Confidant Autumn 2018

Acting for clients as they would want to act for themselves

Autumn issue 2018 Published quarterly

C O N F I DAN T Managing bulls and bears

Emerging opportunities

Going it alone

Heading for a fall?

Paul Killik on how to position portfolios, p4

Patrick Gordon reflects on the Lehman legacy, p6

Svenja Keller’s top tips for budding freelancers, p18

David Stevenson weighs up private equity, p21

Off-piste investing An interview with Parm Sandhu, p12

C O N TA C T S

Save | Plan | Invest

Head Office

Locations

46 Grosvenor Street, Mayfair, London W1K 3HN

Chelsea James Dunn 45 Cadogan Street, London SW3 2Q J Tel: 020 7337 0590 Email: chelsea@killik.com

Richmond Ian King 2 Paradise Road, Surrey TW9 1SE Tel: 020 8948 7337 Email: richmond@killik.com

Chiswick George Harrison 23 Chiswick High Road, London W4 2ND Tel: 020 8090 3303 Email: chiswick@killik.com

Wealth Planning Svenja Keller 46 Grosvenor Street, London W1K 3HN Tel: 020 7337 0724 Email: svenja.keller@killik.com

Esher Paul Martin 9 Esher High Street, Surrey KT10 9RL Tel: 01372 464877 Email: esher@killik.com

City Nicholas Crellin 20 King Street, London EC2V 8EG Tel: 020 7600 9990 Email: city@killik.com

Hampstead Peter Day 2a Downshire Hill, London NW3 1NR Tel: 020 7794 3006 Email: hampstead@killik.com

Kensington Julian Chester 281 Kensington High Street, London W8 6NA Tel: 020 7603 3618 Email: kensington@killik.com

Private Client Team Simon Marsh, Fred Robinson, Kristian Overend, Michael Pate, Michael Berry, Gary Meredith Tel: 020 7337 0400 Mayfair Team Julian Spencer, Jeremy Sheldon Tel: 020 7337 0714 Grosvenor Team Fabrizio Argiolas Tel: 020 7603 5203 Killik Asset Management Graham Neale Tel: 020 7337 0008 Family Office Jer O’Mahony Tel: 020 7337 0664

House of Killik Northcote Road Richard Morris 125 Northcote Road, Battersea SW11 6PS Tel: 0207 337 0455 northcoteroad@killik.com

Killik & Co is a trading name of Killik & Co LLP, a limited liability partnership authorised and regulated by the Financial Conduct Authority and a member of the London Stock Exchange. Registered in England and Wales No OC325132.

Registered office: 46 Grosvenor Street, London W1K 3HN. A list of partners is available on request. Telephone calls are recorded for regulatory purposes, your own protection and quality control.

This communication has been approved by Killik & Co for distribution to retail clients. The value of investments and the income from them may vary and you could lose some or all of your investments. Past performance of investments is not a guide to future performance. The tax treatment of investments may change with future legislation. Prior to taking an investment decision based on the content of this publication, investors should seek advice from their Investment Manager on the suitability of such investment for their personal circumstances. Killik & Co accepts no liability for any loss or other consequence arising from the use of the material contained in this publication to make investment decisions, where advice has not first been sought from their Investment Manager. Killik & Co has no obligation to notify a reader or recipient of this publication in the event that any matter, opinion, projection, forecast or estimate contained herein changes or subsequently becomes inaccurate, or if research coverage on the subject company is withdrawn.

Partners or employees of Killik & Co may have a position or holding in any of the investments covered in this publication.

You may view our policy in respect of managing conflicts of interest on our website.

PERSONAL VIEW

FROM THE EDITOR

Investing’s biggest tragedy Tim Bennett Head of Education “Never confuse me with the facts” was a favourite quip from a former colleague in the days when I was Deputy Editor at Moneyweek magazine. His brilliance at bringing entrepreneurs alive on the page was marred by a surprising inability to work with numbers and charts. Despite being regularly cited by some of his high-profile interviewees as one of the secrets of their investing success, one concept in particular baffled him – how anyone could get wealthy applying the seemingly mundane principles of compound growth.

During my interview with company turnaround specialist and CEO mentor, Parm Sandhu (see pages 12-14), this issue came up again. Parm attributes much of his considerable personal investing success to a very good understanding of the power of the invested pound over long periods of time. He also agrees with me that it offers one of investing’s (arguably life’s) rare free lunches. The tragedy, that forms the title of my article here, is simply

that more people don’t exploit it properly to create wealth for themselves, their families and future generations.

We pondered why this might be. Part of the explanation undoubtedly lies in the way our brains are wired. For example, we are designed to think in what he calls a “linear” rather than “geometric” way. Our Head of Wealth Planning, Svenja Keller, agrees, which is why she emphasises the importance of drawing up long-term financial plans that can model the many long-term variables that will determine the answer to key questions, such as when we can afford to retire. Trying to do this in our heads is nigh-on futile and can even lead to bad decision-making.

The next problem is that our short-term survival instincts, which were embedded millennia ago, make us poor long-term thinkers. A relatively low projected growth rate might not seem as though it is doing much over a five, or even ten-year horizon. However, after 20 or 30 years,

every subsequent year adds a more and more meaningful amount to the total.

The pity is that most people, especially young folk, often don’t think beyond the next five to ten years, which isn’t long enough.

Thirdly, and linked to this, the best outcomes in most walks of life, including journalism and investing, are achieved when we stay the course and finish the task in hand. Too few people grasp that at any annual growth rate, over a long time horizon, a big chunk of your total returns will be generated in the last few years.

Cash in early and you sacrifice what a linear brain may not realise is a huge proportion of your overall returns.

So there you have it – to avoid playing your part in investing’s biggest tragedy, you should grasp the power of compound growth, think long-term and stick to your knitting. I hope that you will enjoy reading Parm’s interview and the rest of this Autumn issue. ●

S EC UR ITIES IN THIS IS SUE

C OMING UP

Teradyne p8

Robots and cobots p8

KION Group p9 Electronic Arts p9 Blackrock Frontiers Investment Trust p10 LondonMetric Property p11 Winton Absolute Return Fund p11 3i Infrastructure p11 CG Absolute Return p11 Creo Medical p16 Caretech p17 Yellowcake p17 DS Smith p22

Investing at the frontier p10 Bond holders beware p15 Playing it safer p16 The plastic problem p22 Up the workers p23 Autumn 2018 — 3

PERSONAL VIEW

Managing risk through market cycles Paul Killik Senior Partner With the S&P 500 recently stalling, having enjoyed one of the longest bull runs in its history, a pattern that has been mirrored by the FTSE All-Share, this quarter I revisit an important question for equity investors – can the history of these key markets act as a guide to the minimum time horizon over which you should feel comfortable investing in, or remaining fully invested in, the stock market?

then took a further 48 months to fully recover back to its 2007 high, closing at 1569.2 points on 29 March 2013. Below I have summarised our findings for the S&P 500 since the end of World War II and the FTSE All Share since inception. We have chosen to use price indices because total return indices (which include any income generated) do not go back far enough to make the data worthwhile.

that led to the Cuban Missile Crisis, and April 1962’s US controversy over the price of steel. The index had recovered fully by the end of September 1963. Then, from February 1966 until October 1966 the index declined by 22% amid a rise in inflation and interest rates, only to fully recover in a little over six months. The length of these two bear markets, from peak to trough to full recovery, were 21 months and 14 months respectively.

Up until the end of August 2018, and measuring a bull run as the length of time from the low point of the previous bear market without another 20%+ decline, the S&P 500 had been in an upward trend for 113 months, or 3,464 days, surpassing the previous record set between October 1990 and March 2000. Since the trough of the 2007 – 2009 bear market, the S&P 500 has gained more than 300% in price terms.

Amidst this good news (captured in chart 1) it seems to me that investors are increasingly focused on the wrong thing – when, or whether, the stock market may suffer a major fall and what to do about it.

Indeed, a large body of work has been dedicated to what is called market timing, something I do not recommend, in part because it requires tricky decisions about when to exit and then re-enter the market.

The S&P 500 Since the end of World War II, the S&P 500 index has experienced ten bear markets, with those that saw the largest drawdowns often lasting the longest. The first occurred between May 1946 and June 1950, a period of four years during which the S&P 500 declined by 28% from peak to trough before recovering fully by mid-1950. This bear market can be characterised in two stages, but was largely the product of the levelling off of the post-war surge in demand, rising inflation, and latterly declining corporate profitability.

Two of the three longest bear markets have occurred since the turn of the millennium.

The bursting of the technology bubble in March 2000 precipitated a decline in the S&P 500 index that lasted for two-and-a-half years and saw the index lose 48% of its value. It would be more than seven years before the index returned to the level it had reached before it began its decline. The S&P 500’s fall during the 2007 – 2009 financial crisis was even greater, as the index declined by 56%. The recovery took five-and-a-half years.

Instead, market cycles should be used as a risk management tool for private investors. To that end, at Killik we have looked at the length of bear markets in the S&P 500 index and the FTSE All Share index and drawn some broad conclusions about how to approach investing in the context of your financial goals.

A brief history of bear markets There are a number of ways to define a bear market. Ours looks at the length of time from the peak of the market, prior to a 20%+ decline, to the index’s recovery to that same peak following a 20%+ decline.

For example, during the financial crisis that began in 2007, the S&P 500 peaked on 12 October 2007 at 1561.8 points. Over the following 17 months, the index lost 56% of its value, bottoming on 6 March 2009. It 4 — Autumn 2018

The shortest bear markets occurred in the 1960s. Between December 1961 and June 1962 the S&P 500 fell 27%, due in part to the uncertainty surrounding the events

The longest bear market, sticking with our earlier definition, occurred between 1973 and 1980. The 1973 oil crisis, in which the Organization of Arab Petroleum Exporting Countries enforced an oil embargo on

Chart 1 – Share price performance of the S&P 500 (to 8th October 2018) 3500

3000

2500

2000-2007 2007-2013 86 months 66 months

2000

1500

1956-1958 26 months

1961-1963 21 months

1000

500

1966-1967 14 months

1973-1980 1980-1982 1987-1989 90 months 23 months 23 months

1968-1972 39 months

1946-1950 48 months

0 45 47 49 51 3 5 57 59 61 3 5 67 9 71 73 75 77 79 81 3 85 87 89 91 3 5 97 9 01 3 5 07 9 11 13 15 17 19 19 19 19 195 195 19 19 19 196 196 19 196 19 19 19 19 19 19 198 19 19 19 19 199 199 19 199 20 200 200 20 200 20 20 20 20

Source: Bloomberg Risk warning: Past performance is no guarantee of future returns. Your capital may be at risk.

a number of countries, including the United States and the United Kingdom, for their support of Israel in the Yom Kippur War, brought about a 48% fall in the S&P 500 index. The S&P 500 bottomed out in October 1974, however, it was not until July 1980, seven-and-a-half years after the decline commenced, that it had surpassed its previous peak. The slow pace of recovery was due largely to a period of stagflation – an unpleasant cocktail of elevated inflation, slowing growth and high unemployment.

