When the Music Stops…

As I write, global stock markets have reached new peaks with key indices such as the Dow Jones, NASDAQ and the FTSE100 trading at all-time highs.

Market volatility as measured by the CBOE Vix index has never been lower, suggesting that risk taking will continue to be rewarded and investors have little to fear. It would appear that equity shareholders have never had it so good and the horrors of the financial crisis of 2008 are but a distant memory.

In the cold light of day however, there are worrying signs of irrational exuberance in a number of sectors. Today’s masters of the universe are no longer to be found on Wall Street but in Silicon Valley. In a world of low growth, investors are willing to pay an extraordinarily high price for future prosperity. Disruptive technologies abound, whether they come from newer innovators such as Uber and Netflix or established giants such as Alphabet, Facebook and Amazon. The latter now commands a market value of $500bn, and the world’s richest man in Jeff Bezos. Ironically Amazon are now buying Wholefood supermarkets and opening bookstores. Hardly a day goes by without a new perceived threat to long-established networks in industries such as retail, technology and transport. Markets have taken the broad view that new is good and old is dead. This ignores the moral hazards of abuse of privacy, market dominance, tax avoidance and weak governance inherent in many of the new business models. Investors who flocked to hot IPO’s such as Twitter and Snapchat are already nursing their wounds. The notion that giants such as BMW, Cisco and Walmart will sit back and do nothing about the new world order seems rather extreme. For investors, there are few better examples of current valuation excess than Tesla, a company whose market capitalisation is greater than that of General Motors based on a forecast production level of around 100,000 electric cars in 2017. In 2016, GM produced ten million cars. As CEO Elon Musk recently remarked, his stock price “is higher than we have the right to deserve”.

Investing in supposedly safe assets is also increasingly fraught with danger. Government bond yields have rarely been lower at a time when inflation looks set to rise and the huge monetary stimulus we have enjoyed over the past decade will one day come to an end. The valuations of consumer staples companies have benefitted from this collapse in bond yields and have delivered outstanding long- term returns to shareholders. However, household names such as Colgate, Coca Cola and Reckitt Benckiser are all faced with a similar problem – very low growth. The responses to such a fundamental problem are often telling. Keep on buying your own highly rated equity or acquire your way out of trouble. In our view both actions are hugely risky and could easily destroy shareholder value, not create it. We also note the recent increase in shareholder activism affecting businesses such as Unilever, Proctor & Gamble and Nestle. It seems that shareholders are not satisfied with the huge returns they have enjoyed in recent years and are intent on squeezing the pips further. The targets then hastily conjure up strategic reviews whilst buying yet more of their own shares and slashing their investment in sales and marketing, the antithesis of what made them great businesses in the first place.

All of this makes us wary of investing in companies on high valuations which claim to be defensive or offer exponential growth. Record market levels globally are becoming increasingly hard to
rationalise and tighter monetary policy combined with rising bond yields could upset the current complacency. Our focus at Saracen now is to look beyond what is currently in favour and reassess
those companies so quickly written off. There is now an opportunity to buy well-established businesses with strong balance sheets at prices which are highly attractive for patient investors. The
parallels with 1999/2000 are becoming all the more prescient. Don’t be left without a chair to sit on when the music stops in today’s hot stocks.

Scott McKenzie, Investment Director

A version of this blog post has been published in the Herald 05/08/17

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