In this months Funds Focus, David Stephenson looks at an Industrials play, Literacy Capital and whats going on at Scottish Mortgage and RIT.
Capital spending has been booming in recent years. In 2021 and 2022 firms in the S&P 500 index of large American firms spent $2.5trn, equivalent to 5% of the country’s GDP, on capex and r&d, a real-terms rise of around a fifth compared with 2018-19. But that boom has now turned to bust – according to a recent Economist magazine report “ an American capex “tracker” produced by Goldman Sachs, a bank, offers a picture of businesses’ outlays, as well as hinting at future intentions. It is currently registering close to zero growth, year on year. A global tracker produced by JPMorgan Chase, another bank, also points to a sharp deceleration. The Economist analysed capital-spending data from 33 OECD countries. In the fourth quarter of last year, capex fell by 1% from the previous quarter.” These big swings in spending on everything from new factories to IT systems are not unusual – capex spending is almost always the first thing to get cut when an economy swings into recession.
It’s not surprising therefore that many industrial company shares are also highly cyclical. But once we move past this volatile cycle, new secular cycles begin to emerge into view. Arguably the most interesting decades-long secular, or structural cycle has acquired the nickname of Bits to Atoms. The best explanation for this shift came in a seminal October 2022 paper from BoA analysts “Fair value in a 5% world”. This posited – accurately in the last few months at least – that we entering a growth reset in a new world dominated by 5% rates, where we’d see a surge in capex spending and a reversion to the historical mean: “5% US core inflation, 5% wages, 5% corporate bond yields today, then 5% Fed Funds by Q1 ’23, 5% unemployment by Q3 ’23.”
Scratch away the more contemporary predictions and you get to a central driver – companies will either have to spend more on capex and automation or pay workers more. Or more elegantly the higher discount rate new world will punish speculators seeking profits in distant futures and reverse “decades of under-investment in “old” industries”. Far too many trillions of dollars have been invested growth capex and valuations and now old economy sectors will get the cash.
If you buy into this analysis – and I think its credible at the very least – then we’re due a massive reordering of capital flows as well as portfolio positioning. “Old” economy sectors such as Energy, Materials, and Industrials are just 15% of the market today compared to 40% last century. According to the BoA analysts, “Market cap would need to grow to $13tn (+160%) for these sectors to regain historical averages. Even getting back to 20% of the S&P 500 would require a $1.5tn market cap gain (+30%).” If that happens, we’re due a massive shift in ETF fund flows.
On a side note, and arguably more useful in the near term, this report also helpfully suggested some high beta ETFs which would get a proper thrashing every time growth wobbles : these high downside beta funds included (ARKK) ARK Innovation ETF, Invesco Wilderhill Clean Energy and the Vanguard Consumer Discretionary ETF.
Since October we’ve had a veritable tsunami of policy development by the US government to reinforce this new world of old world sectors. US government policy is now increasingly focused on revitalising American manufacturing and securing critical supply chains – for example via the Inflation Reduction Act and Chips and Science Act of 2022. And if you read publications like American Affairs, beloved of the new nationalist right in the Republican party, you’ll almost certainly see plenty more radical industrial policy ideas being suggested. The new world is here to stay whoever wins power in the forthcoming US elections – hyper globalisation is over and global trade routes are fracturing and reordering.
But of course, what we’re actually talking about here are a diverse range of distinct, interconnected trends all converging on the same endpoint. There’s the energy transition which is shining a light not only on batteries and renewable power but also on the remorseless rise of critical materials necessary for an energy transition to more electricity usage. There’s also of course the shift to reshore semiconductor manufacture as a strategic priority which intersects in part with increased military spending, much of which requires said chips. And then there’s the core underlying challenge – as we electrify everything, we’ll need a vast power grid reboot which will involve huge engineering spending. Add it all up and you can see that something is definitely happening at a structural level.
We can even see these long-term trends beginning to play out in todays markets. Typical of the industrial bulls are analysts at UK investment bank Peel Hunt who only a few days ago brought out a note on the global industrials sector which was surprisingly positive. They noted that despite all the volatility of the last few years – with tech and growth massively outperforming legacy industrials – industrial sector “margins are on the way to, or already at, record highs. …The profit bridges into 2023 are conservative while balance sheets are very robust, which creates a proactive debate around capital allocation. In addition, a feature of the global results season is historically low leverage levels.” For the Peel Hunt analysts the key to the industrial sector’s strength is pricing power –these are “companies with high market shares and high barriers to entry in process and/or safety-critical applications.”
Not unsurprisingly in recent months earnings have been looking up – 79 of the 300 companies in their industrials watch list have given organic guidance for the coming year. Many double are predicting digit plus growth such as Baker Hughes and Schlumberger, alongside a surprising number of auto companies from Autoliv to VW, as well as top general industrial play Rockwell Automation at 13%.
