Peter Spiller and Christopher Mills: inflation, rising wages and falling profits

Merryn talks to fund managers Peter Spiller and Christopher Mills about the bear market, company valuations and inflation; why wages will have to rise at the expense of company earnings; plus the one asset they’d each buy and hold for ten years.

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Merryn Somerset Webb: Peter, let’s start with you. You have been waiting for this bear market for quite a long time. You’ve got a bear market. Is it what you were expecting?

Peter Spiller: We make quite a lot of effort not to forecast market movements in the short term. I’m with the original JP Morgan. Correct forecast is that markets will fluctuate. But we are driven by value, in the sense that we have felt for quite a long time that the S&P 500 is dangerously overvalued. Then, yes, it is the market we’ve been expecting, but we know nothing about timing. We’ve never claimed to know anything about timing.

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Christopher Mills: It could easily have advanced from here. At the moment the American market appears to be pricing in an extraordinary recessionary environment. So, the forecast for inflation are very bullish, in the sense that they think the market implicitly believes that inflation will collapse. If you look at the five-year, five-years, on the TIPS market, the expectation, the number there is just over 2%, implying that the Fed will not achieve its target. Because the target for the Fed is the PCE. For the CPI the implicit target is somewhere around 235, 240.

We’re somewhere below that, and the belief clearly is that the Fed can achieve dramatic sterling in inflation. And the concern is growing that that would involve some kind of recession. I certainly believe that that linkage is correct. In other words, that inflation cannot be brought back without significantly higher unemployment. Our unemployment today is 3.6. The estimates of where the neutral rate for unemployment is, the so-called now rate, that would stop inflation accelerating is somewhere between four and six.

So, there are people all over the place, but that’s neutral rate. If you have a neutral rate, then we’ll just carrying on growing at the same rate as we had before, which is currently six. And the level that you need to go to if you wanted to reduce that rate is no higher than that. So, we are faced with this horrible prospect, which is very difficult to judge, that a third, which clearly, they felt that they were losing credibility. Quite correctly, because they abolished all considerations of lags.

And they are trying to re-establish some credibility, but it is very unclear how tolerant they will be of rising unemployment, considering the statements that Powell himself made, back in August 2020, about how it isn’t just overall unemployment, but unemployment among his party’s groups, that he’s concerned shouldn’t be high. We just don’t know when he will pivot.

Financial conditions are fairly tight now, not very different from the level where he pivoted in 2018, but given the credibility problems, I anticipate that he will tolerate suitably higher, more watertight natural conditions than then. But where his breakpoint is, we just don’t know. The market’s very much assuming that we get some heated version quite soon, which of course, in nominal terms, we will, just as the anniversary’s passed. But also, the core inflation will be coming down within the forecast period.

So, by the spring of next year, perhaps. And interest rates will rise significantly this year, but will probably be lower at the end of 2023 than they are now. Against that background, with that recession, the one thing that I would say is that earnings estimates look far too high. Still really nice growth in earning in most forecasts. And they look much too high. The idea of a strong dollar in recession and higher interest rates, you get nicely rising earnings. So, I think it’s probably for the birds.

And finally, I read an author this morning, who obviously writes very well in his commentary on limbo, that every single strategist in Wall Street is expecting a positive return from the S&P 500 in the second half of the year. And so, we’re quite a long way from capitulation.

Merryn: Interesting. We started the conversation by saying that valuations in the S&P have been far too high for far too long. And so it’s been perfectly reasonable to expect they’ll fall. And now you see, or I’m certainly getting a lot of information from people saying, look, valuations have fallen quite a lot. This looks perfectly reasonable, and in historical context. But of course, what they’re not doing is taking account of the fact that their E number is wrong.

Christopher: And let’s also remember that E number is virtually the highest it’s been as a proportion of GNT for a very long period of time. So, it’s very hard to disagree with anything that Peter’s just said. And certainly, we expect lots of downgrades all over the place.

Merryn: Do you? And in what kind of timeframe? We’ve been thinking this will start coming quite soon, but we haven’t really seen it happen yet. We’ve seen some isolated examples, where you can see the cost pressures and the revenues coming down etc. And so, you can see it, but generally speaking, as Peter says, most analysts have not even begun to adjust their forecasts.

Peter: Yes, and the damage is going to start coming, in my opinion, with this earning season, because you’ve got the inflationary pressure. You’ve got this massive headwind of a strong dollar. And that’s going to certainly hit a lot of those concept of boring stocks, like the food companies. But those all have large overseas earnings. And they’re all going to have to come down.