The mean length of the ten bear markets in the S&P 500 index since the end of World War II is 3.6 years, or approximately 44 months. The median length is 2.7 years, or 33 months. The longest bear market, between January 1973 and July 1980, lasted 90 months, or seven-and-a-half years and the shortest from February 1966 and April 1967 lasted 14 months (chart two).

The FTSE All Share Unsurprisingly, the FTSE All Share index has experienced a similar performance to that of the S&P 500. Five out of seven bear markets experienced by the index, since its inception in 1962, have coincided with bear markets in the S&P 500. The longest, and the largest drawdown was seen between April 1972 and February 1979 (similar to the 1973 to 1980 decline in the S&P 500).

This decline lasted 6.8 years, or 82 months.

The next two longest bear markets were

during the financial crisis and the dot.com crash, lasting 71 and 62 months respectively. The mean length of the seven bear markets in the FTSE All Share index since 1962 is 3.8 years or 45 months. The median length is 4.0 years or 48 months.

So, how should this analysis influence your approach to investing?

Our three-pronged approach Firstly, it is worth noting that despite some large dips, over the long-term, the equity market has offered superior returns to most other asset classes, including fixed income and in particular cash.

The Barclays Equity Gilt Study finds that since 1899, the real return of UK equities has been on average 5.1% per annum, while long-dated government bonds have returned 1.3% and cash 0.7%. In the US, the equity market has returned an average of 6.7% per annum in real terms since 1925, versus 2.6% for government bonds and 0.4% for cash. There have been periods in both markets of weaker equity performance in both relative and absolute terms, however both studies suggest that the equity market should be an important part of any investment portfolio.

Next, given that timing the market is so difficult, a more sensible approach is to hold the maximum savings in a managed portfolio of good quality long term growth stocks and allow them to do what they do best over time. To determine the amount that should prudently be invested

Chart 2 – S&P 500 Bear Markets

To begin with, we believe that most private investors should only invest in relatively liquid securities. However, rather than then treating an equity portfolio like a bank account, to be dipped into as the need arises, you should divide your savings into three clear buckets; ●● ‘Rainy day funds’, held in cash, cover unanticipated outgoings, whether illness, redundancy or a leaking roof ●● ‘Foreseeable calls on capital’ are then funds earmarked to pay for predictable future expenses which are unlikely to be covered by earnings. These often revolve around children, or grandchildren, and might represent their school or university fees, which are fairly predictable from the point a child is born. The same applies, albeit with less certainty, to weddings or a first house purchase. The aim is to identify these large items of expenditure, estimate the timing and the amount using sensible assumptions and then keep a record. The longest bear market in the S&P 500’s post-war history spanned seven-and-a-half years (chart 2). So we believe that, subject to a judgement about market levels at the time, monies earmarked to cover calls on capital that fall within an eight year time frame should not be invested in the equity market. Instead, they should be in transit to cash, or to short dated fixed income securities with maturities close to that of the expected capital need ●● ‘Lifetime savings’ are the remaining monies that extend beyond these first two buckets and are to be invested with a long-term time horizon, potentially a lifetime or more. History suggests that the bulk of this money should be in equities.

1973-1980

2000-2007

2007-2013

1946-1950

1968-1972

1956-1958

1987-1989

1980-1982

1961-1963

1966-1967 0

20

40 Drawdown, %

in equities requires some planning.

60 Length, no. of months

80

100

None of this is exact science. However, I believe that history provides a useful guide to the positioning of portfolios and in particular in how to mitigate the risk of capital losses that might prevent us achieving our goals. I also believe that whilst a bear market can be psychologically uncomfortable, my approach means that an investor should never have to liquidate their lifetime savings at an inopportune time.

To discuss any of the points raised here, please contact your Investment Manager. ● Autumn 2018 — 5

THE BIG PICTURE

Ten years on: TARP, Trump and tariffs Patrick Gordon Head of Research

A little then a lot Having dithered over what action to take, as Lehman Brothers tottered on the brink of collapse, and miscalculated the short-term fall-out of allowing the failing bank to enter bankruptcy, the US Federal Reserve (the Fed) then acted more decisively than most of its central bank counterparts. It provided vast amounts of liquidity to help to recapitalise the banking system, as it unleashed its $700bn Troubled Asset Relief Programme (TARP). This set the scene for a decade of quantitative easing programmes. These have brought about a massive increase in the size of central bank balance sheets, a position that to-date only the Fed has started to unwind.

The exceptionally low levels of interest rates that ensued in the wake of the crisis have made cash and core government bonds less appealing and simultaneously bolstered investors’ appetites for riskier assets offering higher returns. This demand, coupled with a steadily improving global economic picture and a gradual pick-up in corporate earnings, helped to propel equities to record highs, with the US stock market recently seeing its longest-ever bull market, before October’s decline.

America first The Trump administration’s decision to launch a fiscal stimulus package, despite evidence that the US economy has been 6 — Autumn 2018

doing well, with spare capacity diminishing, has arguably also helped to extend the current US economic cycle.

Recent economic data have shown activity indicators, as well as consumer and business confidence indices (chart 1), near record highs. This all suggests a US economy in robust health at a time when other parts of the world are showing signs of slowing down.

Indeed, the relative strength of the US economic recovery since the financial crisis has enabled the Fed to travel further down the path towards policy normalisation than many of its central bank counterparts.

Having started raising its benchmark interest rate in December 2015, before pausing for a year, the Fed has been steadily hiking rates since December 2016. Most recently, this September, it took the lower bound of the Fed-funds target rate to 2%, with another 0.25 percentage point increase forecast before the end of 2018.

Chart 1 – US Small Business Optimism (NFIB) Index 120 110 100 90 80 70

1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

The 15th September 2018 marked the tenth anniversary of the collapse of US banking giant, Lehman Brothers, an event which ushered in an era of unprecedented central bank intervention. Interest rates fell to record lows and radical policies, such as quantitative easing (asset purchases by those same banks), were implemented.

A decade on, the effects of these policy decisions are still being felt.

This quarter I want to recap why and signal an opportunity for investors.

Source: Bloomberg

So far, the impact of these rate rises has been felt mainly at the short end of the Treasury yield curve, causing it to flatten.

However, given its importance to asset valuations, investors should also pay attention to the 10-year US Treasury yield, which financial analysts refer to as the ‘risk free rate’ (a key benchmark against which other US assets are measured). Should yields on lower-risk assets begin to increase markedly, we could see riskier assets becoming relatively less attractive.

Elsewhere, whilst the Fed has been raising interest rates and is in the process of shrinking its balance sheet, the European Central Bank intends to continue its QE programme until the end of the year, Further, it has signalled that interest rates, which are currently still negative in the eurozone, are not expected to increase until next summer. Relatively loose monetary policy has arguably helped to keep a lid on euro strength. This, in turn, has benefited eurozone exporters, and helped to fuel a large trade surplus, including with the US. Investors should note that this may yet attract further tariff attention from the Trump administration in due course.

Tariff trouble For now though, Washington’s trade dispute focus remains Beijing. Tensions have intensified over recent months, following further tariff announcements from the US and retaliatory measures from the Chinese government. At the time of writing, a resolution to this escalating ‘trade war’ (as is it dubbed in the media) appears to be some way off, since a material change in US trade policy seems fairly unlikely before the mid-term elections in November. The size of China’s trade surplus with the US restricts Beijing’s ability to retaliate directly via counter tariffs. Nonetheless, in a heavily interconnected global economy any worsening of the trade environment – with the potential to bring about supply chain disruptions and competitive currency devaluations – could present a material risk to growth and further upset financial markets.

Dollar dominance Meanwhile, the relative strength of the US dollar is not helping efforts to shrink the US trade deficit. For much of this year, the greenback has been amongst the strongest global currencies, having been supported by a combination of relatively robust US growth, the increasing divergence in central bank interest rates and the Trump administration’s protectionist policies.

THE BIG PICTURE

compelling investment opportunities both there and within the wider region.

Chart 2 – Emerging market currencies performance relative to US dollar (12 months to 2 October 2018) Thai Baht South Korean Won Malaysian Ringgit Hong Kong Dollar Taiwanese Dollar Singapore Dollar Peruvian Sol Polish Zloty Czech Koruna Colombian Peso Bulgarian Lev Chilean Peso Mexican Peso Chinese Renminbi Romanian Leu South African Rand Hungarian Forint Philippine Peso Indonesian Rupiah Indian Rupee Russian Ruble Brazilian Real Turkish Lira Argentine Peso -60

-50

-40

-30

-20

-10

0

10

Source: Bloomberg

This is particularly significant for those emerging markets that are running current account deficits and have US dollar funding requirements.

MSCI USA Index has been stark, as the US market was propelled higher by better corporate earnings and a buoyant technology sector.

The currencies of a number of these more vulnerable economies have come under particular pressure (chart 2 above), whilst some countries with stronger trade balances (chart 3 below) have performed better. This serves as an important reminder to investors that not all emerging markets are the same and they carry different risks and opportunities.

We nonetheless believe that for growth orientated investors with longer-term time horizons, who are able to tolerate bouts of volatility, exposure to emerging markets should be an important part of their portfolios. To us, the recent pull-back in valuations therefore offers a more attractive entry point.

Chart 3 – Selected Emerging Market Current Account balances, % GDP 20 15

Chart 4 – YTD Comparative Performance of MSCI Emerging Markets, MSCI World and MSCI USA Indices (Normalised, 100 as at 29/12/2017) 120

110

0

100

-5 -10 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Argentina

Turkey

Taiwan

Thailand

Source: Bloomberg

90

MSCI Emerging Markets Index MSCI World Index MSCI USA Index

80 Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct 2017 2018 2018 2018 2018 2018 2018 2018 2018 2018 2018

Source: Bloomberg

Emerging opportunities What happens in emerging markets arguably matters more than ever to a global investor. That’s because their influence over the global economy and its outlook has increased dramatically thanks to globalisation and their increasing share of economic output.

In aggregate, emerging markets, as measured by the MSCI Emerging Markets Index, have underperformed developed markets this year. Indeed, as chart 4 below shows, the underperformance of the MSCI Emerging Markets Index relative to the

Killik & Co Security Risk Ratings All research recommendations are issued with a security specific risk rating, represented by a number between 1 and 9. Assessing the relative risk of any security (specific risk) is highly subjective and may change over time. The Killik & Co Risk Rating system uses categories which are intended as guidelines to the specific risks involved, as follows:

1. Restricted Lower Risk

Securities in this category are what we believe to be lower risk investments such as cash, cash equivalents and short dated gilts, and the collective investment vehicles that invest in those instruments.

