Reading links for this month:

• Segra Capital Management: Promises and potential pitfalls of ESG investing.
• Interview with Edward Chancellor: “Prudent investing is impossible these days.”
• Richard Lawrence: Investing in superior businesses.
• Building for generations: Foundations of the LTSE listing principles.
• Arnott Capital: Investing in asymmetric opportunities.

My notes from the Arnott Capital presentation in early August (these are for personal reference only and any mistakes in the transcription are my own):

Presentation:

• Kenny Arnott’s background – he moved to Memphis early in his career to work for Billy Dunavant (uncle of Paul Tudor Jones) and then also worked for his partner Sam Reeves in Fresno, California. They introduced him to the concept of asymmetric investing. Worked at Dunavant from 1990 to 1994, then spent ~5 years at Macquarie before founding Arnott Capital in 1999. 
• They focus on macro drivers to identify risk and opportunities, break it down into 5 key areas: Fed and fiscal flows, the economy, equity market valuations and earnings forecasts, flow and price action, other current social and political considerations. Particularly important to look at rate of change, not the absolute level – that is what drives markets. Then map out a timeline of events that they need to follow for portfolio positioning.
• What are they seeing today in these 5 areas?
  • Fed and fiscal flows – since February, US$3.9 trn (6.6% of global GDP) has been magically created through quantitative easing. We are now witnessing the great monetary inflation, unlike anything the developed world has ever seen. No sign of it ending. Now Congress has become an additional critical player in driving money supply with fiscal programs. Long lasting consequences, plenty of pitfalls and opportunities for many years to come.
  • Economy – we have seen a massive and immediate contraction in economic activity. Loan losses have their attention at the moment, rising at about the same rate of stimulus being put into the system. There may be some fiscal response that forces companies in general to bear more social responsibility. Could be bad for financials; early thesis, but that is one area they are looking at and monitoring.
  • Equity market valuations – important to note that the increase in valuation has not been consistent across stocks. Dichotomy in the market where we have a bull market in a number of large-cap tech stocks, while the rest are trading similar, in his view, to 2001-2004 (seeing earnings downgrades, anaemic price action, value positions not trading very well).
  • Flows and price action – call to put positioning is high, institutional investor positioning is no longer underweight equities, systemic investors likely to turn net sellers. All this indicates downside short-term risk.
  • Social and political considerations – on Covid-19, you have the reopening stocks pricing no reopening, but vaccine stocks pricing a reopening. If we do have a vaccine by Christmas, will be a very different market, present different opportunities. Could be that vaccine is negative for market – has only gone up due to big tech stocks (defensive nature), which may not be beneficiaries of a reopening. Cyclicals may do well, big tech names may do poorly. Other thing to watch is the US election, expect uncertainty will continue into November. 
• In summary, their outlook is slightly negative over the short term, medium term range trading with upside risk to cyclicals if we get a vaccine.
• In terms of the portfolio, they look to identify themes based on a global universe. The critical thing is not where the money is but where the money will go. They have ~100 themes identified as interesting, ~15-20 themes eligible for the portfolio, and then 10-20 themes in the portfolio at any time. Look to size themes at between 10-25%, but will trade around the position (e.g. gold not in their portfolio at moment as it has run too hard). Generally hold 3-10 stocks within a theme. Some of their current long themes: uranium, gold, connecting the future, health and wellness, Hong Kong, agriculture.
• Uranium – market going from surplus to a deficit, very rarely get orderly price behavior. Significant additional cuts to primary supply as a result of Covid-19. US utilities are the guys who are going to drive spot prices up. Buyers are low on inventory, sourcing uranium from a small pool. Catalyst to watch is the Russian Suspension Agreement, has to be finalized by October.
• Connecting the future – focused on 5G wireless technology. An increase in the speed of data transmission will drive an explosion in the internet of things. Ericsson is forecasting a ~350x increase in cellular connected devices from 2020 to 2025. Autonomous vehicles, robot surgery, smart cities, robotic factories – 5G will enable these technologies to come to market. They believe the enablers (e.g. telco operators and hardware providers) will claim increased economics in this upgrade cycle, as they learn from their mistakes in the 3G to 4G upgrade cycle.
• One name they like in this theme is Telstra, which is Australia’s largest telco operator, with 50% market share of mobile/broadband connection. Multiple upside catalysts, share price underpinned by quality infrastructure assets, market perception is a boring, low return business that has done nothing past 4 years but destroy shareholder value. Classic asymmetric opportunity. The asset backing limits downside + call option on 5G. Own the vast majority of their infra assets, now spinning off into a seperate InfraCo, worth around A$2.95 a share. Meanwhile, starting to see industry rationalisation after 4 years of declining ARPU (as a comparable, they look at how the 5G launch reverted the declining ARPU trend in Korea). Other thing they like is the enterprise solutions business, currently 14% of revenue, but expect will continue to grow.
• Health & wellness – trend set to accelerate driven by increasingly health conscious consumers, time savings as a result of WFH (estimate ~8 hours per week). Forecast the industry will grow at 7% CAGR over next 5 years, significantly higher than the growth rate of global GDP. They like Garmin, which makes fitness wearables, provides indoor fitness solutions. #1 or #2 in the end markets they compete in. Secular growth trading on 19x earnings. Below market multiple for above market growth. ~25% of revenues spent on R&D. Didn’t drop a dollar of R&D even in the June quarter, focused on ensuring best in class products for customers. 
• Long HK equities – overwhelmingly negative sentiment for HK, very similar to the mid-1990s. Opportunity with the immigration of US listed Chinese ADRs, could add US$550bn of market cap to the HSI. Recent changes in the share structure of the HSI resulting in a revamp of index weighting, with increased weighting of tech stocks in the index. Valuation beneficiaries: HSI, the Hong Kong exchange, certain index inclusion candidates (e.g. Alibaba).

