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Hidden Forces
Finding Value in an Upside-down World | Charles Heenan & Geoff Legg
00:59:24
In of Hidden Forces, Demetri Kofinas speaks with Kennox Strategic Value Fund investment directors Charles Heenan and Geoff Legg about their investment framework and macro worldview. Known for their focus on top-quality, sector-leading companies,...
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- [00:01]
A
What's up everybody? My name is Demetri Kofinas and you're listening to Hidden Forces, a podcast that inspires investors, entrepreneurs and everyday citizens to challenge consensus narratives and learn how to think critically about the systems of power shaping our world. My guests in this episode of Hidden Forces are Charles Heenan and Jeff Legge, the investment directors and founders of the Kennex Strategic Value Fund, a highly differentiated global equities portfolio of top quality quality sector leading companies available on exceptional valuations. Today's conversation is about finding value in a world that seems to have gone absolutely insane. Not only are developed economies facing challenges and confronting headwinds that require us to think differently about investment risk, but many market participants themselves seem to be increasingly indifferent to value. As an anchor for assessing the investment worthiness of an asset and the price they are willing to pay in order to own it, in the first hour, I asked Charles and Jeff about their value investment framework, how it informs and is informed by their macro worldview, while also touching on the process and philosophy by which they arrive at their investment decisions, including how to position their fund for a world of structurally high inflation, geopolitical risk, and capital controls. In the second hour, we dive much deeper into a discussion about investment philosophy and what it takes to be a great investor. We discussed the difference between luck and skill, action versus patience, what it means to be risk focused as opposed to optimizing for returns, and why the skill set that may have made you money as an entrepreneur or founder could be detrimental to your performance as an investor. We also get a firsthand look into Charles and Jeff's rigorous process for evaluating potential investments and their views on various sectors and asset classes, including energy companies, gold miners, telco retailers and other businesses spread across the United States, Europe and Asia. If you want access to that part of the conversation and you're not already subscribed to Hidden Forces, you can join our Premium feed and listen to the second hour of today's episode by going to HiddenForces IO. Subscribe all of our content tiers give you access to our Premium feed, which you can listen to on your mobile device using your favorite podcast app. Just like you're listening to this episode or right now. If you want to join in on the conversation and become a member of the Hidden Forces Genius community, which includes Q and A calls with guests, access to special research and analysis in person events and dinners. You can also do that on our subscriber page. If you still have questions, feel free to send an email to infoiddenforcesio and I or someone from our team will get right back to you. Lastly, because this conversation deals with investing, nothing we say on this podcast can or should be viewed as financial advice. All opinions expressed by me and my guests are solely our own opinions and should not be relied upon as the.
- [03:18]
B
Basis for financial decisions.
- [03:20]
A
And with that, please enjoy this profoundly thoughtful and incredibly value additive conversation with my guests, Charles Heenan and Jeff Leg.
- [03:34]
B
Charles Heenan and Jeff Leg welcome to Hidden Forces.
- [03:38]
C
Thanks very much.
- [03:40]
B
It's exciting having both of you on the podcast. Your fund was introduced to me by Russell Napier, who is, I believe, on the investment committee of Kennex. My interest was, and I told Russell this, that number one listeners know how much I value Russell's framework, his views around financial repression, industrial policy and national capitalism, which he defines as the use of national savings for national purposes, along with the changing world order and what it means for investors. I was curious in the last conversation we had what other investors he followed or knew of who invested either in that style or who took lessons from or implemented things somewhat similar to how he thinks about the world. And he mention you among a number of funds. Before we start, we're going to get into a lot today, guys. I want to talk about your background at first. We're going to talk about your investment framework, your macro framework. We're going to talk a little bit about philosophy, the philosophy of investing, your process, the companies you invest in, what you look for, asset classes, and a few other miscellaneous questions. But again, before we get into all that, let's just give our audience a little bit of a background into you. Who are you, what's your experience, each of your experience as investors, and what is the origin of Kennex's strategic value fund? Charles, we can start with you if you like.
- [05:03]
C
Yeah, it's great. Thanks, Dimitri. I'm Canadian by accent. I was born in Montreal, Canada. I lived there the first half of my life up until I was 28 years old. I was in the industry and I got into the industry in the early 90s. It's a fascinating time to be in the industry you're talking about. Yeah, pre the Asia crisis you had the peso problems. There's all sorts of things going on back then, but really enjoyed it then decided that I was interested in the industry. I found it fascinating, the combination between the analytical side, where it meets the narrative. This is about stories, but actually you can analyze the numbers and then try and put those two together and then throw on top of that the uncertainty over time. I really enjoyed it. Got into the industry in the early 90s, internationally. A couple of years in, I realized that what really drew me was the buy side. I liked the practical side of making investments. You've got to own the decisions. It's not just enough to say we're going to do some analysis here, we actually need to do something about it. And then you've got to live with that for the next five or 10 or 15 years. So I quit my job in Canada and moved over to the UK and ended up working with a great investor called Angus Tullich and we worked in the Asia PAC and emerging markets. I started in early 97, so a bit of economic history. Thailand goes down, the Thai markets in the Asia market go down in late 97. Then you get into the full Asia crisis and LTCM and the Russia crisis in 98. So fascinating time to be in the markets. So that got me into the buy side and then I decided to set up Kenox. I had been in the industry then for what, 20 years, and I decided actually now I have a clear, clear idea of how I think money should be run. And ideally, you do that as a boutique, you do that as an owner managed company, because we run one fund. This is exactly how we believe money should be run. And this is the easiest way to align as closely as we possibly can for our clients. So there you go. That's what, 12, 15 years in a minute. But it gives you an idea of some of the thinking and some of the evolution for me, ended up here, Edinburgh and Scotland, which is an amazing place to run money, international money. There's a lot, there's a good community, including Russell, who's been here for ages, community of people. So there you go, there's the intro to sort of how this came about.
- [07:33]
B
And Geoffrey, what about you?