One of the things that we’ve been looking at ironically, is companies in the United Kingdom, which have got the tailwind of lots of US dollar earnings, against a relatively small amount of dollar expense. We’re trying to find companies with that sort of tailwind, ie. they’ve got income in dollars, but expenses in sterling.

Merryn: Interesting. I’d love to hear more about those specific companies, but we’ll come to that later. I’m writing it down to remind myself to come back to you on those specific companies in a bit. But what’s your view, Christopher, on inflation? Do you broadly agree with Peter there, that it maybe is not completely transitory, but you’re definitely going to see a fall-off over the next period?

Peter: I tend to think that’s what I said, Merryn.

Merryn: It’s not what you said. You said that in nominal terms, you are going to see a year-on-year comparative fall-off, but I know that your view is that inflation is digging in for the long term, but at a slightly lower level.

Peter: Yes. And that’s our view too. We see it in the companies we’re involved in, because we, as a group, often have board directorships in the companies. And there’s unquestionably people saying, well, thanks for the 5% pay rise, but my cost of living in my life is up over 10%. And that’s got to be one of the issues which is going to come and halt the corporate profits arguments. And I don’t see, I think, probably since lockdown, there’s a lot of people that have left the labour force, both in the United Kingdom and the United States.

We seem to have a lot more long term people who are ill as well, and that probably exists in the United States too. So, I think the labour shortage is going to continue here. And by the way, it’s not just here. The same problem exists in Europe as well, to some extent, and certainly, in the United States.

Merryn: And do you think that’s driven by people dropping out of the workforce A, because they’re unwell, and B, because during Covid, they adjusted their expectations of how life should be? And just decided they would not work, or work in a different way.

Peter: Yes. I think the numbers in the United States is that it’s estimated that some 3 million people have left the labour force. And I think the number for the United Kingdom is about 500,000.

Merryn: Yes, but one wonders if they might not come back in that quite a lot of the people who’ve left the workforce are in their 50s. And one wonders if that’s partly connected to a wealth effect of them looking at their portfolios and looking at their house price. And thinking well, I can live on this. This is okay. But if their portfolio is now off by 15, 20% and their house price is probably going to follow relatively shortly, they may come back into the market.

Peter: They may. It would be speculating to suggest they will. Some of them, I’m sure, will. Some of them probably won’t, but what might tempt them back into the market is obviously higher wages. But higher wages are not necessarily good for the stock market.

Merryn: No. Well, that’s an interesting one, isn’t it, in that I think, I don’t know, Peter, if you would agree with this, but it seems to me that rising real wages would be a good thing? That would be a great thing. Maybe labour hasn’t had enough of a share over the last decade or so, but if we have rising real wages, and this might be a positive in lots of ways, it comes with the automatic negative of being bad for margins, and hence, bad for the stock market.

Peter: I actually do think that the balance share of GDP going to wages, which has been very depressed over the last 30 years, will rise. I’m afraid it has to be at the expense of corporate profits, to some extent, but it’s just part of what I believe to be a very big change in the overall environment. And to summarise, that we will be looking at an economy that behaves much more like economies in the 60s and 70s, not only for the huge inflation in the 70s, but in general terms, than the last 25 years, 30 years.

And that’s because the emergence of China and the huge expansion of globalisation has been a deflationary wind which has served and had varied influences in all sorts of ways. One is that it’s allowed central banks to be very connotative without getting problematic inflation. But certainly another has been distributional, that workers in Western countries have realised that they have to be flexible, I think would be the polite word, in order to keep their jobs in Europe or in America, rather than the Far East.

But all that’s changing. Globalisation is, I think, going to make a very modest impact, if any at all, over the coming decade and exacerbated by what’s happening with Russia. Russia’s having a big influence also, on people’s attitudes to China. There’s undoubtedly a big desire among certain politicians and I think populations in the Western world, to reduce their dependence on China. But in consequence of that is that there will be a big shift of power towards labour.

People always point out that trade unions are much less represented in the labour force than they have been. But I would just want to point to a couple of that. One is that the membership of trade unions tends to lag inflation, but being influenced by it. In other words, when you get circumstances like we have at the present, where peoples’ standards of living are coming under pressure, then they join unions to try and address that. That’s one point. And the other is, of course, that they remain extremely powerful in the public sector.

We’re looking, over the next few months, in the financial period perhaps settlements of public sector wages where the bid and the ask are miles apart. And the offer is 73 and the bid is ten, 12. That sort of thing. And I’m sure they will settle in the middle, but actually, I don’t mean in the middle. I mean somewhere between those two, but very much towards the upper end.

Merryn: It feels like seven or eight, doesn’t it?

