derived great success from a pattern of annualised sequels will typically adopt a committee-driven development cycle, to tick boxes for a greater chance of success. While this provides reliable annual revenues, the shelf life of these games may be far shorter than those whose development phase comes from humble origins. As such, while certain franchises need to maintain a yearly release schedule to stay relevant, Minecraft has continued to grow its appeal even six years on from its original release. Although Microsoft’s £2.5 billion acquisition of Mojang in 2014 provided a natural boost to Minecraft’s reach, the game’s longevity can only be attributed to the core appeal it started with.

As a society, our preference for short-term gain over delayed gratification and longer term rewards is often reflected by the reaction of a share price to quarterly company results. While the requirement of regulators, that companies report frequently, does little to discourage short-term behaviour, recurring patterns through a variety of industries provide a convincing argument as to why a central long-term vision is so important. This is a quality we seek from companies in which we invest and sometimes it is most evident when we visit them in person, at the core of their operations, rather than looking for clues on a balance sheet.

Michael CraineINVESTMENT MANAGER

Creeping ChangeImmediate change is obvious but creeping change is only evident after a period of reflection. Take the altered London skyline or long-haul air travel. Now, one can now fly from London to Perth directly, when it used to take four days and nine stops. The era of slow change has disappeared, replaced by the catalysts of technology. Something new may be more efficient, cheaper, win greater market share and create larger profits but only until something better comes along. Will slower change return?

Historically, rapid change was typically a by-product of war or religion and consequential destruction, while a slower pace was usually associated with interim periods of peace. If this is the price to pay, I am not sure we want it back. Until recently, war and religion bonded foes, tore families apart and created or destroyed wealth. Government-led regeneration achieves the same end-results but realistically it is far less effective than free market capitalism or globalisation armed with technology, explaining why new structures are often named after sport stars and celebrities, rather than generals or saints. There is another price to pay, however. We forget the lessons learnt by earlier generations. Few regularly go to church or acknowledge Sunday as a day of rest. Extremists excepted, I doubt many testosterone-fuelled teenagers would consider signing up to defend the realm if it meant they could not play “Call of Duty” until the early hours (unless they lived in Norway or Sweden where conscription remains compulsory). Moral standings which dictated to earlier generations have disappeared as consumer-driven societies drifted towards pacifism to protect unrelenting appetites. This is where the risk now lies, as Britain has discovered in its dealings with Russia. Here, the terms of engagement appear to be lies, chaos and unpredictability, while years of defence cuts mean that Britain can huff and puff but do little else, while its enemies utilise technology to undermine the bonds of society. The irony behind all of this beggars belief. Earlier sanctions on agricultural exports to Russia transformed its farming base while Western suppliers lost a key market. Meanwhile the nerve agent used in Salisbury was an organophosphorus compound which the British Government forced farmers to use in the 1970s and 80s, quietly choosing to ignore the danger it posed to human health. The lives destroyed by this debacle are an unknown quantity but would run into hundreds if not thousands, rather than two. The British Government is by no means innocent. Our ancestors would not recognise the lives we now lead but unrelenting change means that the risk of sudden regression is growing. Education’s desire to be politically correct and gloss over history’s harsh realities means it now lacks depth. It is decades since a shortage of anything occurred, so mentally, physically and psychologically we are ill-prepared. The nearest any of us has come to conflict is at our fingertips, on social media where ‘micro-aggressions’ occur regularly over anything which portrays suffering, without looking at the broader argument. We can protest in seconds, proceeding with our self-indulgent lifestyles rather than expecting to sacrifice days, months or years to our cause. Counter-attack today is not a missile but the phrase “I am highly

offended”. Try saying that to a party beyond the national border. Gradual and unrelenting change also affects capital markets. Just a few weeks ago, news headlines were dominated by stock market losses, yet in the US, 80% of those transactions were computer-to-computer trades, as one party tried to get the better of another, in a game which has repercussions for everything from interest rates to pensions and our general wellbeing. Yet we see no outcry, or understand who controls the trades. We just accept this as part of life, forgetting that, thirty years ago, computer trading was non-existent. Despite its invisibility, computer trading could cause recessions. We worry about obesity, yet often fail to see that modern diets (ready meals, laden with sugar and salt combined with inactive office jobs) eventually take their toll. The dining room is now a TV room, where family fast food is eaten on the knees, yet we wonder why table manners are deteriorating. We spend hours on the internet looking at cat videos or updates on our cousin’s sponsored walk, yet are ill-informed on current affairs as quality journals face extinction, replaced by media outlets with vested interests. We are oblivious to the fact that our elderly neighbour may need help, as our eyes are glued to a screen. The world may be at our fingertips but it’s internet access we want, forgetting that HMRC’s super computer is reputedly monitoring every bill to assess whether expenditure exceeds declared income. You can’t hide anything from anyone. Creeping change has eroded traditional values and while mostly beneficial, there is a growing risk of naively sleepwalking into a world of unexpected events for which we are ill-prepared. Our most highly cherished value is freedom, yet we take it for granted. The freedom to think, to help ourselves and others, as well as taking responsibility for our actions in the backdrop of a fair and open media, is all based on experiences passed down through generations. False news and computer-driven markets cause growing anxiety and influence opinions. We are not prepared for a trade war, cold war or even a hard Brexit from any perspective, be it physical, social or mental. Although it shouldn’t have come as a surprise, these risks have crept upon us while we were looking elsewhere.

Paul CrockerINVESTMENT DIRECTOR

Quarter 2 2018

Sheep-dipping in Elsenham. It was the law to have police present while dipping….and not a Russian in sight.

Investment Management Briefing Editor: Mary Tait, Investment Director

The views and opinions expressed in this Briefing are those of the authors and do not necessarily reflect the official policy or position of FIM Capital Limited.

The investment team at FIM Capital Limited hopes that you have enjoyed reading our articles this quarter. If you are not currently receiving our Investment Briefing on a regular basis but would like to do so in future, please contact Viv Hounslea at vhounslea@fim.co.im.

+44 (0) 1624 604700 rcollister@fim.co.im Russell Collister - Chief Investment Officer

+44 (0) 1624 604703 tedmonds@fim.co.im Tony Edmonds - Senior Investment Strategist

+44 (0) 1624 604712 brhodes@fim.co.im Barbara Rhodes - Head of Settlements

+44 (0) 1624 604701 pcrocker@fim.co.im Paul Crocker - Investment Director

+44 (0) 1624 604704 mcraine@fim.co.im Michael Craine - Investment Manager

+44 (0) 1624 604710 rhaslett@fim.co.im Ralph Haslett - Chief Operating Officer

+44 (0) 1624 604750 jhaslett@fim.co.im Julie Haslett - Head of Compliance

+44 (0) 1624 604705 pcloete@fim.co.im Pieter Cloete - Investment Analyst

+44 (0) 1624 604702 mtait@fim.co.im Mary Tait - Investment Director