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Redburn ReviewJune 2013

Quis Custodiet Ipsos Custodes? Who Should Own the Banks?

Letter From America1928 and All That

Barnard’s Castle Notes From a Smoky Isle

Gangnam StyleThe Samsung Motive

Contents

Vision in ActionCracking Corporate InertiaWill Hogg 4

Love Will Tear Us ApartSpanish Unemployment Holds the KeyArchie Cotterell 6

Quis Custodiet Ipsos Custodes?Who Should Own the Banks?Jon Kirk 8

My AdviceSupermarkets Must Change Their ModelMarc de Speville 10

Soft CommoditiesInput Need Not Equal OutputJeremy Fialko 11

Barnard’s CastleNotes from a Smoky IsleChris Pitcher 13

Coal ComfortAmerica Sets the Power PriceAhmed Farman 16

Zebra CrossingImplications of the Driverless CarDavid Bracewell 18

Shop Till They DropThe Balance of Power in RetailingAndrew Mobbs 20

Life’s Like ThatPatricia McCormick 21

Gangnam StyleThe Samsung MotiveSumant Wahi 22

ThrillerThe Decade that Paved the WayNicola Merrell 23

Letter from America 1928 and All ThatRowan Joseph 25

Scaling the CliffMaking Sense of Big PharmaAndrew Kocen 26

Eventually“Feral Hogs” and EquitiesRobert Kerr 28

Investors’ Book ClubVolcker: The Triumph of PersistenceWilliam L. SilberIan Harwood 30

Soft Commodities Input Need Not Equal Output (p11)

My AdviceSupermarkets Must Change Their Model (p10)

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Barnard’s CastleNotes from a Smoky Isle (p13)

Redburn Review is published by Redburn Partners LLP, an independent agency stockbroker authorised and regulated by the Financial Conduct Authority. The registered office is 75 King William Street, London EC4N 7BE. Tel: +44 20 7000 2020. www.redburn.com

Welcome to the June issue of the Redburn Review. Our guest essayist,

Will Hogg, is the founder of Kinetic Consulting, a consultancy specialising in leadership. He explains how it is the combination of vision and action that enables management to overcome corporate inertia or atrophy.

With developed markets having claimed and lost multi-year highs, it is little surprise many contributors address the issues arising. Robert Kerr peers through the fog to draw parallels with the ‘joyless’ recovery of 1993, while Nicola Merrell finds echoes of the 1980s in the opportunities ahead. Rowan Joseph, literally following in the apocryphal footsteps of the legendary J.P. Morgan, quizzes shoeshine boys and bellhops about their investment intentions.

At a sector level, Jeremy Fialko examines the marginal benefits (or otherwise) flowing to the FMCG companies from recent falls in soft commodity prices and Andrew Kocen worries about the future direction of the high-flying Pharmaceutical sector. Elsewhere, I survey the tragic state of Spanish unemployment and the risk exalted levels become the new ‘norm’.

Several writers examine the effects of globalisation. Chris Pitcher tells of a recent trip to visit Scotch whisky distilleries on Islay. Conjuring the mist of the Western Isles and the smell of the barrels, he relates the history of Scotch, explaining how global cycles shaped the fortune of this microscopic island – and vice versa.

Overseas influences are writ large in Sumant Wahi’s elucidation of the model and motives of the beast that is Samsung, in David Bracewell’s analysis of the implications for insurers of Google’s driverless cars, and in Ahmed Farman’s explanation of why German power prices could be on the turn.

There is also analysis of changing business models. Jon Kirk ponders who should ‘own’ banks, a question inextricably bound to the wider issue of what banks are for. Marc de Speville advises supermarkets that the way to resist the triple-pronged onslaught of online delivery, premium grocers and hard discounters is to increase their service levels; and Andrew Mobbs delineates the challenges facing general retailers, illustrating how they have given up their margins ‘for you’.

We close with Ian Harwood’s review of William L. Silber’s biography of the indefatigable Paul Volcker and an obituary of the matadora Patricia McCormick. In her achievement and her refusal to bow to prevailing wisdom, McCormick is the perfect analogue for a British prime minister who died the following week, but whose legacy was too great, divisive and commented upon to be decanted into three hundred words.

We hope you enjoy this edition of the Redburn Review.

Archie Cotterell

Redburn Review

4 / Redburn Review / June 2013

Vision in ActionCracking Corporate Inertia

It is time for the annual review and the leadership team awaits the CEO’s

presentation. Economic challenges abound. The top and bottom line are down. Competition is more global, more local, and more aggressive. It is time for a fresh perspective. The audience shows remarkable optimism in believing it could be different this time. The boss stands up. She knows she is a charismatic presenter. Her PowerPoint is perfect. The rehearsals were frequent. She delivers the message and moral with confidence: “Customer focused, multi-functional teams are the answer.” The participants get it. They applaud politely, ask the obligatory questions and have no idea what to do next. The CEO has delivered ‘vision without action’.

Next door, a Corporate Programme Manager in a different enterprise faces a similar situation. His old MBA notes help. The ‘Nine Steps to Lasting Change’ inspire an impressively detailed Critical Path Schedule. After forty minutes’ discussion, the Global Change Team finds an inspiring umbrella for the project: “We deliver what we promise…and more.” One more sceptical team member asks how this will deliver future competitive edge or build shareholder value. There is a polite silence. The discussion moves onto the deployment plan. This is ‘action without vision’.

“Vision without action is a daydream, action without vision is a nightmare,” is a justly famous Japanese proverb. It makes clear that ‘vision with action’ is the indivisible whole required to engage employees and attract investment. However, the issue is the most important targets of these initiatives are often absent. Those people are not in the room because they were not invited. Labelled

‘Change Resisters’, these are individuals reacting to a perceived loss of power, prestige or future. Frequently, this is compounded by the fear they will not cope with a new way of working.

This ‘Permafrost’ segment of managers confronts every CEO driving transformation. It could be a hierarchical segment, such as regional managers and store managers in large retailers (Carrefour, Metro, Tesco). Equally, it could be the mythological ‘Country King’ in a company seeking global scale (Kraft, Kellogg, HSBC).

This is well documented. The challenge is the daily fare of any leader. So, what is a more effective way of tackling this inertia rather than persisting in expensive cognitive dissonance? It is expensive directly and in opportunity cost, and dissonant because it is an unproductive approach to leadership. What, then, is the solution that should give investors confidence in change?

The answer is ‘vision with action’. It is simple, intuitive and easily applicable. It is also common sense, as useful in large corporations as in SMEs. There are four steps to cracking corporate inertia and developing shareholder confidence: (1) a case for change; (2) a compelling picture of the future; (3) competitive, sustainable capabilities; (4) a credible plan to execute.

The first prerequisite for an effective vision is, paradoxically, negative. Nothing happens until there is an accepted case for change, rooted in a healthy mix of external and internal dissatisfaction. A comprehensive yet pragmatic approach is to identify the future needs of the five ‘C’s (customer, consumer, colleague, company, community). Failure to take this step caused an iconic company to spend, in

the words of one of its top executives, “Four years living off our legacy, versus driving our legacy forward.”