Peter: Yes, which is where the private sector already is. And so, I think these are likely to be embedded. And I’m not surprised, because I remember very well back in the 70s there were academic papers written which would show that if people’s real wages fell, then they became unhappy and productivity fell. And actually, you need more than this to keep up with inflation now, because Mr Sunak is dipping his hand into your pocket to a rather greater degree as well. If you need the same real after tax earnings, you’d really want quite a big rise.

Merryn: Yes, you’d need 15%.

Peter: Well, it would have to be something like that. It depends, of course, on how much you’re paid. And therefore how big the impact of these tax changes would be. But national insurance it’s quite significant, and the freezing of allowances is also quite significant. So, of your increase, if you’re reasonably close to the margin, all the increase would be taxed at a higher rate.

Merryn: Yes, which feels very unfair. Sorry, Christopher, what were you going to say?

Christopher: There’s another factor, which I think perhaps investors haven’t really focussed on, and that is that you’d be surprised how many companies basically fix their costs in advance. One of our companies, for example, secured a one-year of electricity at a completely different price to where it is today. And the number of food companies that literally buy their food forward, so there’s even more cost pressure coming into the system than I think most people realise.

For example, we had a company called Greencore in the other day, which does about 1.5 billion in sandwiches. And they were talking about how they’d hedged some of their energy costs. How they’d hedged some of their food costs. But they were seeing huge increases, for example, in the price of chicken, so the sandwiches were going to go from 450 grams to 400 grams. So, you’re going to see shrinkflation as well as people try to hold it together.

But as I said, if those hedges run out, there’s no question that that’s going to add a further dollop to future inflation as well.

Merryn: And Christopher, in the companies that you deal with, what kind of wage demands and wage compromises are you seeing?

Christopher: Obviously trying to keep it back, but it’s pretty well impossible not to increase their wages by five to 6%. But you’re going to see the pressure there, as Peter’s been talking about. Now, fortunately, quite a few companies that we’re involved in have relatively high Ebitda margins, so it’s a bit easier to contain, and labour’s a smaller part of the component. But there are obviously industries where labour’s critical to the thing.

Merryn: And one thing we have to hope is that if real wages do go up, that productivity rises along with it. And Peter, I know that you’re not particularly optimistic about the way that the working from home revolution has affected productivity.

Peter: Yes. I always hesitate to make this point too strongly, because I’m fully aware that many of the listeners will be people who do work from home. And in my experience, universally claim that their productivity’s just as good as it ever was, but my observation is that that is not the case. And there seems to be an, extraordinary at times, tendency, for people to be moving towards a four-and-a-half day week or even a four-day week. That is a way of spending growth in the economy. If you’re not getting a lot of growth, then it’s really quite problematic, I think.

And I think that movement arises out of obviously, the experience of working from home, but more particularly, because of the feeling that the response of the government in the US and in the UK and indeed, in Europe, to the Covid pandemic was that we can spend money. We can solve all your problems just by spending money. The stimulus in the United States was 13% of GDP.

If you compare that with a great natural crisis, where the stimulus was 2% of GDP, you could certainly argue that the latter was too low, but I think the former was clearly too high. And the consequence of that is a belief that somehow we have a right to a certain standard of living, ie. the highest standard of living we’ve had, and that should continue. And if circumstances dictate that that’s difficult, then the government should solve it. So, the tendency for government deficits to remain very high is universal.

And there’s very little resistance to it, certainly from our Prime Minister. And one reason to believe that inflation has to be reasonably high, is that we are poorer, because what we import, in the way of power, food, commodities has gone up. So, as a nation, we are poorer, but we don’t accept that. And so, people struggle in all sorts of ways to preserve their real buying power. And that itself is very inflationary.

Merryn: We’re going to move on from the depressing bits, briefly. I’m sure we’ll end up coming back to them. Christopher, can I go back now to what you were saying earlier, about looking for specific UK companies? And that the correct earnings and costs ratio. What sort of companies are you talking about?

Christopher: One that we’ve been buying recently, which is completely flat on its back, is TP ICAP. It’s the largest inter-broker dealer in the world. Their market cap’s about 900 million, but they have a data analytics business in there that we believe is worth more than the current market cap alone. Significantly more. And if you look at their income, something like 60% of their revenues are in dollars, but only about 40% of their cost base is in dollars. So, that’s an enormous tailwind.

The business itself doesn’t have to be doing great. Its competitor just came in with numbers this morning, which were basically roughly in line with forecasts. So, there’s no reason why this business shouldn’t be roughly in line with forecasts. But the competitor values everything and has accounts in dollars. And expenses and income in euros. They’ve got a massive headwind Another thing that we’ve been buying is Conduit Re which is again, all the income is in dollars. A lot of their expenses are in sterling.