2-3. Restricted Medium Risk

10 5

The rate of growth in China will likely slow over time as the authorities seek to rein in some of the imbalances and excesses in the economy. However, a huge domestic demand base and growing affluence should all combine to provide a strong backdrop for more sustainable growth as the economy transitions increasingly towards being more consumption-based, with a reduced focus on exports and investment. It may well be that US President Trump’s protectionist policies serve only to hasten this transition. ●

We also believe it is important to be discerning when seeking to benefit from the superior growth prospects that some of these economies offer since countries with rather different dynamics are often grouped together under the banner “emerging”.

We continue to favour China and the South East Asian region. Despite the potential for near term disruption from the ongoing US tariff dispute we believe that China’s march towards becoming the world’s largest economy is unstoppable and will continue to present investors with a number of

Securities in this category are what we believe to be medium and lower risk investments including medium and long-dated gilts, investment grade bonds and certain collective investment vehicles investing predominantly in these securities.

4-9. Unrestricted

Securities in this category are what we believe to be higher risk and are drawn from across the United Kingdom and international markets.

These are normally direct equity investment and collective investment vehicles which predominantly hold securities other than investment grade bonds and money market instruments.

The vast majority of the Killik & Co Research recommendations are likely to fall in the unrestricted/higher risk category (4-9) above.

For further details on the Killik & Co Risk Rating system please see the Killik & Co terms and conditions.

Autumn 2018 — 7

EQUITY RESEARCH

Investing in “Industry 4.0” Andrew Duncan Senior Equity Analyst Global industry has experienced a number of seismic shifts, driven by technological advances, over the last few hundred years. It is going through another one now – a fourth Industrial Revolution, “Industry 4.0”.

We want to make sure that investors are well-positioned to benefit. Here is a summary of our recent full research note on this topic – for a copy, please contact your Investment Manager.

The first Industrial Revolution, which occurred during the late 18th and early 19th centuries, saw hand-based production methods gradually replaced by machines.

Fast forward and the world is now entering a fourth Industrial Revolution that is being driven by rapid advances in computing power, connected devices, sensors, and software. This sea-change will allow many industries to become increasingly automated. Over time, it is expected to drive a move away from the traditional human component of many processes. The Holy Grail for firms is a lower operating cost base, alongside improvements in quality and customer satisfaction. The implications for firms and their employees are huge as the winners and losers emerge from this disruption in the workplace.

A tipping point We believe the industrial world is now at a critical juncture. Technological advances have made large scale automation a reality.

Whilst its application to factories and warehouses is not new – the first industrial robots and automated warehouse systems were introduced in the 1960s – the speed of adoption has been accelerating in recent years. The reason is clear – Goldman Sachs estimates that by bringing manufacturing up-to-date with the latest technology, the total cost saving opportunity globally could exceed $500bn.

What’s more, demand for increased automation has been rising in both emerging and developed markets. Alongside the falling cost of these new technologies, wage increases in emerging markets have removed 8 — Autumn 2018

Collaborative robots (“cobots”), on the other hand, are able to work side-by-side with the existing workforce, altering manual workloads by reducing, or even removing, the human role in repetitive, strenuous or dangerous tasks. In addition, cobots are generally cheaper than robots, easier to program and offer a far shorter payback period.

what was once an economic barrier to wide-scale adoption. Meanwhile, a skills shortage in developed markets (or perhaps a lack of labour willing to undertake low-skilled manufacturing work), as well as a greater desire on the part of manufacturers to be closer to their end consumers, means demand for automation technology is rising fast. That’s why we are confident about two trends – firstly, increased manufacturing automation, as part of a drive to lower costs and improve productivity growth and secondly, a rise in the warehouse automation needed to satisfy the booming demand for ecommerce. I will take each briefly in turn.

The rise of the “Cobots” Industrial robots (referred to here as “robots”), in the traditional sense, are typically large, static machines that operate inside protective housing. This keeps them separated from human workers, largely for safety reasons.

We therefore expect that the overall cobot market will continue to grow strongly in the coming years.

For investors, we see a good opportunity to engage with this theme via US robotics and automated test equipment supplier, Teradyne. With a leading market share of over 50% and steady operating margins, this firm is well positioned to see a significant boost in revenue and earnings. Further, we think that the scale of its opportunity is still underappreciated by investors.

Warehouse to home 2018’s consumers increasingly expect to be able to receive almost any product within one day of ordering online. This means that the associated warehouses and distribution centres need to be sited locally and run at optimal efficiency. Given that only around 20% of global warehouses currently use any form of automation, the runway for growth is significant over the coming years.

Key data Name Teradyne KION Group Electronic Arts

Market cap (bn)

P/E ratio

Yield (%)

Price

Currency

Risk rating

6.4

14.7

1.1

35

USD

7

5.8

10.8

2.3

49

EUR

7

34.0

22.9

0

111

USD

7

As at 8th October 2018.

For more information about the Killik & Co Risk Rating system, please refer to page 7.

Please speak to your Investment Manager for further information.

Warehouse automation involves the design and implementation of non-manual processes that can handle the storage, handling and distributing of goods. The aim is to drive significant productivity improvements. For example, installing a multi-shuttle storage and picking system can increase “pick rates” (which may be fairly poor where batches of goods entering a warehouse are separated and allocated manually for onward distribution) by between eight and ten times.

After some steady growth over the last few years, we believe we have reached an inflection point in warehouse automation demand linked to the ongoing rise in ecommerce. This, in turn, is supported by technological advances in areas such as sensors and vision systems.

Enter Germany’s KION Group. Under its Dematic brand (acquired in 2016), it is now the global leader in warehouse automation systems, with a significant presence in North America and Europe. Roughly one third of this business is geared to pure-play ecommerce. In addition, KION is the world’s second largest supplier of forklift trucks globally and enjoys a strong position in Europe, where it has a reputation for technological innovation that delivers lower operating costs.

QUARTERLY ACTIVITY – A SNAPSHOT We continually monitor the market and our extensive list of covered stocks to ensure that our clients are kept abreast of new opportunities. This quarter, we take a look at the global video gaming industry.

Less work, more play Did you know that the average number of hours worked per capita across the G7 countries has fallen 11% since 1990? We expect this trend to continue as increased automation, led by advances in robotics as well as artificial intelligence, contributes to a rise in the overall amount of available leisure

PERSONAL VIEW

time enjoyed by employees and other workers. This extra free time may be spent a number of ways but we believe that a sizeable chunk of it will be directed at gaming of some sort. Video gaming in particular has already seen a ten-fold increase in the number of global participants in little more than a decade. An estimated 2.6 billion people were gaming in 2016, driven by the increasing penetration of mobile phone-based offerings, which now account for more than half of the total number of gamers.

Nonetheless, the traditional console market is also still growing at a steady rate, with new mobile gamers seen as an incremental user base and revenue opportunity. Overall, video gaming is still regarded as a relatively cheap form of entertainment, given the moderate

upfront cost of a console compared to the significant amount of time the average player subsequently engages with a particular title.

Greater engagement, higher profits The industry is undergoing three major changes in the near term, all of which are improving engagement, revenues, and ultimately, profits.

The first is a shift to digital downloads, which remove the physical cost of producing, shipping and selling games. This can result in almost twice the level of operating margin per game sold. Secondly, publishers now offer additional content (known as downloadable

Killik Explains videos

EQUITY RESEARCH

content, or DLC), such as new game modes or extra levels. These boost engagement and the time a player spends in the game. The third change is the rise of in-game purchases (also called micro-transactions, or MTX). These are typically low value, but highly popular, as they help to personalise a gamer’s experience.

Examples include; new weapons within a war game, additional outfits, or in the case of football game FIFA, additional players that can be added to a team.

Getting in on the action This FIFA mode, known as Ultimate Team, has been extremely successful in increasing engagement for, and adding high-margin revenues to, a share that we like – Electronic Arts (EA). This firm is a leading video game publisher, famous for its sports titles such as FIFA (soccer) and Madden NFL (American football), for which it licenses content such as team and player names. EA also produces wholly-owned IP, such as its popular Battlefield game. However, it is the sports games that are particularly attractive given the steady demand for the annual releases of these titles.

From an investment perspective, we believe that publishers like this should be viewed more as media companies, alongside the likes of Disney and Netflix, rather than technology giants, such as Apple and Google. That’s because content is king when it comes to games, just as it is for TV and movie offerings.

In the longer term, there are early signs that the whole industry will benefit from rising interest in eSports and the adoption of the new business models that are becoming possible thanks to developments such as in-game advertising, cloud-based streaming and subscription services. We feel that the potentially lucrative opportunities these will create are not reflected in the value of EA’s shares today.

For more information on Electronic Arts, including a copy of the full research note, please contact your Investment Manager. ●

Every week our Head of Education, Tim Bennett, produces a short video explaining a key topic relevant to investors. To watch his video on payback (mentioned above), please visit killik.com/explains and click on the shares tab.

Autumn 2018 — 9

FUNDS RESEARCH

How to boldly go into frontier markets Gordon Smith Senior Fund Analyst Investors face a problem with the most popular emerging market indices and the funds that follow them – they are increasingly dominated by a small number of markets. For example, just four countries; China, South Korea, Taiwan, and India account for over two thirds of the MSCI Emerging Markets (EM) Index. One way around this problem is to look at strategies that encompass both emerging and frontier markets.

EM or FM? Several issues are emerging for benchmark-aware EM investors. For example, a strong case could be made, on a number of metrics such as GDP per capita, for countries such as South Korea and Taiwan to be classified as developed markets. Meanwhile, whilst we remain positive on the long-term outlook for consumption growth in both China and India, their relative position within EM indices now dwarfs other equally compelling markets.

Enter frontier markets. The term is used to describe a subset of around 30 equity markets considered smaller and less accessible than their emerging peers. This universe includes some of the faster growing global economies (see chart) that generally exhibit better demographic profiles and, in many cases, relatively low aggregate levels of government and corporate debt.

Admittedly, both the broad emerging and frontier market indices have been fairly weak performers so far in 2018. This follows a strong run in 2017, driven largely by an improving global outlook, a stabilisation of commodity prices and a broad-based recovery in emerging market currencies.

More recently, however, global growth expectations have moderated just as negotiations on trade tariffs between the US and China have become more heated.

10 — Autumn 2018

have suffered, thanks to big fiscal and trade deficits that leave them more reliant on foreign capital. Whilst these markets have dragged the broader indices lower, they have hidden stronger performances elsewhere. Vietnam, for example, has continued to benefit from a favourable global export environment in addition to a strong domestic growth story.