The problem is those who should challenge the status quo are frequently those who created it. The cost of ignoring reality, however, is high. The company quoted above fell from third to thirteenth in peer group TSR. The two questions management and shareholders should have asked were: “How are we set up to deliver our current results?” and, critically, “Will that set-up deliver what we need in three, five, ten years?”

Visionary leaders are alchemists. They have the Churchillian knack of visualising a future opportunity that trumps a current negative reality. The clue is in the verb. Painting a compelling picture of the future is as much about EQ as IQ. As leaders from Jesus to Martin Luther King have shown, stories move people. For well known neurological reasons, stories fix a vision directly in the brain of the listener.

Whilst not as dramatic as Steve Jobs’ legends, a powerful example was the device AG Lafley used at P&G in 2000. Confronted with a confused and self-referential organisation, he offered this brutal visual: “Internal focus means looking at each other and looking at each other means showing your ass to the consumer.” He thereby delivered step two, mandating that the “Consumer is boss,” and mobilised more than 130,000 people by replacing one metaphor with another.

If the tendency of many leaders to be too ‘left-brained’ constructs one barrier, many other would-be visionaries stop at the inspiring slogan. Yet a slogan alone lacks the intellectual rigour that underlies a deceptively simple vision. Actionable foresight is underpinned by

June 2013 / Redburn Review / 5

tough, clear, mutually supporting choices and realistic building blocks. The latter point is crucial. It highlights the way to achieve the vision, in terms meaningful to the consumer and/or employees. These could be expressed as Brand, Country, Category or Product targets by year: most likely a combination. Unless this detailed exercise is complete, though, the CEO will not be able to answer the investor’s question: “How does your strategy create long-term, inimitable competitive advantage?”

The first two steps have been achieved and the dream is clear. How does it become more than that? The hard truth is most visions die because leaders miss the apparently obvious step of building competitive, sustainable capabilities. Most people would not give their car keys to a child who had not learnt to drive, yet many leaders do so in their organisations. In the “four years of complacency” company described above, leadership invested significant time and money. The outcome was a powerful and coherent vision. Deployment was so successful that more than 90% of the organisation said they understood, believed and were inspired to act. This was unprecedented.

All the effort, however, fell at the third hurdle. Reality was confronted, an exciting solution was shared and

then lack of organisational bandwidth threatened the entire turnaround. This is painstaking work, as each new strategic building block generally requires the creation of a fresh capability within the team. Too often, a lack of patience or attention to the ‘how’ prevents meaningful progress. The immediate challenge to any new strategy, therefore, must be: “Do you have the leadership bench, business processes, employee skills and supportive culture to make this happen?”

“Fail to plan, plan to fail.” This cliché is the moral of many M&A fiascos or humiliating CEO ‘over-promise and under-deliver’ stories. Without a credible plan to execute, vision combined with capability ensures everyone strives to please the boss, in their own way. As in ‘The Sorcerer’s Apprentice’, the result is well-meaning anarchy. A credible plan means more than the critical path of the second introductory story. That, too, can just become paper on the planner’s wall. The fourth essential task of any change leader is to cascade choices. Employees can only be spectators until each has a work-plan that ties directly to the strategy, within six months of leadership sign-off. The critical words are “each”, “directly” and “six months.”

Middle management is the common challenge at this point. As vested senior

leaders may impede the case for change, so a successful cascade requires action from those who may feel they have most to lose. Frequently, these link positions are filled with underambitious timeservers who hoard knowledge as their last power base. Unblocking this strategy dam requires perseverance, influencing skills and robust tracking systems – both carrot and stick. The last check for any would-be investor in the change, then, is: “Do 100% of your employees at every level have a plan that is hardwired to the strategy?”

Vision and action creates justifiable confidence. This is vision founded in unequivocal, coherent choices that address an understood set of reasons to change. It is action by a capable organisation operating against a cogent plan. Even that, however, is insufficient. Toffler’s observation “The illiterate of the 21st Century will not be those who cannot read or write, but those who cannot learn, unlearn and relearn” applies equally to any corporation. Lack of agility carries uncompromising consequences: only 29 of the first ever Fortune 500 remain on the list.

Will HoggFounder, Kinetic Consulting

Now what?

Love Will Tear Us ApartSpanish Unemployment Holds the Key

There is an inverse correlation between the proliferation of economic indicators and the reduction of investor

comprehension. The more information available, the greater the number of talking heads that fill our screens, the denser the fog that palls over the future. As the euro area limps towards a jobless recovery, German PMIs, French GDP, Spanish debt, Italian housing and UK manufacturing statistics seem in conflict – if not, like their governments, pointing accusatorily at one other.

Amongst this thicket of European data, one series holds particular resonance: Spanish unemployment. Policymakers in a recession-suffocated economy have four levers to ignite recovery: lower interest rates, expansionary fiscal policy, a sliding currency, and increased productivity (shedding labour). The Spanish government, tied to the euro and the ECB, can do nothing about the first three, so labour is taking all the pain.

In consequence, despite marginally more hopeful economic noise, the growth in Spanish unemployment is remorseless. Even allowing for the ballooning black market, the statistics are dramatic. Amongst adults, 27% (6.2 million) are unemployed, including 55% of under-25s. Two million households are without a breadwinner. In 2007, 19% of the unemployed had been unemployed for more than twelve months, today

42% have been. In Castilla-La Mancha, 64% of youths are unemployed against 14% in 2007. The shift from taxpayers to paro (welfare) supplicants has been relentless, causing the deficit to grow, borrowing costs to rise and growth to decline. This is taking place against the backdrop of 2.25 million properties unsold, fixed investment falling, and a current account barely in surplus despite vertiginous unemployment. The result is rising taxes and public service costs are driving people into the black economy.

Those in jobs are ossifying, unable to ascend greasy poles in static enterprises. R&D investment has stagnated. Qualified youngsters, notably scientists and engineers, are leaving, heading for the US or Germany, even the UK. The diaspora caused the population to decline -0.7% last year. If this recalls the mid-1990s, when unemployment spiked to 24%, the similarity is deceptive, the endgame less clear. Then, rates were reduced, the peseta devalued, growth returned. Today, there can be no fall in rates, no devaluation. It is uncertain how much more the economy can take.

It is also uncertain how much more the people can take. The Catholic Primate of Spain, the Archbishop of Toledo, warns of the potential for “social collapse” and “conflict and mutual hatred.” In Toledo, the charity Caritas is handing out bags of

The new normal


food to 40,000 people in a province of 700,000, many of them ‘middle class’. They are subsisting on 12kg of beans, oil, milk and pasta per month per family. Caritas is not certain how long it can continue without its government subsidy: “It was supposed to come in January, but they’re broke too.”