- [07:35]
D
So, well, my background is basically a long history of sitting maths exams, so I trained as an actuary in London, having done an undergraduate degree in maths and physics and a postgraduate degree in financial mathematics. And then just as I was graduating from or qualifying as an actuary, Charles approached me and said, do you want to join Kenox? So up until that point, it had been sort of a very analytical background, but not at all in financial markets in terms of being an investor. So Charles and I, Charles mentioned he moved to Edinburgh back in 1997. I also moved to Edinburgh in 1997, but as an undergraduate. So we knew each other socially, played sport together and kept in touch. After I'd moved to London and Charles had Stayed up in here in Edinburgh. And when he wanted to set up his own fund and set up Kenox, he approached me and said, do you know anyone who you think might be interested in joining me as an analyst? And I maintain that that was a leading question and he was hoping I might say yes, but I don't know that for sure. And the timing.
- [08:38]
C
He passed the test. He passed the test.
- [08:40]
D
I passed the test. And it was good timing for me because I just qualified as an actuary. I was looking what I wanted to do. I was at Taos Perrin and they'd started outsourcing the work that they did on the investment side. So that was no longer an avenue there. I'd taken an interest in it. Charles sat me down, talked through how he invested and it just made a lot of sense to me intuitively. I joined Charles and have been brainwashed ever since into making sure that we're aligned in terms of how we think money should be run.
- [09:08]
B
Fantastic. Well, as I said, there is going to be a portion of this interview where we're going to discuss your investment philosophy in addition to the framework conversation that we're going to get into shortly. One more historical question, or maybe a few. So you launched the fund in 2007. I also noticed that there was another fund that had been launched on the same date, around the same time, called the Contrarian Global Value Fund. What is the through line between that fund and Kennex?
- [09:32]
D
When Charles first launched the fund, I joined him on day one, if you like. So he had done a lot of the work before the fund was launched. We first launched it with some money from an Australian client who seeded a fund for us and we actually launched the fund in Australia and that was called the Kondrarian Global fund. That was 2007. In 2009, we decided it was more helpful to be closer to our clients, not on essentially a 12 hour time difference. And so we bought the company back. So just the two of us owned it. We then have a chairman that joined us. So essentially three of us owned the business and we launched the new fund in the uk. We launched it with exactly the same list of holdings that we had the Australian product. So there's two products there that tie together. But the investment philosophy and the investment team have been continuous throughout.
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B
So what was that like launching a fund really, at the beginning of the biggest financial crisis in 100 years?
- [10:27]
C
Yeah, when we launched the original one in 07, you never really know what's coming and it wasn't obvious. The 1 in 09 was halfway through. But I think it goes, as you say, we'll get into this. As we get into the philosophy, we tend to do quite well when life gets disrupted, that's when you get some amazing opportunities. The fact that I joined Angus Tullock and that on the Asia pac in early 97, just before you had the Asia crisis, the fact that we launched funds into the GFC, the great financial crisis of 0809 and around then that disruption seems 2022. I'm sure we'll get to this. 2022 is one of the toughest years for bonds and equities. Over the years, we had one of our top years making money, not relative, absolute. These types of dislocations really work for us and I'm sure we'll get onto it as we go later on. How? How?
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B
I understand that a significant amount of your personal wealth is also invested in the fund.
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C
Everything I've got in the stock market, I do my asset allocation, which basically is my house, some cash and the stock market, that's the assets I own and everything in the stocks are in the fund. Like I said, we launched this business. It's a very small business, it's very boutique. We want to be as aligned as possible to clients. It just makes sense that you do something you really, really bl believe in and find some people who would like to join you who agree with those beliefs and want to join you in that. It's purity. It's lovely. It's the nice thing about being a small company is you're trying to make as few compromises. We all need to make compromises in this world and that's a good thing. But you try and make as few compromises and a few material compromises as you can. So putting all the money in the fund, one of the things we love about that is it makes everyone a co investor. Everyone who's invested in the fund. We don't think of them as clients. We think of them clients and co investors. They're people who are investing alongside us.
- [12:25]
D
The other thing to say there is it's a global fund, so we can buy any company we want in the world. When Charles started running money, he was running an emerging markets fund that might not be quite so appealing to put all of your wealth into, but essentially, if there's a stock that's listed, we can buy it and that makes it easier for us. I'm the same as Charles, various other asset classes, but in equities, everything I own is in the fund.
- [12:46]
B
So let's transition now to investment framework. Guys, now I'm going to ask this question generally, but you each can decide who wants to take it first. If you both want to answer it, that has to do. Again, investment framework worldview. How would you describe your worldview and how does that inform or is informed by your investment framework?
- [13:05]
C
First and foremost, we're bottom up stock pickers. We will happily and the reason why we get on very well with Russell, who you know well, you've been done this with several times. We get on very well because we understand and can talk his language and we find that fascinating. But at the end of the day, what Russell does and what we do are very, very different in that he is commenting on the world and analyzing the world and we are analyzing companies and we do bottom up stock picking and it's a lovely, lovely thing to do because we all know the incredible amounts of wealth and benefits that have been brought to our society by corporations and companies. Well, we buy stocks in those and hold onto them. Jeff and I have been running this for 17 years. There's still companies we bought 17 years ago that are in the fund now. We're very keen to buy and hold and have a relationship with the companies. Point one, point two. There's a lot of different ways to do this. I think one of the reasons why you're talking to us, Dimitri, is because we're such fascinating characters, I'm sure. But another reason is because not many people have stuck to their knitting in value fund management. You started in the 90s and deep value contrarian investing. There were a lot of people doing it. We've had such an incredible run over the last describe 10, 20, 30 years. There are fewer and fewer people who are excited about going out and finding real bargains. And that's what we do. We go look for bargains. We want to find companies that we think we're getting a really, really attractive price. Now we also want the highest quality we can possibly find. That's the challenge. That's why we want the whole world out there and we only hold about 30 stocks is because want to be super selective and we want to be very, very selective about finding the highest quality companies. We can go on and on and on. But the first point is we're stock pickers. And the second point is you can have huge opportunities when the herd all moves in one direction, they often can ignore they throw the baby out with the bathwater, so to speak. And those are what we're looking for, those real bargains, those gems that are sitting out there.