Meanwhile, the likely future speed of the withdrawal of monetary stimulus by the US Federal Reserve has caused financial conditions to tighten.

One size won’t fit all Nonetheless, investors should be wary of generalising when it comes to emerging and frontier markets. These vast regions include countries that display a hugely diverse range of political regimes, economic conditions and regional idiosyncrasies. Key markets within the frontier category include a disparate mix spanning South and South-east Asia (e.g. Vietnam and Bangladesh); Africa and the Middle East (e.g. Kenya and Kuwait); Latin America (e.g. Argentina); and Europe (e.g. Romania).

Some of their differences have been very apparent during recent spells of market volatility. Equity markets within economies such as Turkey and Argentina

Emerging and frontier markets may well continue to face short-term headwinds and bouts of weak sentiment. In particular, the impact of uncertain US trade negotiations cannot be downplayed.

Yet, for long-term investors, the investment case remains compelling.

Valuation measures, such as the cyclicallyadjusted price/earnings ratio, are at attractive levels compared to developed markets and their own historic levels. The fact that corporate earnings have remained robust on the whole further strengthens the valuation argument.

Those who dare...

Investment in frontier markets is not without risk. Less developed markets are typically not as liquid as other more mature peers and can suffer from higher short-term price volatility. Moreover, countries within this space often exhibit more changeable economic and political

10 year average GDP Growth (%) China India Bangladesh Vietnam Indonesia Kenya Malaysia Oman Nigeria Morocco Bahrain Jordan South Korea Thailand Australia Romania Mexico South Africa Argentina Canada Brazil United States Switzerland Kuwait Germany Russia United Kingdom Netherlands France

0

Source: World Bank

2

4 Emerging

Developed

6 Frontier

8

10

PERSONAL VIEW

conditions, which are quickly reflected in both share price and currency movements.

A relative lack of rigour when it comes to legal and accounting practice also means that disclosed information may be less reliable and leave firms more susceptible to corruption. The small weighting given to these markets in most traditional global benchmarks means that analyst coverage is extremely thin. That, in turn, means their markets trade less efficiently.

However, this creates opportunities for active investors.

Take the London-listed BlackRock Frontiers Investment Trust, which aims to achieve long-term capital growth by investing in companies within any developing market country that falls outside of the eight largest ones targeted by the MSCI Emerging Market Index. The team, led by Sam Vecht, employ a flexible and unconstrained approach – they are benchmark agnostic and able to avoid any areas which they deem uninvestable.

Importantly, they spend a lot of time on the ground. By meeting suppliers, competitors and customers, as well as government officials and other key counterparties, they are able to build an independent view at both a country and company level. This blend of top-down and bottom-up approaches should deliver top-drawer returns. ● Our Emerging Markets Service The BlackRock Frontiers Investment Trust is a constituent of Killik & Co’s recently launched Emerging Markets Service. This fund-based managed service aims to provide access to markets that are exposed to faster growing regions of the world. It invests in strategies run by dedicated Fund Managers investing in companies whose business activities are predominantly in countries or regions classified as emerging, or frontier, markets. To find out more, please contact an Investment Manager.

Please be aware that your capital may be at risk and that past performance does not guarantee future returns.

FUNDS RESEARCH

Key fund data and charts Each quarter we look at the funds that we feel should be cornerstones in a portfolio, subject to your aims and objectives. Here are four core holdings: to discuss any of these in more detail please contact your Investment Manager.

Income & Growth

Absolute Return

LondonMetric Property (LMP-LON)

Winton Absolute Return Fund

Fund Type

UK REIT

Fund Type

Irish UCITS OEIC

Manager

Andrew Jones and team

Manager

Winton Capital

Market Capitalisation

£1.3bn

Market Capitalisation

£32.6m

Ongoing Charges

n/a – internally managed

Ongoing Charge

1.00%

Historic Yield

4.3%

Historic Yield

0.0%

This Real Estate Investment Trust aims to offer an attractive and growing dividend alongside capital growth from a portfolio of distribution and out-of-town retail assets. The team have a strong track record of navigating through property market cycles and adding value through development projects. This has been demonstrated recently through the realignment of the portfolio towards distribution and logistics assets, where the managers see superior income growth prospects. Risk Rating: 6

This fund seeks to provide long-term growth over rolling three year periods in all market conditions by investing in a diversified portfolio of futures and other derivative instruments.

The strategy is systematic and uses statistical techniques to find patterns and relationships in data. Trend-following seeks to benefit from price trends over multiple time horizons and from both upward and downward movements. This approach allows investors to benefit from both rising and falling markets. Risk Rating: 6

Total Return (last five years, indexed)

NAV Total Return (since inception, indexed)

220 200 180 160 140 120 100 80 2013

2014

2015

2016

2017

2018

Income & Growth

107 106 105 104 103 102 101 100 99 98 Jul 2017

Jan 2018

Jul 2018

Absolute Return

3i Infrastructure (3IN-LON)

CG Absolute Return

Fund Type

UK Investment Company

Fund Type

Irish UCITS OEIC

Manager

Phil White and team

Manager

Spiller; Laing; Clothier

Market Capitalisation

£2.0bn

Fund Size

£106m

KID Impact on Return

4.20%

Ongoing Charges

0.70%

Historic Yield

3.5%

Historic Yield

0.3%

The 3i team aim for an attractive combination of income and capital growth from a portfolio of primarily unquoted investments in infrastructure businesses and assets. The company has a focus on economic infrastructure, specifically businesses within key sectors such as transport, communications and utilities. The active management style employed has driven strong returns in recent years as exemplified by the disposal of two holdings at a material premium to holding value over the last 12 months. Risk Rating: 6

CG Absolute Return aims to achieve long-term capital growth, in absolute terms, by investing globally across a spread of asset classes. The investment process rests on two core principles: firstly, asset returns mean-revert over the long term; and secondly, market timing is therefore impossible. Spiller, who has managed the Capital Gearing Trust since 1989 has a strong track record of generating NAV returns that are significantly less volatile than global equity markets. Risk Rating: 4

Total Return (last five years, indexed)

Total Return (last five years, indexed)

240 220 200 180 160 140 120 100 80 2013

2014

2015

2016

2017

2018

130 125 120 115 110 105 100 95 90 May 2016

Nov 2016

May 2017

Nov 2017

May 2018

All chart data source: Bloomberg. Chart data to 8th October 2018. For details of the Killik & Co risk rating system, please refer to page 7.

Autumn 2018 — 11

CLIENT INTERVIEW

“Develop yourself, nurture others and take risks” Parm Sandhu CEO mentor, Non-Executive Chairman and Active Investor After a long and varied career, operating at the top of the telecoms and media sectors, Parm Sandhu is in high demand. Tim Bennett met him to find out what’s keeping him busy and gain his insights on a life well-lived.

and launched a truly integrated, market leading android based multi-device video platform. The TV landscape is fast following the mobile market where Apple and Google (android) are becoming increasingly relevant.

What are you currently working on?

I also chair the board of an early-stage, private-equity-backed investment manager called dataffirm, which was founded by a serial-entrepreneur. It specialises in using AI, big data and machine-learning to make investment decisions. We’ve spent the last two years fine tuning the complex quantitative models needed for the type of equity trading we want to do.

I am fortunate enough to be largely able to pick and choose my projects these days.

Around two-thirds of my time is taken up by non-executive directorships. I mainly work with private companies that are owned by either private equity firms, or credit hedge funds. I also do senior executive mentoring for Merryck & Co and am an active private investor.

12 — Autumn 2018

They tend to come to me. It helps that I maintain a network of financial sponsors in the private equity and credit hedge fund space with an interest in the sorts of turnaround situations I like. I suspect that a lot more opportunities of this type will emerge over the next three to five years as interest rates rise – even modest rises will put businesses with poor balance sheets under pressure. Although I don’t see rates rising far and fast in Europe, (and less quickly than they will in the US), highly leveraged firms will be caught out nonetheless.

Which challenges give you the biggest buzz?

I love taking a contrarian view where I believe that the market has either overreacted to, or even written off, a business because it’s going through a difficult period. My role is to oversee the development of a turnaround strategy and then find a team that can buy into, and execute, it. The most important task I face is appointing the CEO and then helping them. Having the right people, doing the right things, in a situation that many others would avoid, is extremely rewarding.

I love opportunities to make an impact and these tend to arise in situations where others can’t see the potential. For example, I recently served on the board of Eir, the formerly state-owned Irish telecoms firm.

It was sold in April this year for €3.5bn, having been Ireland’s biggest examinership (or, receivership) back in 2012. I was appointed as a key board member by its creditors, tasked with hiring a management team to oversee its revival.

I am currently going through a similar process with a Greek telecoms business called WIND Hellas, where I chair the board of the holding company. I had been watching this number-three firm in a four-player telecoms and media zone for some years. In 2015, one of the funds that held a sizeable position in it approached me to get my opinion on aspects of their strategy. Soon after that, I was asked to join the board and ended up chairing it.

Since then, a couple of credit hedge funds, with whom I have longstanding relationships, have acquired 95% of the equity, including buying out the fund that first got me involved. We’ve refinanced the business, invested in a fibre rollout

How do you find these roles?

Meanwhile, I’m on the board of Hibu, the multinational directories business that owns Yell in the UK. This is another example of a firm that fell from grace as it went through a print-to-digital migration.

It is now 100% digital in the UK and about 60% in the US. Here, the firm provides a digital business-listings guide and a whole suite of digital marketing services to small and medium enterprises. That allows those firms to have a digital presence and then to optimise it, whether via a website, a Facebook page, buying Google Ad Words, or running social media marketing campaigns. We simplify digital for our customers in an increasingly relevant but also increasingly complicated environment.

The separate mentoring work I do with Merryck is all about helping CEOs too.

I enjoy that hugely, because the truth is that I cannot be the perfect sounding board for a CEO at the same time as I am acting as a non-executive with a vested interest. A pure mentor should be there just for the individual and that’s what Merryck can offer.

Do you have any career regrets?

On a leadership development course many years ago, I remember sharing the results of a survey of 80-year-old retirees, who had enjoyed success across a number of different fields. They were asked, “If you had your time again, what would you do differently?”

One answer really struck me and has stayed with me, “We wish we had taken more risk.” Living busy lives, we can become obsessed with how we’re going to survive and look after ourselves in the here and now. However, proper personal development comes from putting yourself in bigger situations that allow you to develop and get the most out of life. And to do that, you have to take a certain amount of risk. Even if some situations don’t subsequently work out the way you expect, each one is still a great learning opportunity. That’s the mindset that I have always tried to develop and it’s why I have very few regrets from a career perspective: I have taken risks, and in aggregate they have worked out for me.