And it’s trading at about a 30% discount to its tangible book value today. There’s some real bargains beginning to be out there at the moment, which we haven’t seen for a very long time. You can actually find companies now trading at four or five times Ebitda, which have actually fundamentally some quite good businesses in them, where there is a bit of pricing faster.

Merryn: But it’s mainly in the UK that you’re seeing value?

Christopher: Yes, absolutely. Our view is that US stocks, as Peter said, are still overvalued. And I think technology stocks are still overvalued too. And that’s before we get all the profit downgrades. There is no rush to buy in the United States, in my opinion.

Merryn: And Peter, are you beginning to see value anywhere? I was talking to someone the other day who was talking about value stocks. And I said, well, what is it that you mean by value stocks? And of course, when he was talking about value, he was talking about specific sectors. Mining is value. Oil is value etc. And then, we moved on to saying, well surely, anything that is cheap is value. Value isn’t about sectors, right? But people in the market today have got it stuck in their head that technology is growth and mining is value.

But, of course, technology can be value as well. Anything can be value.

Peter: Sure. I fear that some technology stocks will become value. But actually, I do think there’s some interesting values beginning to emerge. I certainly wouldn’t disagree, notwithstanding your comment that the oils and commodity stocks are very good value. And for a very good reason, that there are large numbers of investors who simply won’t buy them whatever the price is. That has driven down their value, raised their cost of capital, but it’s also enhanced their long term prospects because, if you talk to oil companies, they really get it. They really get it.

Merryn: What do they get?

Peter: Every second word is about the environment or responsible, or something of that kind. And if they invest in the oil business at all, it’s in projects that have short term payback characteristics. And the result of that is that supply will be really quite constrained, going forward, over the next decade or so, but, very sadly I have to tell you, demand will not be a lot less, absent a worldwide depression. And, if you think about it…

Christopher: Well, personally, Peter, I think that demand’s going to continue to rise.

Peter: Right. But the really depressing thing of course, is that we like to celebrate the fact that 15% of cars sold this year are electric. That means 85% aren’t. And those cars will still be around presumably in 15 years’ time. The idea that we are moving towards zero consumption of oil, which seems to be at the back of some people’s minds, is just not going to happen. So, it is likely, the fundamental position of oil stocks remains very good.

And the valuation has been very depressed by all this. The nuance is that probably, the oil price is as high as it is, at least in part, because of the Ukrainian war. And if peace were declared tomorrow, I’m happy to bet that the oil price will fall. Now, as it happens, I think oil stocks are perfectly cheap at the Brent price of 70, so quite a long way below where we are now. But I’m under no illusions that they go up when the price is moving from 108 to this day, to that 70. I think there is some value there. You just need to be careful how early you are.

Christopher: But even at these prices, look what the oil companies are actually doing with the money. They’re buying their stock back. They’re not going out and doubling their exploration budgets. We have a business that operates in the Permian Basin, which is effectively fracking city. The drill rig character has not soared, despite the oil price, and despite the fact that obviously, there’s a very short payback for the frackers.

The trouble you’ve got, particularly in the United States is that the Biden administration has been so anti the industry that they don’t trust them to go out and spend a lot of money to balloon the production up again. Most people have expected the United States to be producing another million barrels of oil. It’s just not happening, today.

Merryn: It’s interesting. Do you feel, either of you, that the ESG environment is changing, in that, Peter, you referred to large numbers of investors who refused to buy oil companies and miners etc. And they do this because they’re fully focussed on the E in ESG, but bit by bit, I’m talking to more and more people who are pushing the E to one side, and talking about the S. And how important it is to continue to invest in a supply of fossil fuels, in order to keep living standards at reasonable levels. And of course, the G comes into that as well.

This matters. You can argue about what matters more, but obviously, the S is absolutely vital. And we see that in people beginning to change their attitudes towards say, defence stocks as well. These used to be an absolute no-no, but now, of course, a defence stock can very easily fit into an S. So, do you get the sense that the industry is beginning to shift in its ESG absolutism?

Peter: I think it means mature. It used to be very black and white. BAE Systems, they make machines that kill people. So it must be wrong. But now, there’s a possibility that they make machines which defend people, which possibly is right. But there’s also, I think, some more nuance growing in respect of fossil fuels. At least, I hope it is, because we used to have what I’m afraid I call a Pontius Pilate view, which is to say, I use petrol in my car every day.

I heat my house with gas, but I wash my hands of anything to do with the process of getting those commodities to my house. And that rejection of responsibility, I think, was always indefensible, actually. And I think the world is moving on, because, as you say, the people who get hit, if commodity prices are much higher because the cost of capital’s been raised in these industries, are the poor. And it’s really important, I think, just to keep some balance. We all accept that climate change is really important and has to happen.

