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Private Client Letter - October 2014

The US economy is thumbing its nose at the sceptics of quantitative easing (QE).

QE was only ever intended to fill the credit gap left by banks in the wake of the credit crisis in order to help the American economy get back on track. And the economy is indeed recovering. Jobs growth has accelerated and household deleveraging has stopped. Business capital expenditure is benefiting from the surge in shale fracking. Total bank credit grew at a 7.5% annual rate in the second quarter, the fastest since 2007. Prime office rents in Manhattan have climbed by 25% in six months to $2,980 per square foot (£1,850).

And yet, and yet…

The jobs report at the beginning of October reported no sign of wage growth. Surely that is inconsistent with a robust recovery? Core consumer prices, ex food and energy, rose by 1.7% in the twelve months to August, down from July’s 1.9%, so moving away from the Federal Reserve’s target of 2%. This partly reflects the stronger dollar and lower commodity prices, but also says clearly that the economy is not over-heating.

The lack of wage growth is increasingly attracting the attention of the US Federal Reserve (‘the Fed’). Former Chairman Bernanke’s personal passion was avoiding a repeat of the 1930s Great Depression, the subject of his doctoral thesis; the new Chair, Janet Yellen’s personal passion is unemployment. She was attracted to a career in economics because of its great impact on people’s lives and well-being, and regards unemployment as a scourge.

The absence of wage growth is not just an American problem. In half of all OECD countries, real median wages have stagnated since 2000. The acceleration of employee compensation has become the new policy objective in Japan and the UK as well as in the U.S.

Exponential explosion
Average real wages began diverging from productivity some 40 years ago.



Companies began substituting machinery for workers in the 1970s in response to two secular trends. The first was the relative decline in the price of capital equipment; the second was the steady fall in the real cost of capital.

The price of capital equipment has been substantially influenced by the development of the integrated circuit in the 1960s. This set off a new era of cost effective electronics, processing power and information technology. A rule of thumb called ‘Moore’s Law’, named after Gordon Moore, one of the founders of the chipmaker Intel, states that the number of transistors fitting onto one chip doubles every two years.

Doubling every two years? That isn’t such a big deal – is it? There’s a lovely story that illustrates the point.

The game of chess is alleged to have been invented in India by one of the Raj’s wise men. The Raj was delighted with the game and offered the wise man a reward of his own choosing. The man, also a mathematician, replied that he would like rice - just one grain of rice on the first square of the chess board, double that number on the second square, and so on, doubling the number of grains of rice on each of the next 62 squares on the chess board. This seemed to the Raj to be a modest request, so he called for his servants to bring the rice. However, he quickly discovered that it was not at all a modest request as the rice not only swamped the chess board but soon even filled the palace. The number of grains of rice on the last chess square totalled a staggering 18,446,744,070,000,000,000! Placed end-to-end, these grains of rice would stretch approximately 60 trillion miles – and reach from the Earth across space to our nearest star, Alpha Centauri, and back to Earth again.

This exactly illustrates the exponential explosion in processing power built into integrated circuits which has driven down the cost of capital goods. For example, the price of cloud computing through Amazon has fallen by circa 50% every three years since 2006! Google officials have said that the price of hardware used to build the cloud is falling even faster.

Rise of the Machines
In turn this has encouraged the replacement of labour with machines. Volkswagen is filling some retiring baby boomers’ jobs with robots, not people. Applebee’s, a large U.S. restaurant chain, is to install tablet computers at every table by the end of this year for customers to order their food and pay their bills without waiting staff. London Underground is planning driverless trains: these will operate 24/7 and never strike. Rio Tinto and BHP Billiton already employ driverless trucks at mines in Australia for reasons of cost and safety. These trucks are also unaffected by the hot climate and the dust. In the medical industry, image recognition software is replacing radiologists.

Foxconn, scarred by its staff suicide epidemic a few years ago and facing sharp wage hikes, is replacing workers with robots, even working on a ‘lights out’, entirely automated factory in Chengdu.

The second driver of the trend to substitute machines for workers has been the steady fall over the past 40 years in real interest rates and hence the cost of capital.



This is a result primarily of a combination of a global savings glut, particularly in trade surplus countries such as China, as well as, more recently, the ageing of the population as the baby boomers approach retirement. Older people spend and borrow less, and retirement savings re-balance away from equities towards fixed income.

