Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.
As regular readers know, Helicon Thoughts comprise ‘white papers’ or ‘thought pieces’ that we write on an ad-hoc basis, discussing longer-term structural themes and how investors can best to seek to position for these. Typically the stocks cited are holdings with the Helicon Fund, Heptagon Capital’s equity hedge fund that was launched in April 2011. Over the course of the last year, we published eight editions of Helicon Thoughts; with 2012 now commencing, we thought it appropriate to consider the ongoing relevance of these themes.
In particular, five of the eight themes on which we wrote (the data deluge, power shortages, fracking, the rail renaissance and the threat of inflation) are currently implemented via stock holdings within the Fund. It was encouraging to see that these strategies delivered generally positive investment returns over 2011, a trend that we are confident will be replicated going forward.
These themes are non-exhaustive (in other words, we will continue to research further topics of potential importance and corresponding investment strategies) and other subjects on which we have also written (liquefied natural gas, water shortages and energy-efficient housing) may result in holdings within the Fund over time too. Below, we provide a brief summary of our current ‘live’ themes and why we anticipate that their importance will continue to grow over time –
The Data Deluge
Data is ubiquitous and it continues to grow exponentially, driven by the transition from analogue to digital, and the increasing adoption of the internet by both businesses and consumers. All major forms of media – voice, television, radio and print – are now embracing the digital world as are an increasing number of industries. Among others, utilities talk of ‘smart grids’, the oil and gas majors are already mapping ‘digital oilfields’ and the healthcare industry is moving towards electronic patient records
As increasing quantities of digital information are produced, they need to be stored, managed and potentially protected. It is here we have the biggest problem: put simply, today, there is just not enough space. If every person wanted to store every byte of digital content created, there would be a shortfall of around 35%. This gap is expected to grow by more than 60% over the next ten years; in other words, more than 60% of all new data created will not be able to be stored (based on data from IDC, a consultancy).
Virtualisation and a move towards cloud computing represent partial solutions to the data deluge. In the case of the former, this means creating a virtual (rather than an actual) version of something, such as a hardware platform, an operating system or, importantly, a storage device. Cloud computing allows consumers and enterprises to share sophisticated pooled computing infrastructure services. Massive hardware/ software infrastructure (like a utility grid) is utilised by an end-user as and when required, much like electricity is today.
From a stock picker’s perspective, there are many potential ways of gaining exposure to the still-fragmented theme of data deluge. Among the strongest beneficiaries, we highlight EMC and IBM. EMC is a developer of a broad range of information infrastructure and virtual infrastructure technologies and solutions as well as being a play on the cloud, offering core storage market growth together with virtualisation, security, back-up and data warehousing. VMWare (81% owned by EMC) develops the servers that form the basis for the majority of current global server virtualisation. Next, IBM: the company has successfully transformed from a hardware to software-oriented business (more than 60% of its revenues from the latter, which is growing over 250 basis points faster than the group). Its applications are designed to provide efficient solutions to corporates and are geared towards outsourcing and virtualisation. More than 25% of IBM’s R&D spend is also currently being spent on virtualisation and cloud-related projects. In 2011, IBM gained 25% and EMC declined by 6%.
Power shortages: what happens when the lights go out?
There is a structural shortage of power globally and the gap between demand and supply is set to widen in coming years. Over the ten years to 2008, electricity consumption globally has grown by 3.8% p.a. according to the International Energy Agency (IEA), but the rate of growth has been significantly faster in non-OECD countries (7.4% p.a.) than has been the case in more developed, OECD countries (1.0% p.a.). The differential can be explained by the fact that, put simply, as an economy grows, so does demand for energy. This is a function not only of industrialisation, but also increasing consumption patterns with the broader population acquiring ‘basic’ products such as refrigerators and televisions for the first time. Analysis from Oxford Economics suggests that in countries where GDP is growing at more than 5% p.a., demand for power increasing at a logarithmic rate.