- [15:18]
D
Maybe I would sort of extend on the investment framework and say that there's something that you have to believe to be an active manager and that is that markets aren't efficient. If you believe that markets are efficient, by which I mean that the share prices reflect, accurately reflect all the information that's currently available, then you may as well be a passive investor, you may as well buy an index tracker, pay much lower fees and you'll get the market returns. So clearly we believe that the markets are inefficient. Actually, what I believe and we believe is that markets are reasonably efficient on a one year view. So if you're just looking at what the market knows about what companies are going to do for the next 12 months, they're reasonably efficient. But markets are hopelessly inefficient if you're looking at what they're going to do over the next five years or 10 years. And this is essentially what brings us to being value investors is that we believe that there are companies that are a fair reflection of the next 12 months of their operating performance, but are not priced correctly for the next five or 10 years. If that's the view that you come with, then there's an obvious way of investing and that is to find companies where the next 12 months doesn't look that good and that's what the share price reflects. But if you do enough analysis about why the next 12 months don't look good and just every now and then you can say, okay, I see that, I see that we call them a headwind, but I think that there's going to be a tailwind after that. So it's going to survive. This next year that everybody accepts is going to be difficult. And that's why it's priced the way it is priced. And we can get it at a price that reflects that one year view. And if we hold it for longer than that, if we hold it for five or 10 years and we have a turnover on the fund which is about 15%, which in itself means that we hold them on average for five or 10 years. If we can buy them when the price is reflecting a very negative 12 months, and hold them until they're sitting in a period where they're actually doing very well, then we can get a bargain. So that's a potted view of value investing. If you're going to be a long term owner of assets, we call it time arbitrage. Essentially meaning if you're willing to hold assets for longer than the market is Pricing them for you can get a real bargain.
- [17:22]
C
Demetri I'll go on to one more because I'm sure we'll dig deeper onto it. But the last one would be risk focus. We're conservative types. We're focused on protecting our wealth and that of our co investors and growing it in that order. Less worried about get rich quick. Then we get back to the what's our macro views and how we're seeing the backdrop or the general economic and investing in climate. The risks are enormous, absolutely enormous. But we have to be able to cook that into our bottom up stock picking and our contrarian finding contrarian ideas and finding bargains that other people aren't really looking at. That's why we think we're very excited is because we think that all of that is aligning right now. Aligning to be a golden opportunity. I'm sure we'll come to it later.
- [18:10]
B
Ye to Jeff's point about time arbitrage, that's where leverage matters. We'll have a chance to talk about that as well because I'm pretty sure based on what I remember from reading that you guys don't use leverage in the fund. Just to stick with this part of the conversation about the efficient markets hypothesis and that asset prices reflect all available information. Ergo markets are efficient. Do markets go through periods where they are more or less efficient? Are we living through a phase now where markets are less efficient? And partly because value investing in this particular framework has lost so much favor with investors. What does that mean for generating opportunities for funds like yours?
- [18:53]
C
Yeah, I mean an amazing question. Cliff Asness who is well known investor and commentator, he's written an article recently saying in his way back to 82 I believe he went to sort of in four decades he's saying this is the most inefficient market that he's ever seen. So he's gone at least 10 years on me in the industry. But no, it feels that way. I mean I remember reading when I started in the industry in the 90s about the sixes. You could get something on 0.6 times book, 6% dividend yield and 6 times earnings and if you just find that be a little bit selective but actually just buy them all and you'll be fine. I thought wow, we will never see something like that ever again. Finding them all over the place. Now you can look up the Cliff Astina's article. We agree with him. It does feel like it is enormously inefficient market and I think it's A combination. I mean, we can move on to why, but. Yeah, no, I think it's enormously inefficient. And that is a wonderful. I call it a golden opportunity. It's a golden opportunity for what we do because we're able to look into those spots, the weaknesses in the market where people aren't. If you can do that and be patient, the opportunities right now, I think, look absolutely stunning.
- [20:11]
D
I think there's a good reason why that's happened as well. I think it's availability of information. If you're an owner of a pension fund and you're going to someone else to invest it, it's all the wealth that you have, however much that is, it's important to you. 20 years ago, you'd have handed that to a fund manager, he would have bought funds or stocks for you, and you probably wouldn't have tracked it that closely in terms of what was held in those funds, what the underlying stocks were doing. You just look at the headline figures. You see if your fund manager is making a good return for you and you're reasonably happy if they are. Now, everybody has full access to the stock prices of every company that's in their fund. They can ring the fund manager and say, oh, that's interesting. You've put that stock in my fund. It's down 20%. Why do you own it? What that's done is it's made it much, much harder for fund managers to buy stocks that they think are good value. Because that's typically looking at stocks where the share prices have fallen. If your clients are constantly ringing you and say, look, I'm not a fund manager, I don't really know, but I think Apple's a great company. The share price is going up. That seems like something that you should be owning. However, what you've put in is X, Y or Z, the share price is going down. I'm not hearing good press about it. Why have you bought it? For me, those are much, much harder conversations for a fund manager to have with their clients. And I think we always talk about in the short term, financial markets just reflect the weight of money. So where the money is flowing will reflect which share prices are going up and where it's flowing away from which share prices are going down. I think this availability of information to the end client who isn't doing a lot of fundamental research on the fundamental valuations of those companies. If you ask somebody who's got their money in Apple, what's the P E ratio, how much am I paying for Those earnings, they don't typically know that and nor are they interested. They just want to know whether the share price is going up or down for that reason, amongst a number of others. But for me, that's the biggest reason. I think it's fair to say that markets are hugely inefficient and Momentum has had a wonderful time because share prices are going up, are attracting more and more capital, but that is the opportunity for value investing in the longer term, because the company, where money is flowing away from them, as Charles is saying, are getting back to those lovely valuations where you can pay very little for a good quality car.