Mediaeval debt laws do not help. Creditors can pursue all assets of the debtor and a share of future income post bankruptcy – with a hereditary element. Families are being thrown onto the street each week under the infamous Deschucios, their houses sold at auction, leaving them only with their debt. Entering Chapter 11 may be a smart move for a distressed corporate, but there is no equivalent for the humble Spaniard. Small wonder a recent poll declared 87% had lost confidence in Mariano Rajoy’s scandal-ridden government. There is the whiff of cordite in the air. Unemployed youths have to do something. The General casts a long shadow.

This is why, amongst the myriad monthly European economic data, Spanish unemployment is so important: because, given the necessary reliance on the productivity (labour) lever, it will continue ticking remorselessly higher. At present, the peace holds. Yet with 27% unemployed and 55% of the under 25s unemployed, how bad do things have to become before revolución is not just in the air but on the streets? 30% and 60%? 35% and 70%? When does the Guardia Civil decide it has suffered too many pay cuts and colleague redundancies and turn its cannon on the government?

It is critical stuff. Spain is the fourth largest economy in the euro area and has been an ardent supporter of the European project. Its population has, thus far, been remarkably quiescent. The civil war and isolation of the Franco years remain high in the collective consciousness. It does not wish to slide into North Africa.

Yet if that moment arrives, the Germans will have to change tack or Spanish participation in, and hence the euro project itself, is history. If Spain erupts, the Germans must either sanction ECB money-printing, reflate Germany through tax cuts, or allow Spain to leave the euro. None of these are palatable solutions to the keepers of the vault. Whichever route the Germans choose, austerity is over. So the markets watch Spanish unemployment rising, an inevitable result of current policies, and they know every percentage brings them closer to the denouement. Tough love isn’t working.

The Spanish situation trails a secondary question: is the rise in unemployment structural or cyclical? It is a critical point. If this is simply a cycle, Spain will eventually grind its way through. If structural, it will need special measures. The danger is the former becomes the latter. Yet identifying the nature of unemployment is not easy in the pit of recession. In the Thirties, FDR talked of “permanently higher” unemployment in the US, and during the 1964 spike more than 50% of US economists thought employment would never recover; by 1967 it was below 4%.

Changes in technology and demographics lend credence to the structural case. Companies are proving slow to hire, which may reflect a mismatch in skills. The construction worker in a hard hat and yellow caterpillars is not obviously re-employable as a goatee-sporting software guru. People are lost to the job market forever while the ECB focuses on deficit reduction.

As a result, the unemployed applicant has no bargaining power. He or she can cut their asking price, yet this has little traction. A cut may take the salary offered below the subsistence line, or be uneconomic by comparison with welfare. It may make the applicant too cheap to be considered: Arnold Schwarzenegger was unable to find work as a Mr Universe-sized housebuilder in LA until someone suggested he double his rates. Hiring an employee because they are priced too cheaply will cause current worker disquiet. Or there may simply be no economic price given the economic outlook.

The result, as the cyclical becomes structural in Toledo and elsewhere, is a cranking up of human suffering. Unemployment directly causes poverty and debt and corrodes confidence. Indirectly, it wears out the unemployed. A paper by the Columbia University economist, Till Von Wachter, and Daniel Sullivan of the Federal Reserve Bank of Chicago demonstrated mortality was greater amongst victims of the 1981/82 recession and was still higher twenty years later. Meanwhile, a Swedish study shows the capacity of those unemployed for more than a year to process printed information falls by more than 5%.

It is a vicious circle. The phenomenon of long-term unemployment, or hysteresis, bit in Europe in the early 1980s as policymakers offered too little, too late, and rates soared to 8-9%. Although they came down in the recovery, they had rebased permanently to a higher level.

The danger today is that the exceptional becomes the established. A crisis cannot be a crisis forever. After a while it is just the way things are. The structurally higher rates of unemployment experienced in northern mill towns and mining villages in England are now greeted with a shrug. That’s the way it is. It is beyond the interest or imagination or belief of policymakers to address. Austerity fatigue sets in. That’s life, and life, as we know, goes on.

Only for those who left school without qualifications to join the construction boom, or the 64% of youth unemployed in Castilla-La Mancha, it doesn’t. The danger is that post any recovery it still won’t. Or, at least, it won’t in any way identifiable to those employed, or in any way that resonates with policymakers in their shiny reflective buildings in Frankfurt and Berlin. Yet while they prevaricate, unemployment is embedding itself in the economy. The unthinkable is becoming the norm.

Archie Cotterell

Quis Custodiet Ipsos Custodes?Who Should Own The Banks?


Five years on from the onslaught of crisis, the banking industry

still quickens the popular pulse. To voters, politicians and journalists, little appears to have changed. Investment banks still write business, apparently unedited, while bankers enjoy lavish bonuses even as they withhold the oxygen of credit from gasping economies. Bankers, banks and industry investors, even banking analysts, are yet to be forgiven.

The reality is different. Thousands of jobs have been lost, including the high profile scalps needed to satisfy populist bloodlust. Dividends have evaporated and the most lavish pay practices have been consigned to history, allowing banks to rebuild eviscerated capital positions. Regulatory oversight is relentless and intrusive. Balance sheets have been slashed, with some trading inventories reduced 90% from the peak. Certain racier, once highly lucrative business lines are gone forever. Gun-slinging traders are firing blanks, their weapons muzzled by risk controls and incentive schemes.

No one can agree whether the industry has sufficiently reformed, giving rise to the existential question: what is the purpose of banking? The answer, whatever it may be, raises two further questions: who should own the banks, and do they exact an unacceptable return from society?

Myriad academic and central bank studies distil the functions of a bank down to the operation of payments systems and easing the exchange of goods and services, the efficient provision of credit, the stewardship of savings and the facilitation of risk management. Cynics might add a fifth: the enrichment of bankers.

It is in the management of payments systems that banks are most like utilities. The ability to pay and receive money is something we take for granted. However, as those locked out of their bank accounts by RBS’s computer glitches last summer will testify, we are pathetically reliant on these systems. Yet this is no reason for such a business to be state owned or run. It is arguably no more important to society than gas, electricity, water, telecommunications or rail etc, all of which exist in private hands, albeit under close regulation.

The efficient provision of credit is something over which no model of ownership can claim superiority. The disastrous state-directed Chaebol lending in South Korea ahead of the Asian crisis is a good example of political interests leading to the egregious misallocation of credit by a banking system. Likewise, the politically favoured mutual model of ownership does not guarantee high quality lending practices, as failed building societies and the recent property lending losses at the Co-operative Bank bear witness. Naturally, the list of banks in private ownership (including by their own staff) at the time of their failure is somewhat longer, but not disproportionately so given the majority of banks are shareholder owned in the developed world. In other words, the structure of ownership has little bearing over sensible decision-making.

The third function is the stewardship of savings, namely the preservation of wealth and generation of returns on it. Public debate focuses rather more on the former than the latter. The most extreme suggestion is ‘narrow banking’, whereby deposits are invested in government debt. All other lending has to be funded

from wholesale markets. This is a short step to full state ownership, e.g. post office accounts or, in the UK, ‘premium bonds’. It is hard to see how this benefits savers whose returns will be lower (particularly when a deposit guarantee scheme is already in place), or indeed borrowers who will have to pay more for credit in such an inefficient model.