That said, I do have one big transactional regret. In 2009 I bowed to pressure from our financial sponsors to sell German cable giant, Unitymedia, to Liberty Global for €3.5bn. My instinct not to sell at the time was subsequently proved right this summer when Vodafone agreed to buy Unitymedia from Liberty Global in a deal worth over €18bn. Back in 2009, I didn’t keep faith with my own commercial judgement – I regret that.

How would you describe your personal investing style?

Firstly, I am a big believer in sticking to what I know. That means I tend to put money into telecoms and media opportunities plus the alternative asset managers that I have worked with. It’s an approach that requires discipline and an ability not to get distracted by investments I don’t fully understand – I run a fairly concentrated portfolio as a result, but then I don’t believe that diversification adds much value beyond a certain point.

Next, I am undoubtedly a contrarian. The old investing adage talks about being scared when others are greedy, and being greedy when others are scared. I like to frame that as seeing opportunities that others may have overlooked.

In order to do that, I have to be prepared to act on my third investing principle and take a long-term view. This is the aspect that I have to work on hardest and remind

PERSONAL VIEW

myself of most often. It gets easier over time of course, as the longer you are an active investor, the greater your personal track record. I try not to get obsessed by short-term earnings and value creation in the way many stock market investors do.

Fourth, for my bigger investments, I always create financial models of my own.

To help me take the right long-term perspective, I gave up trying to guess cost of capital and discount future cash flow streams to a net present value some time ago and I’ve started thinking in terms of an investment’s future value instead.

Finally, and linked to this, is my appreciation of the power of compound growth. A background as a mathematician helps here. As humans, we tend to think in a linear fashion, whereas compounding offers a logarithmic, or exponential, effect.

Understanding that is the key to grasping its power.

You also have to be able to understand how compound growth pans out over time.

I love, and still return to, an old school formula called the rule of 72. Very simply, if you want to double your money in five years, you’ll need to find an investment that pays around 15% annually (72/15 = 4.8 years). I accept that achieving 15% in the current environment is hard – over the last eight years, I have managed more like 12% – but that’s nonetheless what I have been aiming for. Keep that up for 30 years and you’ll end up with around 64 times your starting sum. The most important thing to recognise is that most of that growth comes at the end – the last five years will give you around half of it. Fail to stay the course and you miss out.

What characterises your most successful investments?

Without a doubt, they have been the ones where I have personally been involved – I therefore agree with whoever said that the best investment any of us ever makes is in ourselves. You have to develop the confidence to back your own judgement – for example I got involved in Irish telecoms giant, EIR, at a time when no-one else would touch it because I could see the potential amidst many doubters at the time.

CLIENT INTERVIEW

I also look for strong founder alignment.

I could cite many examples – I was fortunate enough to have a position at 21st Century Fox which has done very well just recently, as have some of my Liberty investments.

These all have stakeholder alignment, under a strong founder and figurehead.

Unfortunately, I think that raises questions about public companies and the way they are run, as this key ingredient is often missing. I only sit on the board of one public company and, whilst I absolutely agree that the directors need to be seen to discharge their responsibilities fully, I see a growing tendency at many PLCs for this to become something of a box-ticking exercise. It seems to me that the all-important personal judgement that should be behind key decisions sometimes takes a back seat. Two factors seem to be driving this. Firstly, the time required to do a non-executive role properly these days is often not commensurate with the remuneration offered, and secondly everyone is paranoid about being sued, in the US in particular.

Little wonder people like me often prefer to operate away from public markets.

What is the secret to a successful life?

It’s simple, at least on paper – you should strive to get the best out of yourself and perform to your best ability, whilst also helping others get the best out of themselves. Those two objectives go hand-in-hand, whether you are at work or at home.

In order to get the best out of yourself, you need to learn self-awareness and you also need to exercise good self-management.

To get the best out of others, you need to be socially aware and you need to be able to manage relationships well.

Autumn 2018 — 13

CLIENT INTERVIEW

The secret to a life well-lived is therefore constantly working on, and improving in, those four areas; self-awareness, self-management, social awareness and relationship management.

Highly effective people evolve all the time and recognise that life is a journey rather than a destination. For example, whilst I think I measure up pretty well against the first three of those yardsticks, I am still working on my relationship management skills – my natural impatience still lets me down at times!

I also get asked what success is not about – and for me that’s the exclusive pursuit of assets. An article in the Economist quite a few years ago plotted personal wealth against happiness on a chart, based on the results of a study into the relationship between the two. The fascinating thing was that, whilst wealth and happiness do correlate up to a certain point, the line tails off quite quickly. In the UK, for example, peak happiness occurs at around £1 million of assets. Beyond that, worries such as safeguarding wealth, dealing with advisers, organising taxes, coping with the social impact of money start to take over and overall happiness actually starts to decrease. So, whilst we all need a certain level of financial security, we should all regularly review what “wealth” really means to us.

How would you advise the 18-year old you?

It’s a bit of a cliché, but I do believe that hard work pays. So my first piece of advice to my “mini-me” would be to identify your talents and then really apply yourself. I have experienced many personal and professional situations where I haven’t necessarily wanted to get involved, or found

it difficult to, but the more I’ve tried to apply myself, the more I’ve been surprised by how much I’ve got out of all of them.

That said, application needs to be balanced with giving yourself time to explore, socially, geographically, emotionally and intellectually. There’s a very diverse world out there to be discovered and enjoyed and to do so requires an open, receptive mind.

Next, be reasonable and kind, in terms of the expectations that you have of life, and of yourself. Avoid FOMO (“fear of missing out”) at all costs!

Finally, learn to squeeze the most out of what you’re doing today – challenge yourself in the here and now and opportunities will come along.

Are your children good with money?

I tried to teach all three of my daughters from a fairly young age about the value of saving. They had pocket money from the age of five or six – no more than a couple of pounds a week. To encourage them to keep it, I would say, “For every £10 you save rather than spend, we’ll match it by giving you another £10.” It’s a simple but effective system. In the early days, it had mixed success but when their pocket money went up to more like £5 they started to really see the benefit. By the time they were able to show me £100 and

receive another £100 from us, they had well and truly caught the savings bug.

I have also tried to ensure that they understand compound growth. As teenagers, they appreciate the value of the time ahead of them, and so I just encourage them to take a similar perspective with their money. Over recent years we’ve started taking advantage of their junior ISA allowances and junior pensions to give them the full benefit of tax-free growth.

I have also tried to stimulate some interest in investing. Unfortunately one of the first shares my eldest daughter ever owned, BT, lost around 30% of its value fairly soon after she bought it. If nothing else, that taught her about short-term investing risk and the dangers of single stocks!

The other thing I want my kids to understand is the importance of seeing money as a useful means but not letting it become their master. Over my professional career my income has varied, but I have always lived well within it. In other words, your lifestyle needs to fit your income and I want my kids to have the strength of mind to resist the huge social and peer pressure to think that they can simply consume their way to happiness. I always remind them that my wife, Sharon, spent five years working at the Citizens Advice Bureau as an advisor and the vast majority of the cases she handled were underpinned by money problems. Thanks, in part, to the prevalence of social media, I worry that we are becoming money and status-obsessed as a society. I hope my children will set their own goals and standards and then pursue them without wasting time worrying about other peoples. If they can do that, I think they will be a lot happier. ●

Key career milestones ●● Graduated from Cambridge University with a first class MA in Mathematics ●● Qualified as a Chartered Accountant with PwC ●● Finance Director of Liberty Media International and six years at TeleWest Communications plc (now Virgin Media) in a number of senior finance and strategy positions ●● CEO of Unitymedia, Europe’s third largest broadband cable operator, for seven years. Left in 2010 after overseeing its successful sale to Liberty Global for €3.5bn ●● Former non-Executive Director of Eircom, Ireland’s telecoms operator. Successfully sold to NJJ Capital in April 2018 14 — Autumn 2018

PERSONAL VIEW

BONDS RESEARCH

Dealing with default risk Mateusz Malek Head of Bonds Research With the compensation on offer for holding corporate bonds versus ‘safe’ government gilts increasing – typically a sign of rising risk aversion – this quarter I look at how investors should respond to the potential threat of rising defaults.

Tin hat time?

In recent years, we have seen generally good conditions for credit markets in the form of healthy economic growth, rising corporate earnings and accommodative monetary policies. However, a proliferation of lower quality issuers has duly kept default rates above their long-term averages. In its excellent Annual Default Study, ratings agency Moody’s compiles data covering the credit experiences since 1920 of more than 25,000 corporate issuers with long-term, rated bonds, loans or deposits. They report, that during the last twenty years, the global issuer-weighted annual default rate has exceeded its long-term median of 0.8% in every year, bar 2005, 2006 and 2007. During this period, markets have experienced a number of crashes, including the bursting of the dot-com bubble in 2000, the global financial crisis of 2007-2008, the Eurozone debt crisis of 2011-2012 and, more recently, the oil price collapse. As the recent distress in the commodity markets receded last year, there was some respite as the default rate declined to 1.4% in 2017 from 2.1% the year before.

Against this backdrop, investment-grade, sterling corporate bonds have had a pretty poor run this year. At the time of writing, average spreads have widened by the most in seven years (a spread being the difference in the gross redemption yield between a corporate bond and a government bond of similar maturity).

The average spread on the Barclays Sterling Investment-Grade Corporate Bond Index stands at 144 basis points (bps), which is 25bps wider than it was at the beginning of

the year. This, combined with a fall in gilt prices, has generated a -2.8% return from the index so far this year. The rise in bond yields has been particularly dramatic in the subordinated-financials space, where some bond prices have fallen by more than 10% year-to-date. In this context, we think investors should review their holdings with an eye on default risk.

Boring can be beautiful Naturally, the credit rating attached to a particular bond will migrate up and down, as the issuer’s prospects change. The reason that IG bonds rarely default is because they tend to get downgraded to SG ahead of the event. Indeed, a typical potential defaulter will suffer four rating downgrades in five years leading up to the actual default event.

Selling an underperforming bond is therefore one way to mitigate the damage, albeit doing so will likely generate a loss for the holder. In this context, lower duration bonds (those with less time remaining until maturity) can lower the volatility of a bond portfolio. That’s because smaller durations reduce the scale of price reactions when the underlying yields change.

A recap on recovery rates

Safe rather than sorry One obvious way to reduce default risk is to stick to investment-grade (IG) bonds (i.e. those rated Baa3 / BBB- and higher). A large body of historic data demonstrates that such bonds are much less likely to default than those carrying speculative-grade (SG) ratings – over the last twenty-years, the median annual default rate for IG corporates has stood at just 0.05%, compared to 3.02% for SG and 1.32% across all rated debt. Even at the nadir of the financial crisis in 2008, when investment-grade bank Lehman Brothers defaulted, the annual default rate for IG credits peaked at just 0.63% – and that was the highest level since 1938. There is a reason why some bonds are not deemed ‘investment grade’ – once an investor ventures down the credit ratings curve in search of higher-yields, default probabilities increase exponentially. For example, an average BB rated credit is approximately five times more likely to default over a five-year time horizon than even a credit rated just one notch higher, at BBB.