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B
Yeah, I think that phrases what, in the short term, markets are a voting machine. In the long term, they're a weighing machine. That's a very interesting observation. That the availability of information, combined with poor investor education has led to fund managers feeling that the risk of underperformance outweighs the benefits of potentially outperforming the market. And so they become risk averse and so everyone kind of chases the average. In your experience, what other variables create the conditions in which a company's value can be significantly discounted relative to its stock price on a consistent basis in the kind of way we're describing now? An environment that's inefficient. What else do you attribute this to?
- [23:12]
C
I think we've lived through a phenomenal bit of history and you've got this confluence of benchmarking. Everyone's getting benchmarked to the same thing. Benchmarking isn't terrible. Usually it doesn't make sense to make everyone benchmark to the same thing, but everyone gets benchmarked to the same thing. Also, I think it's dangerous to benchmark to a price benchmark if you're being a price index. If you're benchmarking to fundamentals, then the company becomes more profitable, more people will own it. It's an interesting one. If you benchmark to a price. Apple hasn't grown its earnings in three years and the share price is up, what, 40, 50%, is that correct? It is. If more people then start benchmarking on the same thing. Passives, ditto. I mean, one of the biggest issues we've got right now is regulation. I'll come back to it. But one of the biggest issues is that there's been this massive move to the number of investors Jeff was mentioning, the ones bawling out their fund managers. But what about the ones sitting at home on any one of the trading apps that you can get nowadays? A lot of Those aren't fundamental investors. They're trading on price. Between the benchmarking, the ETFs, bull market and FOMO and a lot of social media, you end up with a huge number of investors who are no longer. They're fundamental focused, they're price focused. And that's where you can get this divergent. That is enormous. Now I'll give you one other point right now, which is everyone else is also liquidity focused. You need to have 100% liquidity now. So basically only invest in the mega caps, which has just given us, the globe, an enormous opportunity in things that are just a little bit below people's radar. So the major fund managers, a lot of the hedge funds, a lot of the major momentum traders and so on and so forth, they need liquid. They need it to be able to get in and get out. Well, if you can take a little bit longer term view and you're able to. And we're a niche fund, we think that's brilliant. Right now you want to be a niche fund, you don't want to be running a supertanker because then you got to buy what everyone else is buying right now. The amazing, amazing opportunities in the world and there's a couple of that in the big cap, awful lot of that are in small and mid cap. They don't need to be micro cap, small and mid. Just many, many people aren't looking there and put those together, you're just creating a sweet spot of opportunities. But I believe this is, we've lived through this move to passives in the financial markets. We've never seen as many people all accept price benchmarking. These are things that have never happened before. I think that's creating a huge opportunity. But other people looking at it and say, yeah, but it's never happened before. It doesn't matter.
- [25:48]
B
Yeah, a couple of observations there. First of all, I love the fact that you mentioned how more and more investors are becoming really one way to say it is they're chasing lottery like returns. There's a gambling mentality, I've called this for years financial nihilism. And I think we continue to see this. I mean, we're actually recording this shortly after the President of the United States and his wife both launched meme coins on. I saw that remarkable really in so.
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C
Many ways, on Inauguration Day. Or was it yesterday?
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B
Right before. Right before. Yeah, right before Inauguration Day, A few days before Inauguration Day. And of course that has created a persistently inefficient market and many people, especially people with, with Great trading acumen have been trading and making a lot of money. I think that's a great point. Also, I just want to say I love your point about benchmarking to the price versus benchmarking to cash flow or to some other way of valuing the company. It reminds me of a quote, Charles Goodhart, who had been on the podcast a few years ago, which is, I think when a measure becomes a target, it ceases to become a good measure. So it matters what you benchmark too. We'll have a chance to go through more of these types of questions because I hope we can get through some of this stuff. There's so many things I want to ask, but let's go back to the framework. So we talked a little bit about your investment framework. Let's now talk a little bit about your macro framework because this is where the conversation aligns more closely with some of the discussions I've had with Russell Napier. Because the developed world has recently experienced the most significant bout of inflation in, I would say, roughly 40 years. I'm curious to know your macro view. Again, you guys are value investors, but I have heard you speak about macro. The bigger picture. What is your view on whether this was an exceptional event that was indeed transitory, or if it was the opening salvo and a new secular inflationary trend that's going to last for many more years? And how does that or does that not inform or factor into your analyses and process as value investors?
- [27:46]
C
Yeah, brilliant. I think you're absolutely spot on. What I find fascinating is how so I've been in the market 30 years, which is becoming a longer period of time. A lot of the people when I came into the industry have now moved on those 40 years, though, back to what you just mentioned. The last time we saw major inflation, late 70s, early 80s, that could be a blip. And we might look back in that and say, wow, wasn't that an astounding economic period of economic history? And I think it's having the imagination and the sense of history. You need both. You need to have a sense of history and actually think back to periods. Great Depression, back into the gold standard of the late 19th century. Be able to track back over the course of history and say what is extraordinary and what will rhyme and what will repeat in history. Most of the time it doesn't repeat, but it rhymes. Having that and then being able to think outside the box. When we launched this fund, someone said, well, why don't you do some backtesting? And we did very minimal. Jeff did Most of the backtesting, we did some very minimal backtesting. But you're saying, well, actually where we need to backtest is pre1982 and there's practically no information for what we were trying to do back then. It became less useful. So many funds and things at launch, backtest, but only backtest in one sense of history. So our point is, is think long term and then be imaginative to see risks that can come up and hurt you. I was astounded when we went into GFC and you had quantitative easing and zirp. I mean zero interest rate policy. I never studied economics. I'm a practical person. I prefer economics was too theoretical to me. I never studied academic economics. I very, very much believe in practical economics, what you learn in markets all the time. And I looked at it and I said, well, how in heaven's name is possible to have quantitative easing and zero interest policy and then leave it for a decade? And I think that these are some of the biggest issues we have to answer. So when people say, well, what do you think in the next 10 years? Leverage and the stability of currencies, fiat currencies, two of the biggest backdrop. I mean, you just can't ignore that. How many value investors? I remember Certainly in the 90s, everyone said, oh, macro doesn't matter. It doesn't mean you can predict it. But let me tell you one thing, it definitely matters. And it definitely matters if we are in and period. I think your term, the economic nihilism is excellent because I do think it sums up, potentially sums up the possibility that what we're living through right now is absolutely extraordinary. And everyone will say the only reason why we're not all panicking is because it hasn't stopped yet. It doesn't mean you shouldn't be prepared for it.