The facilitation of risk management takes us into a grey area from the point of view of ideal ownership, though perhaps that is simply a misunderstanding of what ‘facilitation of risk management’ means. To be fair to the industry’s detractors, recent years have seen a drift away from the ‘socially useful’ business of taking risk on behalf of customers, to the once highly remunerative business of punting the bank’s balance sheet in the open markets.

In reality, the former is no different to what insurance companies do: take risk off a customer in return for a premium. Yet you don’t hear many calls for the mass nationalisation of the insurance industry. Those who call for retail banking to be a socialised utility, with investment banking privately owned, are suggesting investment banks can fail without systemic consequences and that retail and SME banking customers do not require access to the risk management tools provided by investment banks. Both assumptions are inaccurate. To my mind, judging the appropriate amount of risk that banks take for themselves rather than passing off into the wider market is a call for management and regulators, and has little to do with ownership structures.

At the other end of the scale lies the practice of betting the bank’s own balance sheet on market positions, aka prop trading. This was of course highly


Eaten it?

lucrative in the bull market, particularly because traders were able to “leverage customer flows” to enhance profits. Those weasel words belie a variety of at best dubious, at worst illicit, techniques, which ultimately increase the cost to customers. At their most malevolent, these include the manipulation of market prices. Allegations of price fixing in the FX markets are now emerging, a depressing echo of the LIBOR scandal.

We all know how dangerous these business lines were once markets hit the buffers. Happily, regulators have now made it impossible or very expensive for banks to engage in such practices, pushing them firmly out of regulated banks into privately owned pools of capital, unprotected by taxpayers. Naturally, the expansion of so-called shadow banking will, to some people’s minds, trigger the next financial crisis.

In short, ownership structures have little bearing on much of what banks do, particularly now their sharper practices have been reined in. One failing of the

crisis was the wrong parties ended up bearing too much of the cost of failure i.e. taxpayers rather than bondholders and uninsured depositors – albeit nobody can doubt shareholders took their share of the losses. However, detailed resolution plans and capital instruments which are explicitly loss-absorbing should address that issue. Thus, arguments that banks should be nationalised because the taxpayer takes all the losses and none of the profits are becoming less valid.

More critical to effective management of banks, with all that means for promoting economic progress, is proper regulation and appropriate management incentives. The former should be more intrusive, though perhaps less complex, while the latter should ensure bankers have more ‘skin in the game’. Recent changes, not always transparent to society at large, have moved the industry a long way in the right direction.

Overall, arguments that banks are a social utility and therefore should be

nationalised because of what they do are naïve or invalid. No ownership structure guarantees better banking practices, though all still leave the possibility private bank shareholders are extracting an unnecessary rent from society. I believe they are not.

Firstly, perspective is needed. Shareholder profits are typically a small proportion of the all-in cost of running a bank. JPMorgan generated 2012 pre-tax profits of $29bn. Adjusting the 2012 P&L mix for a ‘normalised’ interest rate environment, this would represent 10-15% of gross revenues. Interest costs are much more important (c50%) and these are simply returns paid to what are effectively other capital providers including depositors and fixed income investors. Operating expenses and credit losses account for the remaining costs of being in business. Secondly, if you nationalised all banks, competitive pressures would be eroded. Would antitrust authorities tolerate all banks being owned by the same private shareholders? Thirdly, shareholders have influence over management. This may or may not be a good thing, but one has to ask whether the government or customers would offer better oversight? It is doubtful, to say the least. Hence shareholder profits may be a small price to pay for healthy competitive tension and active industry stewardship.

Appropriate risk taking, the safeguarding of savings and the reliable provision of utility functions ultimately reflect bank management incentives and regulators’ intervention rather than the behaviour of owners. Meanwhile, the cost of private shareholders is justifiable in terms of what it means for both competition and innovation. All owners of banks have their specific requirements, many of which clash with the needs of other stakeholders, but in an imperfect world, private shareholders are the least bad of them all.

Jon Kirk

My AdviceSupermarkets Must Change Their Model

A hundred years ago, the hungry shopper would go to the counter

in the corner store, point towards the fish display and say to the man in the grey apron: “What would you recommend?” The man would suggest the freshest fish and, once agreed upon, fillet it if requested, wrap it in greaseproof paper and hand it over. The customer would take it to the till by the door and pay the cashier, who was probably the man in the grey apron’s wife.

This model was destroyed by the supermarkets. They let customers take what they wanted off the shelves and used promotions and placement to make some items more attractive than others. The principle hasn’t changed since inception: self-service, with minimal attempt by the retailer, beyond paid-for promotions, to sell a particular product.

However, this model needs to evolve. The emergence of sophisticated price matching schemes, the growth of online, and the increasing focus on healthy eating and waste reduction are changing consumer behaviour. Food retailers must change too. Clinging to the old ‘pile ’em high, sell ’em cheap’ self-service model is not the way forward.

Shifting consumer demands will require significant investment in training for staff to be able to explain the health advantages or disadvantages of specific products and to suggest different ways of preparing and pairing them. In short, supermarkets need to become more like the fishmongers, butchers and grocers – the man in the grey apron – whose business they took and whose stores they were responsible for closing.

There is much ground to make up. For example, a few weeks ago I went to my local Waitrose to buy something healthy

and tasty for dinner. I asked the lady in the branded paper hat behind the fish counter: “I feel like some fish tonight – what do you recommend? Is there anything particularly fresh, preferably not too expensive?” She answered: “We’ve got lots of nice fish, it’s all very fresh. Have a look for yourself.” While undoubtedly friendly, her insight was not especially useful. Then I noticed the Cornish sardines. They were fresh-looking and reasonably priced, presumably because they were relatively local. “What about the sardines?” I asked, “I had some in Spain recently and they were really tasty.” She replied: “Oh, I don’t know about sardines, we don’t get them in very often… um… I could put them in a ready-to-cook oven bag with some herbs and garlic butter for you.”

Evidently, this is as far as my local Waitrose’s fish preparation advice goes. While it is more than you might receive at most other large chains, it does not work well with all types of fish – especially oily ones such as


Which do you recommend?

sardines and mackerel, which are best to grill. They are also, incidentally, particularly good for you, being rich in the omega-3 fatty acids and vitamin B12 that support cardiovascular health, and vitamin D for bone health and possible anti-cancer properties. Additionally, sardines are high in proteins and low in contaminants such as mercury.

However, at Waitrose and the other supermarkets advice on healthy eating is limited to labels and a traffic light system. These show how much salt, sugar and saturated fat a product contains, and whether it is free from gluten, nuts or other potential allergens. It may also state whether it counts towards your recommended five-a-day fruit and vegetable intake. Whole Foods also includes a nutritional value rating and some supermarkets in the US are starting to employ dieticians that customers can consult about specific health concerns, such as cholesterol or food allergies. Overall, though, supermarkets do a poor job of pro-


actively addressing customers’ increasing desire to eat more healthily and to make sense of the often conflicting advice they hear in the media.