Of course, not everyone is convinced by this near-term prognosis. Morgan Stanley for instance are big bears, seeing echoes of earlier crises (the GFC and 1981) in the current environment. They speculate that there are comparisons with the run-up to the GFC where Manufacturing activity remained surprisingly good, all the way through until late 3Q08 – despite the emergence of credit pressures in 1H07. Their prognosis? Management commentary tends to lag real-world conditions, not lead. For MS, a more accurate parallel though maybe with 1981 and the S&L crisis due to comparative inflation and supply chain characteristics. “Here, IP growth fell consistently between 4Q81 until 2Q83. The recession exacerbated the S&L crisis, also. The emergence of a financial credit dynamic reinforces our view that this is an industrial cycle, like any other. … we are expecting a deeper manufacturing downcycle than usual.”
And it’s fair to say that as we dust off the crystal ball, the upcoming quarter does look troubling for industrials generally. Factset reports that “the industrials sector has recorded the third-largest percentage decrease in estimated (dollar-level) earnings of all eleven [S&P 500] sectors since the start of the quarter at -9.0% (to $31.1 billion from $34.2 billion).” As a result of this deteriorating picture the estimated (year-over-year) earnings growth rate for this sector has declined to 13.1% today from 24.3% on December 31. Overall, 47 of the 70 companies (67%) in the Industrials sector have seen a decrease in their mean EPS estimate during this time. Boeing has notably been the largest contributor to the decrease in expected earnings for this sector since December 31.
This dismal picture isn’t helped by valuations, with the sector not being especially cheap on a forward PE of 17.5 versus 17.3 for S&P 500 – by contrast, the materials sector at a forecast PE of 15.8 and energy at 9.1 still look ‘cheap’.
Stepping back from this blizzard of long-term prognosis and short-term data, it’s also obvious that accessing these big trends is somewhat problematic. The drivers behind say the huge military re-armament push doesn’t entirely overlap with the push to reshore.
French investment bank SocGen has been quietly rolling out a variety of concentrated stock baskets that aim to reflect varying Bits to Atoms shifts. Their Reshoring basket for instance comprises 28 stocks “exposed to the spending of the seven industries that the US Administration sees as critical to the supply chain. These stocks have industrial sector exposure and have outperformed the S&P 500 and S&P 500 Industrials over the past five years.”
Top stocks (by market cap) in this list do include some more military-focused names such as Honeywell, and Raytheon but there’s also other big names in there such as transportation giant Union Pacific as well as industrial logistics outfit Prologis.
The SocGen basket of 28 stocks isn’t available to retail investors, so what should investors buy into if they want to access the industrials theme? The table below lists the main exchange-traded funds which track the industrials sector globally, and regionally. What’s interesting in my view is the relative scarcity of trackers in this space – there are just 12 ETFs with a total AuM (excluding a specialist battery value chain fund) of less than $1 billion. Looking down the list you’ll see many common stocks such as Raytheon, Honeywell and Caterpillar. The good news is that despite the lack of choice, fund fees are very low – all below 30 basis points. Your key choice is whether to go for a US, European or world tracker – my default instinct is to go as broad as possible which would suggest an MMSCI World Industrials tracker – the X Tracker fund with a ticker XDWI in the table below has a US exposure of just under 50% followed by Japan at 13% with Europe overall running at around 30%.
| Niche | Fund | AuM | TER | 1 yr | Top three holdings | |
| European tracker | MSCI Europe Industrials 20/35 Capped | SPDR MSCI Europe Industrials UCITS ETF | 247 | 0.18 | 6.09 |
|
| Cheapest and most US-focused | MSCI USA Industrials | Xtrackers MSCI USA Industrials UCITS | 14 | 0.12 | 1.90 |
|
| Largest (by AuM) World sector tracker | MSCI World Industrials | Xtrackers MSCI World Industrials UCITS ETF | 160 | 0.25 | 1.91 |
|
| Tracker based on main US sector benchmark | S&P Industrial Select Sector (USA) | SPDR S&P US Industrials Select Sector UCITS ETF | 155 | 0.15 | 2.38 |
|
Literacy Capital
Over the last few months, I’ve been warming to a small listed private equity fund called Literacy Capital. It’s fairly unique in that invests in well-established mid-cap UK private businesses – sweet spot £1m to £20m – that need some extra capital to accelerate growth. That means its typical target investments are below the radar for most big listed private equity funds. There are some other unique features – it is in effect an outgrowth of the Paul Pindar (the founder of Capita) family office and has quietly built up a striking track record on realizations. Moving forward, talking to the principals behind the fund – where they are very heavily invested – I was struck by how optimistic they were about deal flow in the next year.
Since then, the shares have slipped from a chunky premium to NAV to a small discount of 6.3%, with the market cap of the fund at £236m on a share price of 394p. The good news is that the deals keep coming in, proving their existing portfolio valuation.