Another important factor that affects default losses is the recovery rate.

Unsurprisingly, bonds and bank loans with a higher claim priority typically enjoy higher average recovery rates. For example, 1st lien (secured) bonds’ recovery rates average 54% on an issuer-weighted basis, according to Moody’s, compared to just 28% for junior-subordinated bonds.

Review, reposition, relax It has been nearly ten years since the default rates on global SG bonds peaked at above 12% in 2009 and sooner or later investors will experience another default cycle of some magnitude, albeit the timing and precise impact remain anyone’s guess. Following years of solid fixed income returns I believe that some investors may want to take steps to review portfolios and look to take pragmatic, defensive steps. These can include; improving average credit ratings and seniority levels, or shortening average durations, even if this means accepting temporarily lower returns.

The overall aim is to reduce the volatility of a portfolio and lower the risk that it contains next year’s default candidate. ● Autumn 2018 — 15

S P E C I A L S I T U AT I O N S

Blending health with safety Mike Savage Head of Special Situations Having enjoyed bullish equity markets since our service was launched in 2010, we have recently become a little more restrained in our positioning.

Headwinds include; rising interest rates, the ongoing possibility of global trade wars and rising geo-political uncertainty. As a result, we have been taking profits in some of the stocks that carry racier valuations (such as WANdisco and Blue Prism) and seeking safer havens in some uncorrelated parts of the market – examples include asset-backed share Caretech and uranium firm Yellowcake (see below).

It is also worth noting that within each bespoke Special Situations portfolio, we finesse the timing of transactions. This means that capital is deployed over a period of weeks or months, rather than in one fell swoop, an approach that reduces the risk associated with a market sell-off.

Further, we rarely invest in a stock without meeting the relevant management team – we hold 10-20 such meetings per week as a result. This forms a necessary and intrinsic part of our investment process.

We place particular emphasis on this as a prelude to any investment at the IPO stage (e.g. Fevertree in 2014) or via a secondary placing (e.g. Creo Medical last July). Here are three firms run by teams we like.

Creo Medical – keyhole investment This early-stage medical devices company is focused on surgical endoscopy. We view Creo as one of the very few ways available in the UK market for investors to gain exposure to a company that can boast significant intellectual property in the field of minimally invasive (aka “keyhole”) surgery. The benefits include better patient outcomes and a lower cost burden on the healthcare system as a result of reduced infection rates and faster recovery times. Keyhole surgery also reduces the need for general anaesthesia.

16 — Autumn 2018

£100,000 of annual recurring revenue, management’s short term target of around 450 physicians could equate to £38m of revenue (net of distributors’ margin).

Within the surgical field, the dual purposing of an endoscope means that, in addition to providing a view inside a patient, it can also be equipped with tools that can undertake some of the procedures that in the past would have required highly invasive open surgery. Creo’s key product, Speedboat, has been developed specifically for the treatment of colorectal cancer and is already both 510(k) approved in the US and CE certified in Europe.

Investors should note that the product is in the early stages of its lifecycle, having been used on only around 30 patients to date. Coincidentally, the company has also trained 30 physicians in how to use the device (with plans to hit 50 by the year end).

If we assume that a single physician with a light usage profile could generate around

In July, the firm raised £48.5m (gross) via a secondary placing at 125p. The aim is to expand the physician training programme, increase the number of routes to market (perhaps via the purchase of a distribution business) as well as invest in R&D to move into other types of endoscopic surgery, specifically related to lung and pancreatic cancer. We believe that the amount raised should prove to be more than enough to take the group to breakeven, which we expect to see in 2020, subject to the group not going direct in the US. What’s more, the firm’s route to profitability could be significantly accelerated should management undertake an acquisition in the meantime.

Caretech – looking after growth CareTech is a leading provider of specialist social care in the UK, with the vast majority of its revenue derived from the public sector. The firm provides residential and non-residential services to children and adults with a variety of needs. These range from learning and physical disabilities to mental health problems. It also provides fostering and family care services.

The end markets that CareTech operates in are large (£12bn+), defensive and highly fragmented. As a player of relative

Key data Market cap (£’m)

P/E ratio

Yield (%)

Price

Currency

Risk rating

Creo Medical

264

n/a

n/a

204

GBp

9

Caretech

279

9.9

2.7

368

GBp

8

Yellowcake

181

n/a

n/a

239

GBp

9

Name

As at 8th October 2018.

For more information about the Killik & Co Risk Rating system, please refer to page 7.

Please speak to your Investment Manager for further information.

scale, with a long track record and good Care Quality Commission ratings, the firm is well positioned to continue its consolidation of this market. An additional differentiator is management’s ability to retain staff at significantly higher levels than the broader sector.

This helps it to provide quality care as well as reducing the cost and disruption associated with replacing staff.

The group has recently announced a recommended cash offer for its closest listed peer Cambian Group, at an enterprise value of £289m, which equates to 12x 2018 earnings before interest, tax, depreciation and amortisation (EBITDA).

We believe that the £6m synergy targets announced by management will prove incredibly conservative. What’s more the combined entity will have significant exposure to children’s services, a better geographic spread within the UK and, most importantly, enjoy economies of scale that will facilitate the delivery of higher quality services than its peers. That in turn should create a virtuous cycle in terms of Caretech’s relationship with local authorities.

Whilst the combined group will have high levels of debt post deal completion (around four times EBITDA, or roughly £300m) this is offset by a freehold property portfolio worth around £590m, the bulk of which we view as residential in nature. Further, we see a path via which management can reduce the debt position quickly. The high level of shareholder support for the deal leads us to believe it will complete and, given that there is little geographic overlap, we would expect a relatively smooth ride from the Competition and Markets Authority.

PERSONAL VIEW

Yellowcake – nuclear profits This is a vehicle designed to provide investors with exposure to the uranium price. It achieves this through both a physical holding of uranium (around 8 Mlb) as well as options to purchase $100m of uranium per annum from Kazatomprom, the Kazakh state-backed entity that is the largest producer in the world). Investing in Yellowcake removes much of the risk that surrounds the exploration, planning, geology and other country-specific issues that can impact any mining company.

The crux of our uranium investment case is that we believe nuclear fuel has an important future in the energy mix.

Even a small move away from fossil fuel powered vehicles to their electric counterparts will significantly increase the demand for electricity. In order to maintain grid stability, this demand cannot be completely satisfied by intermittent sources of power such as wind or solar. The upshot is that the type of more reliable baseload that can be provided by nuclear power or coal and gas (which are increasingly being challenged by emissions targets) will be needed.

This, combined with the dynamics of the uranium market itself, creates a positive outlook for uranium.

The market’s main uranium buyers are utilities, who generally purchase on long term contracts rather than buying in the “spot” market. This is because the complex and highly regulated supply chain that processes “yellowcake” (U3 0 8 , the vivid yellow product of uranium mining) into its end product (fuel rods) can take over 12 months. It can also only be done in a handful of places in the world. The other key factor is that nuclear reactors are either “on” or “off” and any unplanned down time would create serious financial problems for the operator of what is a high fixed cost business. As a result, purchasing patterns have followed a predictable pattern over the last 40 years – periods during which utilities panic-buy large quantities of uranium on contract to secure their supply (which produces an accompanying price spike) are

S P E C I A L S I T U AT I O N S

interspersed with periods of significant uranium price underperformance as those same utilities consume the stock bought under existing, older contracts.

So where are we now? We believe that a turn in the cycle from cyclical lows is due.

US utilities look particularly exposed post 2021, as their contracted cover of uranium falls below 50%. We also expect a significant number of new reactors to come on stream in developing economies, as well as the restarting of Japanese reactors following the Fukushima disaster. Turning to the supply side, we have seen much more rational behaviour from producers in recent times, including production cuts and project curtailments at both Kazatomprom and Cameco (the world’s largest listed uranium producer) in 2016 and 2017. Whilst we do not believe that the price will start to turn upwards in the very immediate term, we note past price moves whilst not a guarantee of future performance, have been very aggressive. ● Testing senior management In August this year, I competed in the World Aquabike Championships alongside Creo CEO, Craig Gulliford.

He swept aside my challenge and finished third. I was just happy to finish!

Autumn 2018 — 17

W E A LT H P L A N N I N G

Are you ready to go it alone?

Svenja Keller Head of Wealth Planning Many employees consider setting up on their own at some stage during their careers. This quarter, Svenja Keller shares her thoughts on what they may need to think about.

What are the key factors in a decision to become self-employed?

There are lots of considerations. You need to start by being honest about whether you are the kind of person who is suited to working for yourself. Some people are attracted by the prospect of arranging their day around their clients and being largely self-directed. If you have a strong work-ethic, the extra hours you put in self-employed are more likely to be reflected in your earnings than as an employee. However, that means you should also have the self-discipline that is needed to avoid being distracted too easily from your work.

Others may prefer working in a bigger team, as an employee, and getting the career benefits that can come with a more defined structure and greater supervision.

Working for an organisation brings many social benefits that can tail off once you are independent. You also have the safety net of a minimum monthly wage, even if your workload fluctuates, and you don’t have to worry about funding holidays.

Someone who is self-employed, on the other hand, has to balance their desire to keep clients happy and earn as much income as possible against their need to enjoy their personal life and take breaks.

If you manage your clients’ expectations properly, that doesn’t have to be a big hurdle, but it’s a factor to consider.

Well before you take the plunge, you will also need to work out whether there is a market for what you want to do and how successfully you think you could develop it. This is a function of how many clients you think you might be able to win and 18 — Autumn 2018

that in turn is driven by the size of your personal network and your ability and desire to make use of it. Some people are better at this than others.

Let’s not forget about the importance of discussing all of this with your partner, or spouse. There are many benefits to being self-employed when it comes to flexibility around childcare for example, but a couple also needs to be ready to manage the change in income patterns and insecurity that comes with self-employment. It naturally helps if the other partner has a stable income so that, as a couple, you can ride out quieter periods.

How do you weigh up sole trader status versus setting up a company?

This is an important decision that is often heavily driven by tax considerations. A limited company structure can offer greater flexibility when it comes to deciding what you take out of your business, and when. That, in turn, allows you to better manage your tax rates, largely because of the different ways available to draw money, for example, as a salary or dividends. Also, if you have a spouse that does a bit of work for you, you can pay them and make use of their allowances.

A sole trader, on the other hand, accepts that whatever comes in will be subject to tax. You can still deduct relevant expenses, but there is no flexibility in terms of sheltering some of the income you earn until you actually need it.