There is a similar dearth of active in-store advice on menu suggestions, how to prepare particular foods or using leftovers to make food last longer. Take the humble onion: how many people know they have strong anti-cancer properties, should be cooked on high heat initially to caramelise the sugars, and only peeled sparingly as the nutrients are concentrated in the outer layers? Imagine if the next time you are in Tesco or Sainsbury buying onions, or just browsing the vegetable department, an employee volunteered this information along with an easy recipe for a tasty French onion soup using old crusty bread you were about to throw out and stock made from a leftover beef joint or chicken carcass. How would this

alter your perception of the brand and your desire to return to the store?

Ensuring staff know enough about products to help customers choose and prepare healthy, affordable, varied meals will not only increase customer loyalty but make employees feel engaged and empowered, creating a positive feedback loop. Of course, this will require upfront investment, but the link between superior employee training and sustainably higher sales densities, growth and profitability is well proven in food retail. Wegmans in the US, Mercadona in Spain, and Sainsbury in the early 1980s are good examples.

Food retailers providing such value-added services and addressing their customers’ evolving needs will assuredly outsell those sticking rigidly to the traditional self-service model. In the UK it will be interesting to see whether Tesco, the challenger, or Sainsbury, the

acknowledged service leader, moves first to grasp this opportunity.

Whoever leads, one thing is clear: increasing service is essential if food retailers are to arrest the remorseless drift of customers online and to hard discounters. Providing human contact and product advice and information at the point of sale is a competitive advantage that cannot be replicated by the employee-light model or the computer-generated recommendations of internet retailers. Offering more for less – in a word, value – has always been at the heart of the food retailers’ offer. Increasing in-store guidance will enable them to expand their middle ground, outflank the hard discounters, erode the upscale retailers’ USP, and provide consumers with more reasons to shop in-store than online.

Marc de Speville

Soft CommoditiesInput Need Not Equal Output

For much of the past three years, the Food Manufacturing sector

has ridden a wave of stronger than expected underlying sales growth, aided by buoyant emerging markets and robust pricing. In a low-return world, this proved a powerful cocktail for share prices. Since June 2010 the Food & Beverage sector has outperformed the Stoxx 600 by 20%.

This was abetted by the manner in which the sector confounded the commodity naysayers. Having survived the 2008 commodity price spike with margins intact, another episode of severe inflation in 2011 led many observers to fear the Food companies were about to be squeezed. Retailers muttered darkly

about having ‘learned their lesson’ and how manufacturers wouldn’t ‘get away with it’ this time round, having pleaded poverty before and then delivered record margins. In the event, history repeated itself. Prices were raised, operating margins protected and the sector appeared ever more indestructible.

Last year passed in a similar vein. However, towards the end of 2012 a number of commodities started to slide as good harvests led to abundant supply. For example, palm oil fell 40% between its April peak and the end of the year. Sugar and Arabica coffee were weak for much of 2012 and this has continued into 2013. Even grain, which was strong following last year’s US drought, is set to

be much cheaper given indications of a huge harvest.

In principle, this should be a good thing for food manufacturers. The tendency to be ‘behind the curve’ in recovering higher prices means when prices fall there is the hope some of these lower prices can be retained. For example, Unilever spends over €2bn pa on edible oils. Consequently, the reduction in average prices between 2013 and 2012 (taking into account some forward buying) should save it around €700m pa – a substantial amount in relation to its €7.0bn pre-tax profits. Even if it was to keep only 15% of this, it would still add 20bp to group margins. Could 2013 be the year in which the


sector throws off the shackles and delivers significant margin expansion? Or is this something of a misconception, and commodity deflation is not much of a positive at all?

Firstly, there is the basic ability to maintain the cost savings. While generalisation is dangerous, in much the same way food companies’ capacity to raise prices to offset cost inflation is better than many perceive, the competitiveness of most markets means the ability to retain lower input prices is more limited. One of the most vivid examples was provided by the soon-to-be acquired D.E Master Blenders 1753 (D.E). With Arabica coffee prices in freefall, Chairman Jan Bennink opined that D.E should hold onto around 70% of the benefit. However, as competitors cut their prices, D.E’s position became unviable and it was forced to follow suit. Indeed, we would be surprised if it has managed to retain a tenth of the figure Bennink originally hoped for.

Even in less overtly ‘commoditised’ categories, it is not straightforward. In 2008/09, Unilever, dominant in the Indian laundry market, thought it would retain a portion of the lower input costs. In the event, local competitors moved quickly to undercut them and the behemoth was forced to respond.

There are also implications for sector organic sales growth. Its robustness over the last two years has fostered a belief this is the new norm given companies’ increased skew towards emerging markets – and multiples have expanded accordingly. In practice, pricing has formed a major portion of this growth and much is likely to dissipate in a more benign, or even deflationary, commodity price environment. Moreover, the price inelasticity of most fast moving consumer goods means we are unlikely to see much of a volume response as pricing fades.

This weaker organic sales growth picture has already been reflected in the downgrades to our Nestlé and Unilever forecasts since the start of 2013. While

Marginal cost

in pure economic terms it could be argued this is irrelevant – less input cost pressure sanctions lower pricing and therefore profits should be unaffected – the importance of underlying sales growth as a driver of ratings means the market is often not so sanguine. Perception plays a role in the ability of FMCG groups to recover the high prices seen as a sign of ‘brand power’, but the passing through of lower prices is deemed a marker of ‘commoditisation’.

Currencies offer another complication. It is easy to check US$ prices of various commodities and assume this is what the food companies will pay for inputs globally. In practice, raw materials are sourced locally and, with most emerging market currencies having depreciated against the dollar, the effective reduction in commodity prices is far lower. In some ways, this is helpful for the food companies. Given the aforementioned link between underlying sales growth and rating, the fact there remain markets where price rises need to be implemented will support sector organic sales growth and thus the rating.

Despite the positive perception, this additional sales growth is, in reality, valueless. Not only is local pricing

concerned with offsetting market inflation, but with these price rises necessitated by currency devaluations, results in dollar, euro or sterling terms will be reduced accordingly.

The large food companies’ P&L flexibility further dampens the visible impact of commodity inflation on profits. Despite the sales growth and robust profits throughout recent periods of commodity price inflation, gross margins have been under pressure. However, a squeeze on SG&A costs, including A&P, has helped to keep operating margins intact. Therefore, even if we see a degree of gross margin restoration, a good portion is likely to be reinvested, reducing the beneficial impact on operating margins.

So, taken together, how beneficial are the recent falls in commodity prices? Given the premium rating attributed to organic sales growth, a slowdown via reduced pricing is likely to undermine this. However, the debate does illustrate the importance of volume and mix: if these grow consistently, most other things should take care of themselves.

Jeremy Fialko

In 1885, Alfred Barnard, the pioneer whisky tourist, embarked

on a grand tour of all the whisky distilleries of Scotland, Ireland and England. It was a time of burgeoning consumer and commercial interest in Scotch as advances in production and transportation opened new markets across Kingdom and Empire and contributed mightily to the Imperial Exchequer. The industrial backdrop he encountered during the late Victorian whisky boom has striking parallels with the current buoyancy for Scotch.