But there’s every difference between investing constructively to achieve that. And simply saying that there are whole parts of the market that simply won’ be involved. And on the social side as well. We have always put emphasis on that. We believe that building social housing, that also is very constructive and positive. And finally, on governance. Governance has been particular about [unclear] in the investment trust business. We have, over the years, influenced a lot of boards to change their governance, and still believe there’s scope there.

But on a more general basis, I think the danger of the whole ESG movement has been to push the production of anything that’s slightly controversial into the hands of people who don’t care. Commodity companies, mining companies sell their coal because they know it’s controversial but it goes to a company which is going to do nothing else but expand its coal mine. I think it’s really important to have an overall understanding of the effect of what you do.

And I think directors is coming under some pressure in this way, as opposed to just divest yourself of everything that’s controversial. And sell it to private equity.

Christopher: I’ll give you a good example of that. RTZ sold its coal operations to Glencore. And my understanding is it took a bit of time to get the sale through. By the time it actually happened, RTZ actually had to pay Glencore to take them away because they were being so profitable. And they’d earned so much money in the intervening period. It’s potty.

Merryn: It is. Are you feeling the entry of rationality into the ESG debate as well, Christopher?

Christopher: Well, we get asked endless questions about to what extent do we look at the ESG credentials of the companies we invest in. And we’ve seen, in some cases, they’re doing really silly things. I’ll give you an example. Not name the company, but basically, one of our holdings. The banks were reluctant to lend money to it because part of its business was in the coal industry. So, they divested themselves of that business at what turned out to be a catastrophically low price, in retrospect.

It's being imposed on companies, not just by investors, but by the people who provide the financial sources. And it goes to Peter’s comment about the cost of capital. And if the cost of capital is so high you can’t be in the business, even though it’s a necessary business, where do you go?

Merryn: Yes, well, as Peter says, it goes into different hands.

Christopher: Correct. But that’s not necessarily in the interests of us as shareholders in companies.

Merryn: Or of the world. It’s not in the interests of anyone who’s keen for there to be full transparency across the types of industry that people worry about. We want companies and businesses like that listed, so that we can know what’s going on.

Christopher: Yes. I suppose, as another issue, the cost of listing is disproportionate to the size of some of these very small companies. And it’s certainly something I, and other institutional investors, are discussing. Because if you have a £15, £20 million market cap, you can often have £800,000 a year of public company costs attached to that, which makes little or no sense, because it’s a material part of their profitability.

Merryn: So, what do you do about that? If you were in charge, how would you make it easier and less expensive to be listed? That was one of my bugbears as well. And I think it’s incredibly important that as many companies as possible are listed, so that everyone can A, share in the information, and B, share in the wealth creation.

What would you do make this better, make it okay?

Christopher: Well, I think non-executives are over-rewarded, in my opinion. We had to, again, it’s not particularly fair to tell you the company’s name, but the company is not doing particularly well. It’s got some cost pressures. The profits were down, but the non-executives decided they were going to reward themselves with an increase. And myself and the other two largest investors basically said, you’ve got a choice. You can have the increase, but there’s going to be one less of you, or we’re going to roll it back.

And by the way, we agreed to roll it back to what it was before. But in our hearts, we really were thinking we should roll it back considerably. I think, for these small companies, the fees should not exceed £25 or £35,000 a year, with the chairman getting ten grand more.

Merryn: And what happened in this case? What was the resolution?

Christopher: They agreed not to take the pay rise.

Merryn: Interesting. But even if you paid all non-execs across the small cap sector 20 grand, you still wouldn’t have solved the problem that you’re talking about.

Christopher: Well, no, and the other thing is, we’re quite aggressive. Again, the fees of the investment banks take for doing very little, need to come down. We’re just in discussions. Is it really appropriate that the investment bank charges 5% or 6% for raising you money for a business? And on it goes. When existing investors put the money in, you can negotiate that fee down a bit. And again, we’re quite aggressive at that, but just the whole thing costs too much money.

Merryn: I see that. Too much money and too much time with the regulatory burden.

Christopher: I’m not so sure that that’s so much the problem. We, as you might know, have actually been leaders in doing public to private, but the typical company that we’re privatising would have a market cap of less than 30 million. And very frequently, we did one which was seven or eight million. Literally, just by taking it off the market, we increased the profits overnight by 30%.

I don’t think there’s an easy solution to it, because the trouble, of course, is as soon as you have a relatively buoyant market, all the investment banks want to put all these companies onto the market. And quite often, we see things going onto the market which, quite frankly, just shouldn’t be there. Full stop.

Merryn: So, they are always too small to be on the market?

Christopher: Absolutely.