The much more contentious part of the equation, however, is supply. Power is a utility without which people, businesses and economies cannot operate; it is valued most when it is absent, or put another way, the opportunity cost of not having power is significant. Evidence abounds to support this contention. According to a recent study by the United Nations, the five worst-affected countries for power outages are (in order): Bangladesh, Nepal, Kosovo, Albania and Pakistan. Sub-Saharan Africa also appears heavily within the list, and Congo, Kenya, Nigeria and Uganda all feature in the UN’s top-twenty most affected. As recently as May 2011, a power outage in Karachi, Pakistan left 18m people without electricity for over three hours. The Beaconhouse Institute of Public Policy, a local think-tank, calculates that Pakistan’s power shortages in 2008 cost the country 2% of its GDP, or over $1bn in lost export earnings. A different study, cited in a recent New York Times article, suggested that for Uganda, the cost of power and fuel shortages was equivalent to as much as 5% of its GDP.
For many developing economies, however, the ability to purchase new infrastructure is simply not possible and rental is often the favoured option, particularly given opportunity cost considerations. UK-listed Aggreko dominates the global energy rental market. Following the acquisition of General Electrics’ energy rentals business in 2006 combined with healthy organic growth, Aggreko is now six times the size of its nearest competitor (Caterpillar) and serves customers in over 100 countries globally. The company has enjoyed annual double-digit revenue and earnings growth over the last five years and consensus sell-side estimates predict at least 10% p.a. growth over the following three years. Its market leadership looks set to endure owing to its scale, expertise in distribution and logistics and its strong end-user relationships. In 2011, Aggreko gained 32%.
It is well-understood that the world’s energy needs are increasing, driven both by population change and industrialisation, particularly in emerging economies. Global energy major, Shell, for example, predicts that worldwide energy demands will rise by two-thirds between now and 2050. At the same time, several other factors are influencing the equation: first, there is a declining supply of conventional energy sources (think oil, coal); second, countries are increasingly seeking ‘energy independence,’ rebalancing towards domestic sources of supply wherever possible; and, third, environmental concerns are re-orienting energy debates towards greener sources of power.
For many, gas – in its various forms – provides the answers to several of these conundrums. Where fracking fits into the equation is as follows: it is the process that makes it economical for energy companies to tunnel at least 5,000 feet below ground to remove gas; via a combination of directional drilling and pumping, rocks are fractured and gas is released. According to the Energy Information Administration (EIA), the US Government’s energy body, there are 48 major shale gas basins globally, located in 32 different countries. These basins contain at least 6,000 billion cubic feet of reserves. Although the industry is still highly nascent, China has the greatest level of potential shale reserves, followed by the US, with Argentina, Australia, Brazil and Poland also offering rich resources.
Calculations from Spears & Associates, a consultancy, suggest that the combined directional drilling and pressure pumping market was worth $42bn on a global basis in 2011, rising to $62bn in 2015. Demand for pumps is being driven not just by the development of new fracking sites, but also by the replacement/ upgrade cycle relating to existing pumps currently working at higher pressure levels and with less down-time than in the past.
Three players dominate the frack pump market: UK-listed Weir Group has around a 30% share, double that of its nearest competitor, FMC Technologies (Gardner Denver ranks third by share). Weir’s dominant position is a result of its 2007 purchase of Texas-based SPM. Since acquisition, Weir has increased capacity at SPM by more than 30% and in its last reported results, SPM’s order book showed year-on-year growth of more than 80%. While oil & gas comprises just over 30% of Weir’s revenues, it is responsible for the majority of the company’s current earnings growth. In 2011, Weir Group gained 14%.
Full steam ahead: the rail renaissance
Population growth, the industrialisation and urbanisation of the emerging world, and an expansion in global trade flows imply that both more people and goods will need to be transported over time. When grappling with this dynamic, central planners as well as both individuals and companies are deeply conscious not only of the relative cost of competing transport mechanisms but are also increasingly aware of arguments relating both to diminishing conventional fuel sources and to climate change. Put simply, rail represents the most efficient way of dealing with these challenges.