Worker-lite growth
Another aspect of technological innovation is the shift in consumption from ‘stuff’ to ‘fluff’ (Economist, 4 October 2014). People are spending more on services (healthcare, education, telecoms) and less on goods. The value of goods in world trade has fallen from 71% of exports in 1980 to 57% in 2008. Services are less labour intensive than physical assembly, again undermining the demand for labour. Despite their dominant positions, Google and Facebook today employ less than 50,000 workers each, far fewer workers than General Motors and Kodak at their peak.

In the first Industrial Revolution that began in the late 18th century and the second some 100 years later, workers lost jobs to Cartwright’s power loom, Edison’s electric lighting and Benz’s horseless carriage. However, these and the many other inventions created employment opportunities on a mass scale. The third Industrial Revolution, commencing a further 100 years on in the late 20th century and which we are still living through, is producing numerous amazing inventions - but little employment. The upshot has been that the growth in per capita GDP is significantly lower than in the first two industrial revolutions.

GDP per person, average annual % change over 25-year periods


The clear consequence of the rise of machines over labour is the adverse impact on consumption. Robots do not buy cars! Digitisation is steadily eroding aggregate demand.

Lower demand means lower growth… lower employment… lower inflation… lower long term interest rates... No surprise then that Fed Chair Yellen has stated that, even when the economy is back on track, an unusually accommodative monetary policy will still be required.

The low yield environment is here for a while yet.

At the beginning of 2014, anyone who knew anything about economics could have told you that US Treasuries were heading into a long term bear market as quantitative easing was tapered on the back of the recovery. Unfortunately Treasuries had dropped out of their economics class and did not do what they were supposed to. The rally in Treasuries this year has been one of the big surprises for macro investors. Economics making astrology look respectable, as per our from cover quote from J.K. Galbraith, one of the world’s most renowned economists.

Digital technologies of course present similar headwinds around the globe. Other continents faced additional challenges too. In the €urozone, Germany’s economic backbone, exports, are weakening. France and Italy are struggling to garner adequate political support for much-needed structural reform. In Japan, Prime Minister Abe is baulking at the impact of the policy-induced 30% depreciation of the ¥en on energy prices given that Japan imports all its oil, a key cost component in the economy. In China, Beijing is treading the well planned but delicate tight-rope of financial reform and re-balancing the economy from exports to services without causing undue hardship in both government and private sectors.

Six years on from the credit crisis, the backdrop for investors is still opaque and challenging.

Sticking to our last
At Veritas our response remains to stick firmly to our last. We do not attempt to forecast markets. Instead we invest in what we know and understand – sound businesses with a moat, well managed and financially strong, with the tailwind of a global growth theme and bought on a sensible valuation.

Our current high conviction themes filter stocks with the tailwinds of structural growth (‘Rising tide’), with sustainable competitive advantages in attractive industries (‘2020 Industry winners’) and those with pricing power (‘Scarcity and supply constraint’).

A recent addition to our client portfolios, as appropriate to the mandate, is Comcast fitting both our ‘Rising tide’ structural growth sub-theme of technological innovation as well as our ‘Scarcity’ theme.

Comcast is the United States’ largest pay-TV operator – their BskyB, if you will. It provides high speed data and voice services in major cities, with 23 million video subscribers, 21 million high speed internet customers and 11 million telephone customers. Huge investment in cable infrastructure results in a network that is hard to replicate quickly or economically, providing a barrier to entry – our ‘Scarcity’ theme. The group also owns 100% of NBCUniversal, which operates NBC, local TV stations, cable networks and theme parks.

Cable continues to take the majority share of broadband in the US given its faster speeds, particularly as more viewing migrates to tablets and smartphones. Owning NBCUniversal brings ownership of content (our ‘Scarcity’ theme again), including Harry Potter theme parks, and helps to hedge the growth in programming costs, the most significant expense category. X1 is the company’s new operating system that seamlessly combines on-demand, recorded and on-line video in an attractive interface, all part of the high level of service expected by subscribers.

Comcast is attractive in its own right in our view, but offers additional potential upside at present from its bid for Time Warner Cable which we believe will go ahead. The merger offers both significant operating synergies and will extend cable network coverage to 43 of the top 50 metropolitan areas. This in turn will reduce the need for people to leave Comcast when they move house, so lowering churn and improving profitability.

The group is cash flow rich, which benefits shareholders both through dividends and buybacks.

The share is at a discount to our intrinsic value even if the merger does not go through, but – if it does – the upside rises significantly.


Meg Woods
14th October, 2014