Over two years, armed with a tape measure and an eye for detail, he recorded the ownership, methods and machinery of all the distilleries he visited. Barnard was not himself a distiller, but as secretary of Harper’s Weekly Gazette, a journal dedicated to the wine and spirits trade, he had association, and through the Gazette he serialised his travels.

I discovered Barnard’s work last year while researching the history of Scotch whisky for a report on today’s industry leader, Diageo. His despatches illuminate the first golden age for Scotch with vital data and context. Through his digressions one gains a snapshot of life in late Victorian Britain, a simple lens revealing an age of engineering, exploration and Empire. The book also inspired me to conduct some primary research and, through tracing part of his journey, root the current whisky boom in historical context.

Hence I arranged a busman’s holiday to Islay. With Redburn reluctant to sanction a two-year sabbatical, my ambition was necessarily less comprehensive than Barnard’s, and the island provided a microcosm of the Scotch whisky industry. It also provides the smoky

heart of many a blend and some of the most widely known malts. Peat defines the spirit of the island, with two broad churches: the ‘peated’ and the ‘unpeated’. Etched peat bogs line the main roads, carved furrows to provide fuel for the islanders, fuel for the maltings, fuel for the whisky. I had read much about its history and knew many of its malts on first-name terms, but had never visited. Forewarned by Scots colleagues, I chose April to avoid the ‘midge season’.

Thankfully, like Barnard, I was “not doomed to travel alone” but was accompanied by my father and father-in-law. Both engineers by trade, they offered able support when discussions with enthusiastic distillery managers became too technical for a “teenage scribbler.” My father is an Islay devotee while my father-in-law’s tastes lean towards the lighter Speyside malts. For one it was a pilgrimage, long overdue, for the other a chance of conversion.

Barnard had the romantic notion of beginning in the Orkneys and “entering the land of Whisky by sea,” but the weather proved unfavourable. Instead, he opted for more modern transport and took the night mail from Euston to Glasgow. We similarly chose the most time-and-cost efficient mode of travel and entered the land of Whisky on the early morning easyJet flight from Luton.

Barnard made Glasgow his base for several days. Fortified with a substantial breakfast and having engaged a horse and trap he arrived at his first distillery, Port Dundas. Proximity may have determined the itinerary, but his starting point was significant in the industry’s development. Port Dundas was owned by the newly formed Distillers Company Limited (DCL), a grain distilling collective which would become the


Barnard’s CastleNotes from a Smoky Isle

base for Diageo’s Scotch business today. Had we decided to follow assiduously in Barnard’s footsteps, we would have encountered disappointment on day one: in 2009 Diageo closed Port Dundas and consolidated its grain whisky production at Cameronbridge in Fife.

Indeed, it would have taken six locked or nonexistent gates before we found the first distillery in Barnard’s book still active today. Since 1900 whisky production has rebalanced away from Glasgow and Campbeltown in the southwest to Speyside and

English whisky


Tourists welcome

and the distillery was bought by DCL and remained silent, or at most barely audible, until after World War Two.

In the early 1970s, as the second golden age for Scotch was nearing its peak led by demand from the United States, the distillery was rebuilt by DCL and capacity expanded from two to six stills. Again the market turned, as the American love affair with Scotch ended, but production continued despite a significant drop in demand in the 1980s. Recently Diageo nearly doubled the distillery’s capacity again to support the growth of Johnnie Walker, Caol Ila being a principal source of spirit for the world’s leading blend. The Paps have stood silent witness to dramatic changes at their neighbour across the Sound.

Great optimism was the prevailing mood of the whisky industry in the 1880s and is the common thread between our trip and Barnard’s. New capital was attracted on the promise of unquenchable demand across Britain and the Empire. By 1885 Scotch production had increased to within a dram of 18 million gallons pa, while on Islay production exceeded 1 million gallons. Distilleries such as Bunnahabhain and Bruichladdich were the entrepreneurial start-ups of the time, both built in 1881 to service the boom.

Today, the whisky industry finds itself in a similarly buoyant mood. While many distilleries have fallen silent, capacity is again being added. By 2015, on Islay alone, we estimate capacity will have increased by more than one-third since 2009. The bulk of this has been at Caol Ila, but Rémy Cointreau, the new owner of Bruichladdich, has committed to double capacity again and we would not be surprised if the Port Charlotte distillery was reopened. The island even welcomed its first new distillery for more than a century when Kilchoman opened in 2005.

New capital may be returning, but production methods remain largely unchanged. Our tours were steeped in Victoriana: the floor maltings

the northeast. This would have been mourned by Barnard, as the region featured prominently and favourably in his writing. Our trip, however, was a celebration not a lamentation and so we headed straight out of Glasgow.

Of all the changes since Barnard, transportation is perhaps the greatest. Railways, roads and air travel have spread the reach of Scotch. Islay boasts an airport with two flights a day from Glasgow, but we opted for the coastal drive and ferry. Thankfully we did not have to depend on a horse and trap, as Europcar provided the relative luxury of a modest hatchback.

Driving the west coast of Scotland has been an ambition since reading ‘Raw Spirit’ by the late novelist Iain Banks. Banks also embarked on a distillery-bagging tour of Scotland under the loose pretence of finding the “perfect dram” while indulging his love of driving Scotland’s “great wee roads.” I do not recall if the A816 from Oban to Lochgilphead featured but, even constrained by the best a 1.6 litre Skoda engine could muster, I began to understand what had stirred Banks so profoundly.

From the Kennacraig ferry terminal onwards, our journey began to rhyme with Barnard’s. Judging by his

description, the two-hour crossing had altered in neither duration nor distraction, the pace of ferry travel as impervious as the surrounding quartzite to the passage of time. From the boat, the Isle of Jura, Islay’s desolate neighbour, dominates the skyline as it did in the 1880s. I had been intrigued by Barnard’s romantic references to the ‘Paps of Jura’, three monumental rocks “with no shadow to break their terrible ruggedness.” By chance, we had chosen a clear spring day to make the approach. The Paps did not disappoint.

Disembarked at Port Askaig, we headed up the hill and down to Caol Ila, the largest distillery on the island. Our starting point, again determined by proximity, lacked none of the poignancy of Port Dundas. Founded in 1846 in “the wildest and most picturesque locality” Barnard had yet seen, Caol Ila’s history maps the tumultuous cycles enjoyed and endured by the Scotch industry.

The business struggled initially and changed hands several times. However, by the time Barnard visited, demand was such that the distillery had expanded, with every drop ferried to the mainland already allocated. This popularity was not enough to weather the precipitous downturn in the whisky market after 1899. The owners went into liquidation


at Bowmore, the grain mill at Bruichladdich, the blackened stills at Bunnahabhain, the burnished brass spirits safe at Lagavulin. Steel had, on occasion, been touted as a cost-effective and easier-to-maintain replacement, but more often copper and wood prevailed. Barnard would feel at home in Islay’s still houses today. The process remains the same and each distillery remains unique with only the distillery manager fully versed in its idiosyncrasies. Progress has not meant uniformity, thank goodness.