At the heart of the case for rail is that the network has substantial economies of scale; it is capable of high levels of capacity utilisation. Speed and reliability are also compelling supporting factors. Greater efficiency also means lower costs. The US Department of Transportation (DoT) calculates that operating costs (measured by per tonne per mile) and locomotion costs (defined on a per container per mile basis) are between four and five times more expensive for truck relative to rail. In a world of diminishing energy resources, rail makes sense. The ‘peak oil’ argument is well-understood and on the DoT’s analysis, for every 100 miles travelled, trains consume 19 gallons of fuel, compared with 57 gallons for a truck, making them three times more efficient. Rail is also notably safer and ‘greener’ than other competing forms of transport.
There are very few ways for investors to gain direct exposure to the rail theme. Indeed, the value attached to scarcity only increases the relative attractiveness of rail. Consolidation has resulted in a highly concentrated industry and there remain just six quoted rail companies. Our two preferred names within the universe are Kansas City Southern (KSU) and Canadian National Railway (CNR). The former looks to be the best-positioned railroad in the Americas, with over 6,000 miles of track spanning not only the US, but also Mexico and Panama. As such, KSU is poised to benefit from increased cross-border traffic, particularly given the generic growth prospects for the Mexican economy (augmented by an increasing number of US companies setting up low cost operations there) as well as the development of the Lázaro Cárdenas port hub. Consensus expectations forecast better growth prospects for KSU than any other listed railroad. Canadian National remains the industry benchmark, operating the most efficient and productive network in the Americas. Limited further investment is required in its business, implying scope for potential cash returns to investors going forward. In 2011, Kansas City Southern gained 42% and Canadian National Railway 21%.
Letting the genie out of the bottle: inflation in the nation
The problem is well known: put simply, there is too much leverage and not enough growth in the world economy. Against this background and in attempting to deal with this challenge, if Central Banks appear willing to tolerate some inflation most likely via further quantitative easing, the key subsequent challenges are threefold. First, what happens if inflation gets out of control; next, knowing when it has got out of control; and, finally, how to bring it back under control. Once the genie is out of the bottle, it is often hard to return it to its appropriate place. Moreover, the transition from the first phase to the second, from benign to malign, is unlikely to be linear. When inflation (and future expectations thereof) becomes rampant, it will be swift, sudden and shocking for many.
In periods of weak economic growth (as is currently the case), inflation could help equities to outperform, subject to several caveats. Steadily rising inflation would drive positive equity returns, at least during its benign phase, as revenues would likely increase at a faster rate than costs, boosting margins and earnings. Furthermore, higher inflation would make bonds – as an alternative to equities – less attractive as an asset class.
Those companies that have typically performed best when inflation has started to rise (in a scenario where starting valuations are compelling and there is scope for organic earnings growth) are characterised by several factors, namely: they have pricing power, are effective at managing costs, capable of identifying new sources of demand and have the potential to de-equitise (allocate their capital effectively. In 2011, our basket of ‘inflation beneficiaries’ (ARM, Elekta, IBM, Linde, Mead Johnson, Pearson and Reckitt Benckiser) gained 19% on a market-cap weighted average basis.
Alexander Gunz, Fund Manager, Heptagon Capital
The document is provided for information purposes only and does not constitute investment advice or any recommendation to buy, or sell or otherwise transact in any investments. The document is not intended to be construed as investment research. The contents of this document are based upon sources of information which Heptagon Capital LLP believes to be reliable. However, except to the extent required by applicable law or regulations, no guarantee, warranty or representation (express or implied) is given as to the accuracy or completeness of this document or its contents and, Heptagon Capital LLP, its affiliate companies and its members, officers, employees, agents and advisors do not accept any liability or responsibility in respect of the information or any views expressed herein. Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation. Where this document provides forward-looking statements which are based on relevant reports, current opinions, expectations and projections, actual results could differ materially from those anticipated in such statements. All opinions and estimates included in the document are subject to change without notice and Heptagon Capital LLP is under no obligation to update or revise information contained in the document. Furthermore, Heptagon Capital LLP disclaims any liability for any loss, damage, costs or expenses (including direct, indirect, special and consequential) howsoever arising which any person may suffer or incur as a result of viewing or utilising any information included in this document.
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