- [30:35]
B
Just to tie it back and then, Jeff, I'd love to hear your thoughts just to tie back the process here. Is that what you mean when I've heard you say this? Is this what you mean when you say that economic history is one way that you source new ideas?
- [30:46]
C
Absolutely, yeah. No, onto Jeff. No, absolutely. You have to have a context. I think it's really important to have a context for this. One of the context is stuff does change. What we are doing is we are buying companies that are having headwinds. We'll get into it. We often buy companies in a J curve. They're going through a tough operational time, but the price overreacts. You get something that's going through a difficult short Term period. And the price goes down, earnings go off 20, 30% and the share price goes down 50 or 80. You say, well, if that turns and actually the industries right themselves. And that's what should happen when, if we're all rational players, we will take supply out of the game. Supply comes off and demand recovers and things go back up again. That should happen if we're living in a time where money is free and everything goes off in different directions. That has to give you opportunities and threats and problems. So absolutely 100%. The back of our head is always saying, well, we know what's happened in the last year or two or three. We go and look at the last 20 very clearly and often 30 years, just for context. And then you even have to be able to track back and say, yeah, but this has been a time where we've had extraordinary financial situations. Does that change again?
- [32:05]
B
So, Jeff, I'm going to tack something on to this next question, which is going to to be a compendium to the previous one. So feel free to take it as one larger question about inflation. I asked Charles before whether or not the inflation was transitory, whether it was an exceptional event, or what was the opening salvo of a new secular inflationary regime that's going to last for many more years. Feel free to answer that, but also in doing so, what, in your view are the structural drivers of inflation that you've identified this time around, and are we undervaluing or under counting the role of technological innovation or innovative government policies, for example, what we're seeing in Argentina, to alter this otherwise inflationary trajectory?
- [32:48]
D
Yeah. I mean, I think the one thing I'd add to the first part of that question is for what we do, the reason that inflation is so important is because it ultimately affects interest rates. And actually what affects stock prices as we see them and actually affects what is the right way to invest is what happens to interest rates. From a very simplistic level, if you just say there's two ways of investing, there's value investing, where you're investing in the way that we do, you're looking at companies that are having a harder time and you're paying much lower multiples of earnings to buy them, and the opposite end of the scale is growth investing, where potentially you don't even mind if it's profitable today. But if you can see a company that is going to grow those earnings stream very quickly over the next five, 10, 15 years, what does interest rates do to the correct, if you like, price of those two Earnings streams. Well, if you have a very low interest rate and you assume that essentially what people are doing are they're discounting back future earnings, an earnings profile to give you a price today. The higher the interest rate rate, the more your near term earnings are worth versus long term earnings. So if you're a growth company, your earnings stream, or the bulk of it may be 5, 10, 15 years in the future. If you have to discount that back at 5% or 6% interest rate, those are worth significantly less than if you discount them back at a 0% interest rate. So I think what we saw, and it comes back to what we were talking about, about market efficiencies and why we think they're so inefficient at the moment when we had zero interest rates, it makes complete sense for high growth companies to be worth almost an infinite amount. In fact, if you use 0 as your discount rate, they are worth an infinite amount, providing you find a company that's going to continue growing earnings. What we're now starting to see is a more inflationary environment where whether that's transitory or not is a little bit harder to predict. But, but I think it's very unlikely we're going to switch back to an environment where we have zero percent interest rates because of all the distortions it's caused and yet asset prices haven't yet changed to reflect that change in interest rate environment. So I think it's very difficult to say exactly what inflation is going to do. Certainly I would hope you don't depend on my answer to it. But all the additional friction that we're putting into the system, whether that's tariffs, whether it's trade wars with different countries, the US wanting to create everything that it buys at home rather than importing it elsewhere and making it more expensive, you import it, all of those things, they make some sense in terms of making your own country more efficient and giving your own companies an advantage. But they will create an inflationary environment. And of course we built so much debt and we haven't really talked about debt, but debt on a country level. So government debt, debt, they've printed money, they release bonds, they need money or they spend money much quicker than they're getting it through tax intake and so on, that debt governments have a huge. Governments have got a huge incentive to keep inflation at a rate that actually starts to bring down that debt level. So I think it's probably very low. Inflation or no, inflation is transitory. Just because there's so much incentive to keep inflation and I think that does mean that we're likely to have non zero interest rates.
- [36:08]
B
Rates, yeah. I just want to emphasize it's a great point about money is free. Another term I have often used to describe the changing investment landscape along with financial analysis has been narrative investing. Because when money is free, what matters is who can tell the best story. We have absolutely seen that Jim Chanos, the famous short seller has often talked about the importance of TAM total addressable market and investor pitch deck. What's the optimal outcome? The optimal outcome becomes much more important in a world where money is free. I think that's a really great point. The next question that follows naturally from this is how does one position for such an inflationary world and why do you guys feel that you are well positioned for such an inflationary environment?
- [36:54]
C
At Kennex, the risk focus makes a huge difference. And right now I would say there's two massive risks. One is the debt itself and one is the crowding effect. It's that it's a little bit of economic nihilism, but it's often the price driven people that is we've ended up with 75% of the index being in the US and that's a very crowded trade. So we're just saying be careful of valuations, especially when interest rates could go up. And the second one is debt. Be very, very careful of debt that is affecting the companies we own. So there's no leverage in the fund. You asked earlier if we leverage. We're not a hedge fund or anything like is cash and equities only. And we basically run no cash right now. So it's basically equities. But even if you look on the.