Peter: There’s an additional regulatory problem, which is a marvellous example of unintended consequences. The well-meaning regulators that have produced circumstances where liquidity in small companies is pitifully small, weak. And the consequence of that is very wide spread. Actually, for investors, it’s really difficult for them to invest in those areas at all.

The investment trust is what I specialise in here, but the consequences of that have meant that a trust with market caps of probably less than somewhere between 400 and 500 million, have no viability, in the sense that they can serve investors meaningfully. And that, after all, is their purpose. And compared that to capital gearing. When I first started, the market cap was less than half a million, still traded most days. It was extraordinary. I think there is a big issue there, which is something that investment trust directors are going to have to address.

Merryn: Interesting. Let’s go back to the bit that the readers will really be waiting for, which is what else? How should they be invested now? What should they be in? Peter, you talked about energy stocks and commodity stocks. And you were on the verge of saying something else, I think.

Peter: I think there are some emerging values. One is in TIPS in America. The ten year yields of positive 70 basis points doesn’t sound fantastic, but I think will be a lot better than most portfolios achieve over the coming five years. And actually, I think there’ll be significant capital gain as well, because I think those yields will go down as inflation proves not to be so transitory as the market’s assuming. But there’s also, I’m going to mention an asset class, which I would put money on, no one has ever recommended to you in the last 15 years or so.

Merryn: This is exciting.

Peter: Which is the Japanese yen. The yen has fallen really dramatically. And it’s on a PPP basis. It’s about 50% cheap, relative to its historic levels. There’s been a very obvious reason for that, is there’s very little inflation in Japan. And their rates aren’t going up, and they’re going up everywhere else. And all the foreign exchange market cares about now is relative interest rates. So, that’s fine. But if you think about it, if inflation in Japan is 2% this year, and it’s 8% in pounds and dollars and euros. Then that’s another 6% that adds to the cheapness of the yen.

And there’s a lot of funding going on in yen. And the bell, I fear, might have been rung by an investment trust. I remember very well, back in the 70s, investment trusts used to borrow Swiss francs. And why did they do that? Because the coupon was really low and you could make it turn on the income from equities. Needless to say, the Swiss franc absolutely soared and they lost huge sums of capital. When I read that an investment trust was borrowing yen the other day, admittedly borrowing with yen assets.

Merryn: So, not quite as bad as it could be.

Peter: I’m not condemning them, but it still rang a bell for me. We must be very close to the bottom for the year. And if we are, two things might develop. One is that people might switch from nominal yields to real yield differences. And that looks very different because real yields are very negative in short paper in all of these countries. And in my view, will be, although that’s not the consensus.

Whereas in Japan, obviously, they’ve got no inflation. You don’t have real yields. And the final thing is, of course, there’s a tremendous amount of funding in yen. So, people have borrowed yen to buy absolutely everything, but if it moves up, then those people will cover. And it will move up a lot more.

Christopher: But Peter, you could almost make exactly the same argument for the Swiss franc, couldn’t you? Their inflation’s about 2%. They actually increased interest rates, so they’re very quarter negative at the moment. There’s massive borrowing in Swiss francs to invest all over Eastern Europe. It’s very similar. You could make very similar arguments.

Peter: Yes, I know it’s a slight difference, Christopher. I know that you will have quite recent experience of the cost of living in Switzerland. And it’s not low.

Merryn: Peter, would you buy Japanese equities?

Peter: Well, I think they are more interesting. One of the unfortunate characteristics of equity markets is their powerful correlation. I think Japanese equities are very reasonable value. And their profits clearly, have a tailwind from the value of the yen, so I think they’re fine. Actually, I think the UK market is not particularly overpriced, other than there are all sorts of negatives, but it is much more reasonably priced than other markets. But all my experience says that if the S&P 500 goes down, then correlations actually usually go to one.

It isn’t just that the others fall. They fall just as much. With that caveat, I think that the Japanese equity market is fine.

Merryn: What about gold? Would either of you hold gold now?

Peter: I do hold a tiny bit.

Merryn: You do?

Peter: But I think TIPS are far more better value.

Merryn: Christopher?

Christopher: No, we’ve never held gold as an asset class. Our investment philosophy is basically try to find companies which we think are fundamentally undervalued to their private market value, and then, try to secure a catalyst that will unlock that value for investors. And obviously, ourselves, as big shareholders in these companies. So, I think it’s what we’ve done for 40 years now. A bit longer, actually.

So, I think if you’ve got a product, your product goes in and out of favour, but actually, if you have a discipline, and you stick to the discipline, it works in the long term. And quite often, quite well in the short term. If you’d invested in North Atlantic smaller companies trust when I took it over in 1982, the NAB was 34p and it’s £52 today.