Then there is the liability issue – a limited liability company offers more personal protection than sole trader status. That said, a lot of big companies will probably ask for a personal guarantee if you are set up as a limited company before they will work with you. Companies also come with a separate set of rules in terms of when tax is paid, plus extra disclosure and reporting requirements.

In short, there are pros and cons to both routes.

How does self-employment change personal and household budgeting?

As with everything in life, where there is an upside there is usually also a downside to match! Here, it is that the flexibility of self-employment comes with greater uncertainty in terms of your income.

Some people are not psychologically suited to unpredictability and it can present a serious practical challenge if you are either injured, or fall ill.

One way to manage income fluctuations is to ensure that in months where you earn a lot of money, you set it to one side to bolster less lucrative times. This is easier said than done and requires discipline.

Being employed doesn’t make the same demand, as you know your income level in advance and can budget accordingly.

One regular mistake I see self-employed people making is they only run one account for both their personal and

PERSONAL VIEW

will need to prove your earnings. If you’ve just started out, that could become quite difficult so we sometimes recommend that clients revisit this later on, once they are better established.

business income and expenditure and therefore tend to spend what they can see is available. I would advise that everything related to a business is kept separate and you then work out an allowance you will draw for personal spending. It’s a lot clearer to have two accounts and make sure that you are properly budgeting and managing cash flow on both sides.

One of the biggest differences, in cash flow terms, between being employed and self-employed is tax. As an employee, tax is handled for you by your payroll team.

However, once you are self-employed, you not only have to take responsibility for your own tax affairs but you also need to manage cash flow carefully. You may not have to pay the tax on amounts invoiced for some time and this needs to be budgeted for to avoid nasty surprises in the form of unexpected tax and national insurance bills. Get this wrong and you face fines, plus the possibility of a visit from HMRC, who have the power to declare you bankrupt in a worst case scenario.

I personally recommend bringing in an accountant to deal with that side of things so that you can focus on managing and growing your business. Even relatively knowledgeable entrepreneurs can otherwise find accounting and tax time consuming, distracting and expensive.

At what stage should someone think about engaging a Planner?

As early as possible, because they can help you on a number of fronts. I think it’s really important to make a financial plan, whatever your employment status, but it’s particularly important if you are running your own business. Some key questions to ask yourself whilst putting it together include; ●●

Do I have a big enough cash reserves to cover the early months?

●●

How much do I think will be coming in every month once I am established?

●●

Is that going to be enough – will it cover my regular expenditure?

●●

If not, have I got other resources from which I can pay for costs?

●●

What do I need to put aside for the longer term and how will I afford it?

W E A LT H P L A N N I N G

Then there is critical illness cover, which pays out a lump sum under a set of prescribed circumstances. It could help you to clear a mortgage, or make changes to your house after a life-changing illness or injury.

Next, a planner can focus on the longer term, something busy entrepreneurs or freelancers tend to overlook. You need to make sure that you’re not just living in the moment, but that you are thinking about “what if?” scenarios and setting aside funds for the future. A lot of people assume that the risk of them falling seriously ill, or getting injured, is quite low. They may be right, but the impact, if it happens, is enormous. As an employee, your employer will probably have most of these types of risks covered somewhere in your contract but that’s not true when you go it alone. You need to ask yourself some difficult questions; ●●

What if I am too ill to work or get injured (physically or mentally, through stress)?

●●

What if I succumb to a major illness, such as cancer?

●●

What will my family do if I die?

Insurance is available to cover all of these.

For example, an Income Protection Policy (in the past, it has been called PHI, or Permanent Health Insurance) will pay out a regular amount for the duration that you’re unable to work, subject to a deferment period (a minimum time during which you are ill). Thereafter, it normally pays out until retirement. One hurdle is that as a self-employed individual, you

The third type of policy to consider is life cover, which pays out an amount to your beneficiaries if you die. As an employee, you will probably benefit from “death in service” cover (which pays out a multiple of your annual salary) – this needs to be replaced once you are self-employed.

Death in service can be replicated through what’s called a Relevant Life Policy, which can be taken out if you have set up a limited company. The policy would be taken out by your company and it attracts corporation tax relief. Care is required to write these correctly, but these plans can nonetheless be a good way to achieve tax efficient life cover.

One thing many clients don’t realise is that statistically, the probability of dying is much lower than that of contracting a

This summer I was delighted to complete the Ultra Trail Mont Blanc, covering 171km in 42 hours and 38 minutes. In the process I raised over £10,000 for charity, including a £5,000 donation from the Killik & Co Charitable Trust. A huge thank-you to all those who supported me (and to my husband for putting up with my extensive training regime!).

Autumn 2018 — 19

W E A LT H P L A N N I N G

serious illness, so life cover tends to be a lot cheaper than other forms of insurance.

However, just setting that up for cost reasons alone is not a great idea – I would suggest most people look at income protection and even critical illness cover first. Budgets naturally do constrain what people are prepared to spend but this can be a mistake where the impact of sudden illness or disability could be massive.

Once the basic protections have been agreed and set up, then it’s important to carry out regular reviews as your circumstances change. Again, a Planner can help with this.

The other key thing we do is a cash flow analysis. We have a model whereby we plug in everything that you have: your assets and liabilities, income, expenditure, and we project it forward over the very long term. Then we can start creating different ‘what if ’ scenarios. None of them are pinpoint accurate but they give clients a good sense of direction, and help us to make decisions together whether around retirement, or what would happen if they died. For example, once it becomes clear that a family simply couldn’t operate without a certain level of income, the need for cover becomes obvious.

Sometimes this modelling can also throw out pleasant surprises – we may be able to advise a client that they can afford to spend more, or retire earlier, than they thought possible. The reason they sometimes get it wrong varies – forward cash flow modelling of all the key variables, such as inflation and investment returns, is very difficult to do in your head and people are often too cautious (or ambitious) with their assumptions.

What about retirement?

A lot of people seem to assume that this won’t be a problem, as they will either downsize their homes or sell their business to pay for retirement. This not only leaves them with all of their retirement eggs in one basket but it may be underpinned by some unrealistic assumptions.

Yes, a house is a tangible asset that will always have an intrinsic value but when the time comes, how many people will be able to give up a family home, or

20 — Autumn 2018

significantly cut the number of bedrooms they have, or even move to another, cheaper area? It all sounds plausible 20-30 years ahead but it isn’t always as easy as people assume. Indeed, some retirees actually want a nicer property in a more expensive area, perhaps in a town or city, when they retire and will need to pay for it, rather than release equity.

Selling a business and living off the proceeds is also fraught with risk. Businesses can fail at any time and successful ones are often dependent on you, as the founder, or another key individual. As a result, there may not be as much value to sell on as you assume. It is therefore also vital to have a succession plan in place, or you may never get out at all. An adviser must be ready to be honest and realistic with owners about what they may get out once they decide to let their business go.

For most clients, therefore, some sort of pension make sense. It could be a personal pension, stakeholder pension, or a SIPP – the right one will depend on your circumstances.

The good news is that a pension contribution can be a really tax efficient way of getting money out of a company because you get corporation tax relief on the amount paid in, as long as the contribution falls within certain criteria.

Recent freedoms, and the ability to pass on death benefits or assets on death, also make pensions far more flexible than they used to be.

and your mortgage may become slightly more expensive.

Things can get more difficult still if your mortgage deal expires, or is about to, after you’ve left employment. Banks usually ask for a few years’ of accounts and things can get tricky if you can’t provide them.

The other person to think about bringing on board early, depending on the size of your business, is a solicitor. If you plan to operate as a limited company, they can ensure that everything is set up correctly. For example, if there will be more than one owner, you’ll need a shareholder agreement. They should be able to guide you on worst case planning, for example around wills and powers of attorney, although this is an area where our Tax and Trustee experts can also help out. These don’t have to be complicated, or expensive, but forgetting about them can lead to big problems later. My usual rule of thumb applies here, as with any other adviser: since most people don’t know what they don’t know, why take the risk of finding out the hard way later? ● Self-employment – a checklist Here is a reminder of just some of the issues that are worth addressing if you plan to become self-employed. To discuss these in more detail, please contact an Investment Manager or Wealth Planner. ●●

Have you discussed this change with other members of your family?

●●

When are you planning to inform your bank and mortgage lender?

●●

Have you set up separate personal and business accounts?

●●

Do you have a budget and a comprehensive financial plan?

●●

Have you spoken to an accountant, planner and/or a solicitor?

●●

Are you covered if things go wrong?

●●

How will you provide for your retirement?

●●

What is your succession plan?

Who else should you talk to?

To reiterate an earlier point, you should engage an accountant first and foremost.

After that an early conversation with your bank makes sense. First off, you’ll want to check out your options in terms of business accounts. Also have a think about your mortgage. If you are within a current deal when you turn self-employed, there may be an obligation to tell the lender straight, even if they don’t choose to follow up.

Anyone looking to remortgage may find this gets trickier self-employed, because the lender takes on more risk – they have to be sure that there is enough money coming in, that the deal is affordable and that you have a steady stream of business for the longer term. They will ask a lot of questions

PERSONAL VIEW

OPINION

Crashing the private equity party David Stevenson Columnist and Active Investor Traditionally, private equity (PE) was the preserve of generously funded private partnerships, which would lock in big chunks of institutional money for five to ten years. However, over the last few years we’ve seen a bevy of well-known retail names, ranging from Baillie Gifford to Neil Woodford, elbow their way in.

Should retail investors follow suit?

VC versus PE At one end of the spectrum lies the world of venture capital (VC) investing. This targets starts ups (a space where the crowd-funders also operate) and earlier stage businesses that are typically less than seven or eight years old. However, there are important differences between, say, the listed funds that invest in technology-based university spin outs and the pre-IPO funds. The latter focus on much more mature businesses that are on the verge of getting onto either AIM, or the main London Stock Exchange market.

Moreover, the VC space is very different to the more mainstream world of private equity (PE). Here the focus is usually on businesses with a value of many hundreds of millions, a good number of whom are the product of spin outs, or leveraged management buy outs at more established businesses. Within this much bigger arena – typically the preserve of well-established giants, such as KKR or Blackstone – there are crucial differences between the various operating models. For instance, HgCapital, a listed PE house, applies a unique mandate that invests in businesses that are typically more “mid-market” than its peers and focused in specific geographies (such as Europe) and sectors (such as technologyenabled business services).

Methodologies also vary enormously. Some managers specialise in intricate financial engineering and layering up firms with debt (usually in “mezzanine” structures that involve subordinated loans) to generate returns. Others are more operationally focused on delivering commercial turnarounds. The private equity world has

also expanded recently to include a related, but discrete, universe of funds that ‘lend’ money to more established businesses, rather than investing purely through equity.