- [37:42]
B
Balance of our companies, that's fascinating because actually I've read through your documents and you talk about how you always kept roughly 20% of your money in cash. What does that suggest about how bullish you are at the moment?
- [37:56]
C
It was post pandemic that we said listen, we're finding bargains, which is always important. You can always find bargains anywhere in the world. But also they're uncorrelated. We're finding really interesting opportunities and they're just not the same. Listen, if I wanted to go put 100% of my four or five years ago we had about 25% of the fund in energy majors. So that is oil majors, although you got to call them energy majors because they're now obviously so much in gas. But basically in those majors, 25%, we could have had 100% of the portfolio in that coming out of the GFC. It was lovely, but it's very correlated and there's risks there that you don't want to take. We're trying to run a diversified, risk focused fund. So don't get down. The key is, in the last few years we've seen the opportunities open up enormously, but also the diversity of those opportunities. So, no, we're very interested. You're right. We have up to 20% cash and for quite a long time, right up until the pandemic, we ran up to 20% cash. It ranged between about 8 and about 15 for most of the time, but we were running 8% cash. And then post pandemic, we're saying, oh, well, there's all these bargains out there. Now is the time to go buying if we're finding the right stuff. We're pretty worried post pandemic that a lot of the build that we had been writing as a society were coming due. We run quantitative easing, that's increased risk. We're running bigger fiscal deficits, that's increased risk. And we're pretty scared about what can happen economically. But if you're finding bargains and you're finding great companies and the opportunity is there and you can offset those risks, especially those risks, that can go very well. So point one is focus on the debt, focus on the valuations. Valuation matters a of lot. Jeff's talked about that already. Valuations matter a lot if inflation goes up. The other one is we're huge believers in the capital cycle. We own quite a lot in energy because they hadn't been invested in energy. There is a lot of questions around climate change and whether carbon they release and so on and so forth, but that makes a lot of sense. But actually, if we still need this stuff and we've been underinvesting, then actually a small recovery in demand can lead to a very high increase in profits. And so that capital cycle can protect against inflationary environment. Listen, if we need this stuff and you happen to be one of the few people who want it, and there's more demand than supply and there's no more supply coming on, it doesn't really matter what inflation is. You've got pricing power and that's what we're looking for.
- [40:16]
B
So the combination between those things, value, debt, capital cycle. Let's focus in on value a second here. What are the most important attributes that you look for in companies that you believe are positioned to do well during periods of structurally high inflation? And where does something like cost control come in?
- [40:35]
C
Yeah, so pricing Power in inflation, you want pricing power. And again, that comes from. What we're really looking for is you're trying to do the analysis on both sides. Any company you look at, you have to consider everything. And so that is macro as well as micro. That is, you've got to have a context of what listen, if you're taking a huge amount of debt on and interest rate goes up, you have to be aware of that. You have to be aware if the currency goes crashing down, if the supply chain breaks, et cetera, et cetera. But what you're always trying to find is a company that has concrete competitive advantages. So you know why it was able to have a profitable niche. If you can, then you make a guess at demand. Truthfully, it's an educated guess, but demand is awfully hard. Like financial markets, demand changes quite quickly. And what you can see though, it's easier to make a proxy on supply. So what we always like to see is industries that have gone through a tough time and that takes time and you can see supply coming off, off. That is a really interesting combination. But then you're looking for concrete competitive advantages. I'll give you an example. Stella is a nice little company that we have. We know their niche. They manufacture shoes. They literally make the shoes for the producers. They make some Nikes, it's about a third of their business, and other sports shoes. But what they tend to do is a very specialized, high design, high cost runs that are only run for a couple hundred thousand shoes. So normal runs are a couple million shoes for a large company like Nike and so on and so forth. Not many people can profitably make the bottom end. Then of course we've had this massive transition in the last few years in that many people are wearing thousand pound trainers, thousand dollar running shoes, luxury running shoes, trainers as we call them here in the uk. These guys got in very early and have a reputation and have their whole business set up to be able to do this, that once they've got one or two luxury brands who are saying, well actually this is a really interesting market for us who can do this. We're only going to go to the guys that we have already a reputation there that gives them a concrete competitive advantage, it is seen by their competitors, it's seen by their clients, it's seen by everyone that they are good at this niche and people are very keen on that niche. Now luxury brands tend to pay quite well because they know how important it is. They're charging a premium, they have to be, be providing an excellent product that's a concrete competitive advantage in the minds of the clients. These guys have a very, very strong reputation there. Anytime we can identify that. That's quite different to Sky New Zealand. Sky New Zealand is a streaming and satellite business. But again, you got a satellite and you got the dishes on someone's hotel or house. It's a concrete competitive advantage. Every company we're looking for is that way.
- [43:29]
B
I just want to go back to this question about attributes of companies that perform well, well in inflation. Jeff, feel free to take it if you like. I had specifically asked where does cost control rank? And you responded by mentioning pricing power. The reason I actually asked it that way is because it made an impression on me in one of my conversations with Russell several years ago where he mentioned that in inflationary cycles, all companies, not all companies, but more companies have pricing power. What really becomes a challenge is cost control because costs are going up because it's an inflationary environment. And so that's why I asked it. So I want to just re ask it again. Maybe that sort of recontextualizes it.
- [44:06]
A
But how important is it, how difficult.
- [44:08]
B
Is it to find companies that have cost control? Is that something that you look at? How do you go about that? That's my question.