The latest news is that the fund has sold a significant stake in Kernel Global to Three Hills Capital Partners”. According to fund analysts at Liberum, this deal “values BOOK’s stake at £28.6m, representing a 3.7% uplift to NAV. BOOK will receive £19m in cash, which will be used to repay the RCF and make additional investments. The sale represents a 9.8x net return to BOOK and a 6.7x cost based on cash proceeds. The original investment was in 2018. Kernel Global was BOOK’s fourth-largest investment, at 7.6% of NAV, as at 31 December 2022. The company is involved in the recruitment ecosystem.” Kernel was Literacy’s fourth largest investment (equating to 7.6% of NAV).
Literacy says it intends to use the cash proceeds to repay the amounts drawn under its Revolving Credit Facility, before recycling these proceeds into new investments. It says “this [deal] represents a highly profitable and successful investment for Literacy, demonstrating the team’s commitment to actively managing the portfolio and recycling proceeds to fund new investments in the pipeline.”
I think Literacy Capital could be a great long-term investment but I’m ever so slightly wary on the timing front. Sentiment towards private equity is still very poor and although the fund has slipped to a small discount, that 6% discount is minuscule compared to the huge discounts at say Oakley Capital Investments (which I also rate very highly). That said, Literacy Capital is absolutely a fund worth keeping a very close eye on.
Scottish Mortgage and RIT
There’s been a lot of press commentary about Scottish Mortgage in recent weeks. I won’t rehash the acrimonious debates at board level but simply observe that the nub of the issue is whether the funds increased focus – in recent years – on its unlisted portfolio of private businesses is well managed. Critics say no, most other observers are not so sure. Here’s the observation of fund analysts at Numis who note that these investments are managed by “a dedicated Private Companies Team of eight investors and an additional 30 investors who source and research both private and public companies”. The managers also very regularly review the valuation of those investments – again according to Numis analysts “in the 12 months to December 2022, Scottish Mortgage made 585 adjustments to its 92 unquoted investments, with 78% revalued at least four times”. I would also observe that the level of disclosure of that private portfolio is very detailed. Around 30% of the businesses are cash generative and another 55% are within 1 to 3 years of being cash generative. These private portfolio businesses are also all big entities in terms of market cap with over 85% valued at $2 bn or more with the vast majority late-stage, pre-IPO businesses. That of course makes the fund vulnerable to current market conditions where the chances of an IPO are close to zero. That does present SMT with a challenge: as Investec recently noted in their own sell note on SMT “We expect a late-stage venture capital industry valuation reset, and despite Baillie Gifford’s proactive and dynamic valuation process, we do not believe this wider industry reset and subsequent impact on broader sentiment is fully discounted.” That, I think, is a fair assessment and I would maintain that more haircuts in terms of valuations are on their way for SMT’s private assets portfolio – as is already the case at Chrysalis Investments which has spent much of the last year deploying its red marker pen.
But, and here’s the nub of the issue, at some stage – not imminently – the markets will turn and then the upside of those investments will become apparent (and will have a leveraged impact on the upside). To repeat, I don’t think that opportunity is now, or even in the next few months, but at some stage, the high-quality portfolio of SMT assets will come into their own. I continue to hold the funds shares in my portfolios but I wouldn’t add to that holding given current market conditions.
It’s a rather different story over at another long-term investor favourite RIT Capital Partners. For many years I have bracketed this venerable and trusted fund alongside its peers in the defensive, ‘safe haven’ category: Personal Assets, the Ruffer Investment Company and Capital Gearing. Not anymore. Since 2020 I have watched the volatility of the share price with increasing concern. Its clear that the fund has structurally changed and increased its exposure to riskier private equity and VC assets.
These assets may have produced impressive results in the recent past but currently – as SMT demonstrates – PE and VC investments are almost the last place you want to be in you want safe haven assets. And then there’s the issue of manager remuneration – an issue that has figured very prominently in another recent sell note from that respected Investec team of fund analysts. Here’s their recent, incendiary claim:
“we were surprised to see a share-based payment of £20.3m, bringing total such payments in the last three financial years to £55m. This prompted us to establish on what grounds these were paid. However, while it is best practice to provide full details of such incentive schemes, RIT Capital falls short of these standards. Given a shareholder total return of just 5.6% over the past three financial years, materially behind KPIs, and a further price fall of 11.2% year-to-date, investors are entitled to ask RIT Capital why it does not make full disclosure… we find that while the past few years have been challenging, there has been a significant increase in share-based awards, particularly in the last three years. A key driver of the share-based awards was clearly the spectacular performance of the VC book in 2021 and, given this, we question whether the incentive structure is asymmetric, i.e. the managers were rewarded for gains during a period when a tsunami of easy money drove valuations to nose-bleed levels, but there is no adjustment if valuations normalise.”
I agree. None of the above detracts from the quality of the management team nor from the long-term strategy – devoting more money to private assets probably does make more sense. But the fund is radically different now, with drastically different remuneration structures, and frankly disappointing returns. Avoid.
David Stevenson
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