Q&A: 

• How do they use macro drivers to manage drawdowns? First and foremost, they think flows are what drives the market, starts with the Fed, now also looking at fiscal flows. One of the valuable things about being a global, thematic investor is you can often apply the insights from work in one area to another. 18 months ago, for example, they were very interested in African swine fever and what investment opportunities that might bring. Early indications at the time were it could decimate the pig herd in China, potentially significant implications given pork consumption levels in the country. They did quite a bit of work trying to find meat companies that would benefit, didn’t end up doing much. When Covid-19 came around end of last year, they had no idea it would be a global pandemic, but knew it would present an interesting opportunity. Even as they watched the risks of Covid-19 unfold in China in Jan, they were stopped out of their large index short positions. They made the prudent decision to get out of illiquid small cap positions, which cost them money in Jan and Feb. Positioned the portfolio really safely as they went into March, put on a large short position in equity indices and financials, areas they felt were going to give the most alpha in a difficult environment. Then when the Fed came in with enormous stimulus, respected the power of liquidity provided, lifted the index hedge, covered the short financials.
• Views on other areas:
  • Gold – this is related to what is going on with money supply. Expansion is really going to stress the whole fiat money system, people are looking for alternate stores of wealth, likely to see this persist for a decade or longer. At the same time, they are not going to own gold if it has had a massive run and they think there is risk of a pull-back. They think about it as trading rather than investing gold exposure.
  • Outlook for financials – if you look at what happened with REITS in Australia, they were forced to forgive rent for the retailer tenants, but they have not had compensation on the other side (in terms of debt repayment). Ended up being the meat in the sandwich. Governments may eventually ask financials to bear some of the pain, rise in loan losses. Some banks trading cheaply, others (e.g. CBA) have no differentiation from peers yet are trading at much higher multiples. What would change their thesis? If the Fed allows the curve to steepen, that will be beneficial for banks.