- [44:16]
D
I think it is one that's very difficult to tell. Everybody says that they've got cost control until they get hit by inflation and the costs go up and you hear about it after the event. One of the things that is helpful for us, obviously not overpaying, but also companies that have a reasonable history of defending margins. Charles talked very briefly. We've got a number of tools, one of which is to look over 25 or 30 years of history of financial statements for each of the companies that we buy. What we'll do, we pull numbers straight from Bloomberg at this stage, not doing any research on it, just pulling the numbers from Bloomberg and saying we want to look at the profit and loss, the balance sheet and the cash flow statement for each of the last 25 or 30 years. No forward projections in those numbers because we don't really believe that anyone's very good at forecasting. Just look back 25 years and look at periods where we've had inflation. Look at periods where earnings have fallen significantly and ask the question, what's caused that to happen? Then by looking back in time, you're going to get a much better view for whether they can really defend margins in difficult times, times than you are by asking management or trying to project earnings two years forwards. The analysts out there are all going to say we've got a good idea of what's going to happen. You can see wherever you get your data from, you can see one, two, three year projections and they all essentially say that margins are going to stay roughly the same and earnings and revenues are going to grow at 5% or 10% or whatever the number is. But actually when you look back, you realize that's not the case. You look forward and analyst views is always that things are very stable and things don't change that much much. You look backwards and you realize the opposite is true. Things change all the time. And if you find the years that they had a tough time, you read the annual report the year before. Nobody's ever predicting that they're going to have a tough time the next year. But by looking backwards, you actually get a really good idea how good have these companies been in these situations. If they haven't been very good, then you can go and ask management what's different now to what you did back in 1997 or whenever the last tough time. One other thing that I'd like to come back to that we mentioned a couple of times is debt. Value investing generally invests in companies that have high debt. And the reason that's the case is because the prices fluctuate much more quickly. If you're a leveraged company, when things go well, the price goes very high. When things go poorly, you get squeezed and the price goes much lower. So you get deeper valuations in companies that have a lot of debt. Two things that I'd say about that. One, just going back to why we invest the way that we do. We're buying companies that are going through a tough time. We're buying them thinking that the price might be efficient on that one year view, but isn't on a five year view. The hardest thing that we have to do is try and predict when it's going to go from that period of headwinds to that period of tailwinds. If we get that wrong by a couple of years, we'd love to buy companies where Charles mentioned the J Curve. Things are about to get get much better next year. We always think that when we buy them, if we get that wrong and it turns out to be two or three years until you get those tailwinds for that company. You buy highly leveraged companies with a lot of debt on the balance sheet and you get companies that go out of business altogether. That's fundamentally why we don't want to buy companies that have high leverage because it fits with our philosophy of taking advantage of that time arbitrage. But right now we don't want to do it because, yes, interest rates have been a little bit higher for a couple of years now, but it's not until you roll over that debt that you see it hitting your margins and hitting your P and L. I think until it does, it's amazing. But until actually that debt gets rolled over, you don't realize how much trouble some of those companies are in.
- [47:52]
B
So we're going to have a chance to go through a lot of this in the process section of this conversation. Just one more question about this question of cost control. One of the things that we saw during the pandemic that explained or that informed the transitory inflationary hypothesis, which was indeed true, is that there were supply chain disruptions.
- [48:10]
A
Is that something that you look at.
- [48:12]
B
In other words, how much control a company has over its supply chains, how vulnerable its supply chains are? Do you look to find companies that have less variability, that have more resiliency within their supply chains when looking to invest in anticipation of such an inflationary climate? Where does that factor in and feel, Feel free to respond, Whoever wants to take that?
- [48:32]
C
Yeah, I mean, without question, you're trying to identify where the weaknesses are in the story and the profit narrative. These guys are making profits because they're getting revenues. The revenues then have to cover all the expenses. You're trying to estimate as much as possible where the cost pressures come. And generally we think we can do that to a reasonable degree. But are we structurally building it around that, oh, we know for sure these cost pressures are really stuck in. Again, I would come back to the concrete competitive advantage. You're looking at their cost base and saying, well, if they've got enough pricing power, that will give them an advantage and we try and keep an eye on their costs as much as we possibly can. That's key. Supply chain is absolutely. You're aware of the risks. One of the things I quite like saying is one of the great things in our industry is you're not risk averse because you're all taking risk. You have to manage your risks and you have to try and be aware of your risks. It's very rare that stuff that's blown up on us hasn't been something that we'd never, never, never thought of before. You believe that it was a lesser likelihood of coming through or it just came through when you didn't. Supply chains, really tight supply chains is a risk. For instance, we own an interesting little retailer Here in the uk they're very low cost. They're selling, it's a dollar store equivalent Target, those sorts of company here in the uk they've done extraordinarily well, but they import quite a lot from China. That's a question we've gone through internally multiple times, We've gone to management multiple times. At some point you just have to say, well for now, either we say it's not investable or whether we like it or not. That one, for instance, on about 10 times earning has about a 10% historic dividend yield. So we're saying as a mid sized holding in our company, that's a risk we're willing to take. Even though their supply chain, if the Red Sea goes down, that is a delay for them, it's a cost increase for them. Those are things that you're aware of. We just have to be comfortable with the risks we're taking.
- [50:36]
B
You've mentioned correlation a number of times. We're going to have a chance to talk about that in the second hour during the part where we discuss process. Another guest who's been on the podcast a number of times, Daniel Paris, who runs the Federated Hermes Strategic Dividend Fund Fund, often talks about how the dividend is, among other things, a good heuristic for value. What role does the dividend play? I know that you don't need the company to issue a dividend, you're not dividend focused. But what role does the dividend play in your investment framework?