The only profound change on the island has been ownership. When Barnard visited, the proprietors were family businesses, local farmers or entrepreneurial merchants from Glasgow. Only Bruichladdich and Bunnahabhain were incorporated into the anonymity of a corporation. The first great consolidation arrived after the whisky bubble burst in 1899, when DCL acquired both Caol Ila and Lagavulin. The other Islay distilleries have passed through multiple hands. Today’s ownership is as exotic as Scotch’s appeal is global, with French, Japanese, American, South African and, until recently, Trinidadian interests on the island. Only Kilchoman is independently and locally owned; a farm distillery in the original spirit of production predating even the Victorian era.

Bubbles may not form in Scotch, unless soda is added, but the industry has been prone to overextension on more than one occasion. Unlike its

cross-channel cousin, no industry body limits production of Scotch as one does for Cognac; the only regulation is capital and demand. By 1885, production had doubled over the past forty years and would double again by the turn of the century. Many fortunes were made, but a speculative bubble had formed and it burst spectacularly when Pattison, a leading blender, was found guilty of fraudulent practice. This caused a collapse of confidence and the Scottish banks withdrew the credit on which the Pattison edifice had been constructed. The industry fell in on itself, weighed down by inventories, and many distillers and blenders went out of business not because of reduced demand but on account of a lack of capital.

When Barnard’s book was published, there were 129 whisky distilleries licensed in Scotland, two more than when he embarked on his trip. He visited them all, although it must have felt at times like the painting of the Forth Road Bridge. Had the pre-eminent distillery bagger of the age attempted his task at the peak of the Victorian boom, he would have found it even more arduous, as over fifty would have been added to his itinerary.

A century later, the task for the aspiring Barnard was significantly easier. Transportation had advanced and the number of distilleries in Scotland had fallen below 100. Numbers are rising, reaching 105 last year and our research has identified another dozen in varying

stages of development. The same is true in the other regions Barnard visited.

Ireland did not benefit from the late Victorian whisky boom. Its crown as the leading whisky producing nation was usurped by the enterprising Scots in the 1830s owing to their proactive adoption and promotion of the blend. For too long the poor cousin, Irish whisky is enjoying a similar renaissance. Until recently, the number of working distilleries had dwindled to four, from almost 100 in 1830, and the 27 documented by Barnard. Led by Jameson, under the ownership of Pernod Ricard, Irish whisky is back in vogue, its triple distilled profile suiting the palette of the US drinker and its outsider status easing its acceptance onto the rider of many a demanding rock star. We have read of at least five new distilleries in planning in Ireland.

In England, which has a gin heritage, there are four distilleries producing and maturing the raw spirit for whisky. Two have been born out of brewers – Adnams in Suffolk and St Austell in Cornwall – another, The English Whisky Company, started by a Norfolk farmer; the county had been selling barley to the Scots for distillation. Even London has its own distillery and planning permission was recently granted for a malt distillery in the Lake District. Welsh whisky is back on today’s map, having not featured on Barnard’s, following the construction of a distillery at Penderyn in the Brecon Beacons in 2000.

Tomorrow the world


If production is the barometer of confidence, the outlook for the industry is as robust as it was when Barnard was writing. We share this confidence. Yes, the Scotch whisky industry is prone to bubbles but, as the late Victorian boom demonstrates, these can take decades to form and great fortunes can be amassed along the way.

Our investment thesis on Diageo distils the idea that demand for Scotch has entered a third golden age. There is a renaissance in broader whisky consumption in mature markets such as the United States, the United Kingdom and Japan. This provides a solid base to offset declines in other mature markets such as France and South Korea. More significant are the swelling ranks of middle-class consumers in developing markets who are starting to adopt Scotch. This broad-based demand was

evident in the newly renovated visitor centres on Islay, where exotic scripts and tongues educate a diverse mix of spirited students. Smart new hotels cater for large numbers of whisky tourists, attracting pilgrims from the old markets and converts from further afield.

Scotch has moved beyond its Scottishness. In many new markets it is drunk mixed in bars by younger consumers. It is a versatile drink bridging class and age, uniting connoisseur and clubber. Cognac is increasingly positioned as a luxury, whereas the blend has democratised Scotch, with the malt offering discernment.

India underwrites the industry’s confidence. Following its Imperial introduction, whisky is no longer the preserve of British officers, engineers and bureaucrats. Local whiskies have grown in scale and quality making India

the largest consumer of whiskies in the world. Scotch remains aspirational but affordability restricts its share. With rising household income and the potential for lower import tariffs, however, India is positioned to become the largest Scotch market the world has ever seen by 2030, exceeding the total consumed by Americans in 1975 or the Empire in 1899. Only then, when Scotch has become ubiquitous on the subcontinent and middle-class mores move on, will a bubble have fully formed. The greatest parallel between Barnard’s time and what we learnt on Islay is that the Third Golden Age for Scotch has many years to run, constrained by neither capital nor latent demand.

Chris Pitcher

Coal ComfortAmerica Sets the Power Price

Amidst the noise and resentment caused in Europe by American exports from Starbucks and Amazon to

Coca-Cola and McDonalds, little is heard about steam coal. Yet coal forms 75% of the power price, which directly reflects the production cost of coal-fired generation. Consequently, the outlook for European coal is critical, particularly in the context of the German power price, and so the earnings of German utilities, and it is directly influenced by imported American coal.

The crucial coal price is European seaborne steam (aka thermal). The majority of the steam coal imported into Europe arrives at three ports: Antwerp, Rotterdam and Amsterdam. The benchmark steam coal price is set by the internationally traded seaborne steam coal. The European steam coal price has been very weak over the last two years, the 2014 forward price having fallen by 35% since June 2011. This is supply-driven weakness, and particularly relates to US coal being exported to Europe. However, there is increasing evidence this supply-driven weakness may be abating.

The volume of global seaborne steam coal trade rose 20% between 2010 and 2012 and exports to Europe increased 25%. Those from the US to Europe increased 249%. Clearly, one need look little further for the reason behind the weakness in the German power price. The growth was primarily caused by the US shale gas revolution. Low gas prices as a result of shale gas made running gas-fired power plants economical relative to coal-fired generation. This, in combination with mild weather, inevitably resulted in a dramatic switch from coal- to gas-fired generation in the US in 2012. In turn, this caused a diversion of US (and Colombian) volumes to Europe as coal suppliers sought alternative markets to offset absentee US demand. In the process, the US switched from being a swing supplier to a marginal supplier to Europe.