Having mastered these complexities, the next challenge for an investor is deciding the best way to access this growing asset class. For example, do they invest directly through a single fund, with a single fund manager, or via a fund of funds that invests across different managers? Return profiles will also vary – a debt-focused strategy may deliver income for example, whereas other strategies may aim for growth.

A dangerous dance for novices Before deciding, investors should ensure they understand the risks. For starters, nearly all of these investments are, by their nature, illiquid.

Next, the reporting of returns and the associated risks can be relatively poor.

Listed private equity funds have made huge strides in how they convey portfolio performance but overall the industry remains far from transparent.

This is especially true when it comes to deal fees, LLP (limited liability partnership) structure fees, or annual management charges (AMCs). Many PE funds still operate at the higher end of the cost spectrum. The best managers can justify this on the basis of the work involved, the risk they undertake and subsequent performance improvements. However, cynics may point out that many rely heavily on leverage and financial engineering. During the recent low interest-rate cycle, this enthusiasm for debt could place investors at risk if market conditions change.

Then there is the exit problem. Some PE houses fatten up a solid business, oversell its prospects and then attempt to list it at a lofty valuation. Investors buy into these IPOs only to get a shock later in the form of a share price tumble.

Only fools rush in I am not Dr Doom on the whole sector.

I suspect that public markets investors such as Gervais Williams at Miton are right when they say that some of the best growth prospects come from fast growing private businesses. Many of these firms are propelled by disruptive technology and a willingness to take the kind of risks large company stakeholders can’t, or won’t, tolerate. I’m also struck by the number of well-run private businesses that are choosing to ignore public markets altogether and continue to work with PE and VC firms.

Nonetheless, private investors should choose their entry point carefully.

Growth-orientated equity investors can achieve exposure to private businesses via a listed fund of funds, albeit returns have not been stellar. There is also a small handful of single fund managers that I admire enormously. Income investors may like to look at direct lending funds but take note that these are risky in the event of a downturn in the credit cycle.

Overall, I am wary of the recent rush into this space. I feel that we may be close to late-cycle for the current wave of M&A activity, which means that exit prices could start falling within the next 18 months. If that happens, many PE firms will start to struggle and any resulting opportunities will be absorbed by specialist funds. Retail investors joining this party now need to pick their drinks and their dance partners carefully and be prepared for the possibility of a hangover.

David is a publisher at etfstream.com and runs the adventurousinvestor.com blog site. ● Autumn 2018 — 21

INVESTMENT MANAGER VIEW

Profiting from the war on plastic Rachel Winter Senior Investment Manager 14,000. That’s the number of single-use plastic bottles sold in the UK every minute. 95% of those plastic bottles will not be recycled. A big chunk of the remaining 5% will be recycled into lower grade plastics that cannot be recycled again. Over the same 60 seconds, more than 4,000 disposable coffee cups will also be handed out. Such is the difficulty of separating paper cups from their waterproof plastic lining that just one in every four hundred cups is recycled.

As governments and consumers wake up to the scale of the environmental challenge this plastic mountain is creating, a huge opportunity awaits the firms that are trying to reduce the impact. This quarter I want to talk about one – DS Smith.

Clutching at straws Global plastic waste is becoming a major challenge. One area of the Pacific Ocean that is heavily polluted with plastic debris is thought to be three times the size of France. It is so large that it boasts its own acronym, the GPGP, or Great Pacific Garbage Patch. Meanwhile, a recent investigation by the Guardian estimated that the plastic packaging waste generated

by Britain’s leading supermarkets each year could fill enough skips to extend from London to Sydney.

Environmentalists have long been campaigning for a crackdown on single-use plastics, and importantly, governments are finally starting to take note. Recent initiatives include the 5p carrier bag charge, aimed at reducing usage, and the much publicised veto of plastic straws. However, whilst these are steps in the right direction, they are baby ones given the scale of the wider problem.

So why isn’t more being done?

The problem is the sheer lack of recyclable alternatives that are commercially viable on a large scale. A lack of recycling technology is also an issue. Food companies like to use black plastic packaging because they claim that it makes food look more appetising. And 22 — Autumn 2018

although much of it is technically recyclable, the current generation of waste sorting machines are unable to recognise it and so most of it gets sent to landfill.

Stripping back plastic Packaging innovation and advances in recycling technology are desperately needed. One company looking at both of these areas is FTSE 100 packaging giant DS Smith. This UK-based business offers multinational capabilities and expertise in plastics, paper, packaging, and recycling. Management recognise that, on the one hand, packaging demand will rise as the convenience food and e-commerce markets continue to expand, but also that, on the other, consumers increasingly want their packaging to be made from plastics that don’t pollute and cardboard that isn’t dependent on deforestation.

DS Smith has spent the last two years trying to solve the coffee cup problem, and it has now built a major site in the South East with the capability and the capacity to recycle virtually all of the coffee cups used in the UK each year.

This major achievement has not yet received the recognition it deserves, largely because waste collection firms are not delivering cups to the new plant as they do not have the infrastructure in place to do so. However, in a key recent move, Costa Coffee has started paying waste management firms a premium to sort and collect cups – other major coffee chains will likely follow suit as they recognise the growing importance of corporate social responsibility to investors and consumers alike.

Boxing cleverly Whilst DS Smith has undoubtedly made impressive progress in the recycling space, it is the production of corrugated cardboard that remains its core offering.

Zion Research recently estimated that the global corrugated packaging market was worth $250 billion in 2017 and will be worth $317 billion by 2023. Demand for boxes continues to grow as we order more and more items online, and DS Smith now

counts Amazon as one of its cardboard box customers, after the company was named and shamed in the media for using excessively large boxes for deliveries.

Since logistics are paid for by volume rather than weight, Amazon was wasting significant sums of money by paying to transport boxes that largely contained air.

DS Smith has dramatically reduced the amount of waste by producing boxes in a much greater range of sizes and shapes.

An attractive investment package The firm’s shares trade on a multiple of 12.6x 2019 expected earnings, which does not seem a demanding valuation for a company that is achieving its target return on capital employed (ROCE) of 12-15%.

Additionally the shares offer a well-covered divided yield of 3.3%. Lastly, DS Smith’s recent acquisition of Europac, a major European competitor, should allow it to reap the benefits of greater economies of scale. This augurs well for investors. ●

O P I N I O N

“Worker Power” is no panacea Matthew Lynn Columnist and Author Staff represented on the board.

Dividends split between workers and shareholders. Compulsory schemes that pay employees in shares as well as salary. As they look at ways of re-connecting capitalism with ordinary people, these are just some of the proposals being mooted by politicians in the UK and elsewhere. Some form of enhanced worker power has become the latest conduit for the critics who want to achieve a free market system that works more fairly for all participants.

However, despite the headlines it is currently generating, I am not convinced that this is the right solution.

Political football In September, as the political season kicked off again, the Shadow Chancellor John McDonnell became the latest politician to argue for a major extension of worker power. His proposals include both profit sharing and worker representation on the main board for any private company with more than 250 staff. “Ownership funds” would force companies to give their workers both a stake in their company and a say in its direction.

protest parties has demonstrated just how disillusioned many people have become with a global system of capitalism that delivers stagnant incomes and rising debt to the majority, whilst enriching a small group of “Fat Cat” directors. Greater worker participation is a concept that satisfies the needs of politicians who are keen to be seen to be “doing something”.

The lesson from “Dieselgate” Less cynical fans say the result should be better pay and greater involvement for the average employee.

Take the UK retail giant John Lewis. It has enjoyed a brilliant run as a worker co-operative, at least until its recent profits plunge. You don’t have to look too hard to find parallel examples elsewhere, such as the Mondragon Group in Spain with revenues of more than 12 billion euros.

Germany meanwhile has long insisted on some form of worker involvement across the corporate spectrum. No one would want to discourage these specific initiatives – quite the reverse.

He is no lone voice. Influential think-tanks, such as the UK Institute for Public Policy Research, have been pushing for something similar. Prime Minister Theresa May even flirted with the concept at the last election, although like much of her manifesto, the proposals faded away after the votes were counted.

Meanwhile, in the US, the leading Democrat Senator Elizabeth Warren has put forward proposals that would compel companies with more than $1bn in revenue to have 40% of their boards made up of worker directors. In France, Prime Minister Emmanuel Macron has also pushed more worker representation at a senior management level as a quid pro quo for some long-overdue labour market reforms. In short, the idea is fast becoming fashionable just about everywhere.

Should we be surprised? Not really. The widespread and rapid rise of populist,

However, as research in the Harvard Business Review this month makes clear, worker participation is not the easy fix it is made out to be. In fact, the existing evidence suggests that there is no clear correlation between having workers on boards and improvements in labour relations or corporate performance.

Sometimes it works, but just as often it doesn’t. Besides, if worker co-ops were genuinely that much better, surely we’d

already be seeing greater numbers of them as existing role models for the concept steadily outperform their peers?

There is little sign of improved ethical standards either. Volkswagen, for example, has always set impeccable labour representation standards but that didn’t stop the ‘Dieselgate’ scandal that followed evidence of widespread cheating on emissions standards. “What matters most is the functioning of the “entire package” of a country’s economic institutions… changes at the margins rarely have the intended effect if they are not part of a broader framework,” concludes the Harvard study.

A better approach The truth is that whilst it undoubtedly garners headlines for its proponents, worker power is not as simple, or effective, as is sometimes claimed. In a worst case, it just becomes a box to be ticked by human resources managers. In reality, few staff have the expertise to make a useful contribution to the management of a company. Meanwhile, profit sharing only works when people are able to make a meaningful difference personally to the amount of money a business generates. In most cases companies are better off paying simpler bonuses.

Besides, I would argue that the greatest ‘powers’ workers can be given are the ability to build skills and the freedom to move to a different job. The task of government is therefore to strive for an economy that offers both full-employment and rapid growth (right now the UK has the first ingredient but not the second) and the flexibility to allow workers to move to better paid employment. And the best way to achieve all that? Tax cuts and deregulation. Instead, several countries are in danger of imposing yet more rules and red-tape on their corporate champions in the name of enhancing worker rights. I am not sure they will be thanked for their efforts. ● Autumn 2018 — 23

USA

OR

China?

How are you balancing the emerging and developed markets in your investment portfolio?

To find out more about our Advised Investment Services and how we can work with you, contact us on 020 7337 0709 or visit killik.com/usa-or-china.

Investment and Wealth Management Awards 2015 Winner

Investment and Wealth Management Awards 2014 Winner

Best Discretionary/Advisory Wealth Manager Killik & Co

Best Discretionary/Advisory Wealth Manager Killik & Co

As is the very nature of investing, there are inherent risks and the value of your investments will both rise and fall over time.

Please do not assume that past performance will repeat itself and you must be comfortable in the knowledge that you may receive less than you originally invested. Killik & Co is authorised and regulated by the Financial Conduct Authority.