Merryn: Not bad.

Christopher: And it’s been down to, like I said, a logical process. Find a company. Understand what it’s businesses are. Make sure it’s got a reasonable balance sheet. It’s generating cash. And then, figure out how to unlock that discount. That’s worked very well for us over very long periods of time. And that’s why I said earlier on, we’re now starting to see things again which, in our opinion, are genuinely cheap. And the example I gave you of TP ICAP, we had the management in. And they said, in their opinion, Parameta alone was worth £1,5 billion.

The core business makes well over 100 million in cash. And you’re looking at a market cap today of a little more than 900 million. And already there’s one activist on the shareholder list. Every institution whose owned it have been killed in it. And it’s down 70%. And when they came in, they were actively saying, we’ve now split Parameta. It’s an independent company in its own right. It pays for its own research from us.

It would be even more value if it was an independent company in its own right because the two other players in the market would then sell them their research and their figures. And you have a global world leader. So, that’s an example. Something we’ve been buying recently, Central Media. If you look at that, it’s got a market cap of about £65 million. It’s got no debt. 13 million in cash. And they’re on track, we believe, for their three year plan, which ends at the end of next year.

Where if you excluded public company expense, you’d be looking at about 12 million of Ebitda. And they’ve got some really good assets in there, like The Lawyer. They aren’t a print business anymore. Print is now less than about 1% of profits. We think The Lawyer is worth ten times Ebitda. And that’s about four million of it. So, you’re buying the rest at one times. It’s just crazy.

Peter: Can I say, we have been invested in Christopher’s fund for pretty well, the whole of that 40 years. And certainly, the large bulk of it. And I do think, just to endorse the model, that all those problems with smaller companies, which have depressed prices for regulatory reasons, liquidity reasons, and so forth. It does offer extraordinary value to someone who buys the company and takes it private. I think that circumstances, the environment in which he operates has actually improved in that respect. So, more power to him.

Merryn: Let’s finish just by asking. You two have both been in this business for a long time. And you’re both very good at what you do. If you were to have to buy one asset, maybe just even one stock, although that’s pushing it slightly tomorrow, and hold it for ten years, what would it be?

Peter: Chris, you go.

Merryn: The answer can’t be my fund, by the way.

Peter: Funnily enough, I was just going to say that.

Christopher: What would it be? Obviously, it can’t be a private company either. The problem is, I’m going to be 100% truthful with you, we don’t expect many of our companies to be independent in ten years’ time.

So, if I find one that probably would still be. So, why don’t we go with On The Market. On The Market competes against Right Move and Zoopla. And it’s number three in the industry. It’s not going to get taken over, because 60% of the shares are held by estate agents. Current market cap is about 65 million. It’s got no debt. It’s got about nine million in cash. And the story is really simple. Right Move charges an estate agent £1,300 per estate agency office. They charge £200.

They only charge £100 for builders. And their revenues for last year were about £30 million. They intend to increase pricing to £300, but our model says they only get their pricing to £200 for builders, which would still make them incredibly compared, very good to beat Right Move, because their cost per lien is only £1,40 against a Right Move cost per lien of over £4. So, they’ve remained very competitive. And if you look at the business model, they increased their advertising a lot last year, because when Covid was around, they didn’t do much.

It’s 10,6 million last year. They think they can increase their revenues by 2024 to 45 million. They wouldn’t have to increase the advertising to more than 12 million and if you look at the 2024 numbers, the market’s forecasting 14 million, but we think that’s a bit conservative. It could easily be 15 million. By then, they’d have £22 or £24 million in cash. I can’t see the number of estate agents going down, particularly. They’ll be around in ten years’ time.

Merryn: Even with a house price crash, we won’t get rid of any estate agents at all?

Christopher: I don’t think we’re going to see a house price crash, because I’m afraid, I think the government’s policy is going to achieve one thing, which is an unintended consequence, is the government’s gone after the house builders to such an extent that very few of them are going to be massively increasing the number of houses they’re building anytime soon. And I speak with some experience, because I’ve been on the board of MJ Gleeson for a long period of time now. And we are one of the few house builders that are still committed to increase the number of houses.

And we’ve just announced this morning that we’d actually doubled our housing production over the last five years. And we’re committed to growth. But when we talk to other house builders, virtually nobody’s saying they intend to increase production anytime soon. So, I don’t think house prices are going to collapse. And the fact of the matter is the agents have to take these services from people like Right Move and us and On The Market, because when someone comes to sell their house, they want to know what platforms they’re going to be on.