- [51:05]
D
Yeah, I mean it is a lovely valuation point to use and it also shows discipline for the company and it allows you to be paid to work. So coming back to the same point again, the hardest thing we have to do is get timing right. If you're going to get a 5% dividend yield or often higher. In fact, the average dividend yield on our stocks at the moment is 5%. If you're going to get 5% or perhaps slightly more while you wait until the headwinds turn to tailwinds, that's a lovely situation to be in. One of the ways to think about returns on equities is to break it down into the two sides. There's investment return. That's your dividend yield plus your earnings growth. So easiest to think of it on One Year View. If you get paid a 5% dividend yield and your earnings grow 5%, all things being equal, you make a 10% return on that company. That's your investment return. The second side of it is what we call the speculative return. And this is quoting research that was done by John Bogle way back when, 2013 I think. Last time I saw. I don't know if he's updated it since, but last time I saw it, the biggest fluctuating factor is the speculative return. So that's if your earnings multiple goes from 10 to 20, then you make a huge return on that company, even if the earnings have only grown at 5% and the dividend's been 5%. So you have your investment return and then your speculative return. What tends to happen over time is that the earnings multiple, so the speculative part of your return mean reverts. So companies get more expensive and then they get cheaper, they get more expensive. But broadly speaking, that fluctuates and it super inflates your returns for a period and then it deflates your returns for a period. So that comes back to the two main things that you can use to make returns in the long term. It's the dividend yield and the earnings growth. So as value investors, we're typically buying companies where the dividend yield is higher. So you've got a bit of a kickstart on the market. There's there if then by being selective you can buy companies where you think I actually understand that the earnings are depressed at the moment. That's why we're buying it right now. You can also get high growth on those earnings because you're buying them from a depressed starting point. This is sort of value investing 101. What you're really trying to do is buy a company where you're getting a good dividend yield, you're getting a good earnings growth because you're buying it when the earnings are depressed. And then by buying at a low multiple multiple, you can also get the speculative return on top if you're willing to sell it when that earnings multiple comes higher. So dividend yield for us is an important factor. We also coming back to that, being risk aware, we want management to be sensible. If you're having a tough time often when we're buying them, if your earnings are lower than they typically have been, if your cash flows aren't where you want them to be, cut the dividend. This is something that we can do that income investors can't in that situation, they have to sell the company. We're saying, actually what we're witnessing here is a company that's doing something very sensible. We don't want them to take on debt to pay the dividend yield. We'd rather they cut the dividend yield in the short term. Run the business sensibly and then when the good times come back, pay the dividend again. We don't have to buy companies, as you've rightly pointed out, we don't have to buy companies that pay a dividend. We don't have to buy companies that are constantly increasing the dividend. But we love them to pay it to us when things are going well.
- [54:27]
C
Sorry, I'm going to go one more just on. I think it's so important, as Jeff said, due to one, the valuation metric, it tells you if it's undervalued or not or indicates its value or not. And number two, it's management's choices, what they are doing with the money. And it is a strong indicator. It wouldn't be the top one for me, but it's top three because I think it's absolutely inherent to what we do. And we've picked up many companies. I was mentioning Stella with a shoe manufacturer that yielded 12% for about 18 months and a dividend yield of 12% for about 18 months. And you're saying, well, why A lot.
- [55:03]
B
Easier to be patient if you're.
- [55:05]
C
It's a lot easier to be patient. Exactly. So we think. I mean, it's absolutely enormous. So yeah, no, I think it's. As you point out, we're not income investors. But for both those reasons for valuation and for the respect from management and what their capital allocation, it just makes for a very, very attractive return for risk focused investors. Listen, if you're back to your get rich quick or die trying, it doesn't matter as much actually, if you're really worried about protecting your capital and protecting your buying power over the long term and making money dividend can be very, very powerful.
- [55:40]
B
Speaking of patience, I've been very patient because we're working through some of these core questions, but the ones I'm really excited about are going to come in the second hour with respect to philosophy and process. Very last question before we move to second hour, guys. And that has to do with geopolitical risk. I've heard you say, Charles, it might have been you, it may have been Jeff, it might have been both of you that you need to position your portfolio in a way that takes account of geopolitical risk. What do you mean and how do you accomplish that?
- [56:08]
C
It's a huge challenge. But I think that the major point is that if you think about risk all the different places, that just can be very helpful. We talk about countercyclic. So there's many things that are pro cyclical and the profits are going up and the earnings are going up and the price is going up. And you pile into that. It's called momentum. It's momentum investing. There's other things that are countercyclical. If you held I'll never forget my dad, who is a lovely man, no longer with us and a lawyer, but one of the few bits of financial he was a very wise investor. One of the things he says, listen, if you can offset some of your own risks, you should probably own an energy company because that's one of your corporations costs. As an individual, your cost is energy. And so they do. Well, you can think of the same thing at geopolitical risk. If the world blows up in energy terms, actually something like Equinor, which is mostly gas, but some oil energy assets just off of Norway on the edge of Europe, that is an exceptionally well placed asset. If things get really tricky in the Middle east, if they get even trickier in Russia and so on and so forth, having something in a safe jurisdiction that provides that it's a way that you can offset some of those geopolitical risks. We try and just play that through all the way around the world. So we don't try and predict what's going to happen and then buy something. But we say if it happens, can we have things in the portfolio that will do well? That countercyclical mentality, and a classic one here, is gold. We have had and still hold some gold miners. We can come back to that. That is a classic countercyclical. When stuff gets tough, that's when you find that you want all gold. Famous saying in the markets is own 10% of your portfolio in gold and hope it never goes up. That's the type of mentality we have for the geopolitical well, we're going to.
- [57:59]
B
I mean that was one of my questions. Gold's role, the energy sector. We're going to have a chance to talk about asset classes as well as process and philosophy. As I mentioned in the second hour, for anyone new to the program, Hidden Forces is listener supported. We don't accept advertisers or commercial sponsors. The entire show is funded from top to bottom by listeners like you. If you want access to the second hour of today's conversation with Charles and Jeff, head over to HiddenForces IO. Subscribe and sign up to one of our three content tiers. All subscribers gain access to our premium feed, which you can use to listen to the rest of today's conversation on your mobile device using your favorite podcast app. Just like you're listening to this episode right now. Guys, stick around. We're going to move the rest of our conversation onto the Premium feed.
- [58:49]
A
If you want to listen in on the rest of today's conversation, head over to HiddenForces IO, subscribe and join our Premium feed. If you want to join in on the conversation and become a member of the Hidden Forces Genius community, you can also do that through our subscriber page. Today's episode was produced by me and edited by Stylianos Nicolaou. For more episodes, you can check out our website at hiddenforces IO, you can follow me on Twitter ophinas, and you can email me at infoiddenforcesio. As always, thanks for listening.
- [59:25]
B
We'll see you next time.