If you stop and think about it, by 2024, you’ll be looking at a business, strip out the cash being valued at £14 million, with recurring revenues at £15 million. And Right Move, for better or worse, increases its pricing every year. So, if I had to bet on something for ten years, that would be it.

Merryn: Excellent. Well, thank you. That’s very clear and well explained. And everyone will now be rushing out to buy it, I’m afraid, and then bringing you up in ten years when they’re not happy. Not financial advice, by the way, listeners. Not financial advice. Peter?

Peter: Well, if I might admit to two. One is very simple. It’s the 2045 TIP, which produces a real yield of about one and a quarter, I think that will be significantly higher than most portfolios experience over the next ten years. And if I had to prove it, and pick a stock, it would be Grainger. Most property companies are going to suffer from higher interest rates. And the cap rate applied to their valuation will undoubtedly move adversely. But I think Grainger would not be very badly hit by that.

And I expect rents broadly to keep pace with wages over the next ten years. And that probably is their growth rate plus take the developers as well. I think it’s very solid, but I do worry about all the UK investments because of something that Chris has referred to, which is the arbitrary taxation that populous governments. And I fear this government may be conservative in name, but it is completely populous.

So, the levy on bills to householders is one, windfall profits tax on oil companies is another. Potential taxes or regulations to reduce the profits of renewable energy, unbelievably, are in the wind. So, any investment in the UK has to take account of that. Basically, if your industry does well, you can expect a populous government to somehow try and redistribute some of that profit towards the population as a whole, ie. itself.

I do think it’s an alarming feature of the UK. It’s not particularly different from Europe, certainly, where we’re seeing similar sorts of things. But it’s a big change.

Christopher: I think there’s also another class that comes to me. They’re quite hard to find, but they do exist, which holds very large amounts of client cash, but they get the interest rates on it. I’ll give you an example of that. It’s a company called Appreciate. Market cap about 50 million. Has about 18 million in cash. No debt. Not a great business. It’s a loyalty programme for companies, and it also does Christmas savings for DNE people. But, on top of that, it has actually, cash of £160 million.

Most of that isn’t theirs, but they get the interest income on it. And people aren’t looking at these things, and factoring it in. There’s another one called Curtis Bank, which I can’t talk too much about, because I’m on the board of it. But it’s a statement of fact that it has a billion pounds of other people’s money in cash. And they get the first 0.75% and then, they get 60% of everything above 0.75.

Merryn: Where are they getting more than 0.75? Impressive.

Christopher: If you think interest rates are going up to 2.5%, you can do the maths on a billion.

Merryn: That’s it. A whole new sector of companies that I hadn’t thought about. And of course, you’ve got the investment platforms there as well, haven’t you? Holding all our cash and paying us no interest on them.

Christopher: You absolutely have all the investment platforms doing that. Now, the government has looked at the investment platforms, but you’re right, Hargreaves Lansdown has billions of cash hanging around the place of other people’s money.

Merryn: I think they are all beginning to pay small amounts of interest on it.

Christopher: Yes, they are. They’re all having to, but they’re also taking in nice sums. One of our private companies is very much in this space. Basically, what it has to do, is pay the rate that somebody would get if they’ve got £5,000 in Barclays Bank. But of course, they’ve got £100 million, so they’re getting massively higher return than you would get as an individual.

Merryn: There we go. See how optimistic we’ve managed to be? I’m not sure that was an optimistic end, but we’ve found lots of things to invest in. We’re not completely miserable. The next decade, it looks okay. Right? Just say yes.

Christopher: Yes, it does. We’ve all seen this before, sadly. I started in 1975. I’ve seen quite a few cycles, and Peter must be even earlier than that.

Peter: Well, I think one thing one can say is that in 1974, even if you had perfect hindsight, it was jolly difficult to preserve the real value of your capital. So, stock markets crashed. Bull markets crashed. We had exchange controls. Property was in a crisis. The greatest ambition you could have had, or should have had, for that year was to preserve your money, in real terms. And I think investments like that, just to finish up, I’d like to draw the parallel of the game of grandma’s footsteps, which I’m sure you know.

Merryn: Yes.

Peter: But, for those who don’t, it’s where granny faces the wall at the end of a garden or a drawing room. And small children line up at the other end and the first one to touch her, wins. But if she turns round and sees you moving, you’re out. And any halfway intelligent three-year-old works out pretty quickly that granny never turns around twice quickly in succession. So, when she’s just turned round, they run very hard. And then they prepare to stop very quickly. But all I will say about today’s market is that granny has not turned round for a very long time.

Merryn: That is a really dangerous place to end, but that’s what we’re going to do. Everyone’s got a lot of thinking through to do on that one. Peter, Christopher, thank you so much for joining us today. That was absolutely fascinating and also incredibly useful.