However, there is evidence the cycle is turning. US domestic demand is picking up. This is because US coal-fired plants are regaining their lost share in electricity generation. In the first quarter, US coal-fired generation rose 13% QoQ and gas-fired generation was down 8%. Moreover, a US Energy Information


Administration (EIA) report in June forecast US coal-fired generation share would increase from c37% in 2012 to c40% in 2013. The EIA also stated it expects the spot gas price to average $3.9/mmbtu in 2013 and $4.0/mmbtu in 2013, after $2.8/mmbtu in 2012. Gas prices closer to $4.0/mmbtu mean coal-fired generation economics become more attractive relative to gas-fired generation. This increase in domestic coal consumption should reduce the supply available for exports. Indeed, the EIA expects US steam coal exports to decline 25% in 2013 from 2012.

American miners and utilities concur. Peabody recently stated that US coal generation should recover 75% of 2012’s lost demand. It also expects US steam coal exports to decline 2012-13, at a time global seaborne steam coal demand is expected to increase more than 6% on growing Asian demand. American Electric Power (US utility) and James River (US miner) made similar observations. Both noted the resurgence of coal-fired generation in the US electricity generation mix.

Coal production is also being cut. The continuous drop in coal prices has hit coal producers’ margins hard. Accordingly, production cuts in the US have occurred. Appalachian coal production has declined 7% YoY over the first 17 weeks of 2013.

At current low coal prices, there appears little benefit in exporting US coal to Europe. We calculate the netback premium (the margin a US coal exporter would make) has fallen substantially. Having been c$20/tonne in January 2012, it is now slightly negative. This should ease the volume of supplies being diverted from the US to Europe.

Another important consideration is the US gas price. Currently US gas prices are hovering around the $4/mmbtu mark and are roughly 50% higher than in Q1 2012. While part of this might relate to the cold weather, there are fundamental factors likely to provide support to current gas price levels. US gas production and storage volumes are declining according to EIA data published in May.

All the fundamentals therefore point to a tightening of US steam coal supply-demand dynamics. This should ease the supply-driven weakness in European steam coal prices. However, European steam coal prices continue to fall. The 2014 forward European coal price has fallen 14% since the start of the year. The issue, then, is whether this is merely a delayed reaction due to contracted volumes or if there is another factor at play.

Clearly the weakness in the European steam coal price is largely supply-driven. The primary constituent of the over-supply has been the excess supply from the US as gas has displaced coal in the generation sector. However, all the signs point to a recovery in the US steam coal fundamentals: demand is picking up as coal-fired generation gains share in US, and US (Appalachian) coal production is cut. The netback premium from exporting US steam coal to Europe is now negative. The iron laws of supply and demand, therefore, combine to suggest there will be a tightening of US coal fundamentals and a diminution of exports. Much as this may sail under the radar of those who protest against American cultural imperialism and economic hegemony, it is a precursor to an upturn in European steam coal prices.

Ahmed Farman

Steam borne

sailing under the radar of protests against American imperialism, it is a precursor to an upturn in European steam coal prices


Zebra CrossingImplications of the Driverless Car

Contrary to the old adage, there are three certainties in life:

death, taxes and motor insurance. Each year, 1.3 million people die on the world’s roads, whilst another 50 million are injured. In most developed countries, therefore, anyone owning a motor vehicle is required by law to have insurance. Allied to rising car ownership, this means motor insurance is the single largest type of non-life insurance within Europe, at 40% of premiums. This could be about to change.

Over time, neither car manufacturers nor governments have shirked their responsibility towards improving road safety. The manufacturers developed devices such as seatbelts and air bags and governments enforced their use.

Historically, technological limitations have kept the focus on improving car safety in the event of an accident, rather than accident prevention. Human error accounts for 75-90% of road traffic accidents, so anything pre-emptively assisting the avoidance of collisions has the potential to reduce accident frequency materially.

Today, technological advance is shifting the manufacturers’ focus. Many vehicles are equipped with rear sensors, adaptive cruise controls and autonomous emergency braking (AEB) systems, all of which are proving popular. AEB systems alone can reduce accidents by 27% and materially reduce injuries if an accident occurs. Meanwhile, the European Commission is vociferously supporting the introduction of eCall by 2015, a system which calls emergency services after an accident, giving the GPS location. This should reduce response time by 40% and 50% in urban and rural areas respectively.

Telematic devices that record and give feedback on journey details (speed, location, G-force, time of day) are increasingly prominent, particularly for new motorists. Following successful completion of the test, most drivers are simply abandoned to their inexperience – for example, motorway driving in the UK is prohibited until the test is passed, yet there is no mandatory instruction for motorway driving after the test. Young drivers (17-20 years old) are ten times more likely to be killed or injured than the average motorist, so improving their skills will have a material positive effect on accident frequency.

Perhaps the most pertinent point is Volvo’s mission statement: “Nobody will be killed or seriously injured in or by a new Volvo by 2020.” This is a bold statement and, regardless of whether one believes it or not, emphasises the extent of vehicle safety improvements expected over the coming decade.

Such advances do not stop at driver aids. Volvo is also involved in SARTRE (Safe Road Trains for the Environment), a project funded by the European Commission. This aims to allow a train of vehicles to drive in a convoy controlled by the lead vehicle, which will be operated by a professional driver. The cars in the convoy or ‘train’ will relinquish control of their vehicles to this driver. The goal is to improve safety, reduce emissions and costs and enable the erstwhile driver to undertake other activities whilst travelling. Successful road tests have involved a four-vehicle convoy travelling at speeds up to 90kph (56mph) with just four metres between each car. Little adaption to current manufacturer specification is required.

The vehicle developed by Google, which is attracting interest and

investment from other OEMs such as Audi and Mercedes, could offer even more profound change. Google has road-tested a vehicle which drives itself. Over 700,000km of automated travel has been recorded without incident. Google expects this technology to be ready within 3-5 years, though it will no doubt be longer before this vehicle, straight out of sci-fi, lands in the (salesman-less?) showroom. Nevertheless, it is reasonable to believe the fully automated vehicle will be available within the next decade, though the cost may mean a mass solution is not imminent.

Reaching 100mph


Such advances in road safety will reduce both the severity and frequency of accidents. It is an established trend. Road accidents have declined 4.2% pa on average over the last ten years in the UK, including 7.2% pa in the last five. The weak economy has helped, lowering the number of miles driven, but it is the advance in vehicle technology that will push continued reduction.

Aside from improved vehicle safety, diminishing car usage will reduce congestion and therefore accidents. In large urban areas (80% of England’s population is classified as urban) the carpool is becoming popular. ZipCar, now owned by Avis, is one of the larger schemes with over a million users worldwide. It claims each of its vehicles is responsible for taking twenty cars off the road. With self-driving vehicles eventually offering the option of the car automatically turning up at the member’s front door when bidden, carpool convenience is a considerable advantage for urban residents with limited parking who clock up minimal mileage.

The implications for the motor insurance industry in a lower or no-accident environment are profound. The initial reaction must be that this will be a boon for insurers as vehicles will become increasingly safe, meaning there will be fewer accidents and reduced injuries. Enhanced features such as in-car cameras (for reading road signs within the driverless car) also mean liability assessment will be more straightforward. Fraudulent claims (7% of total insurance costs in the UK in 2011, rising from 5% in 2010) will be less prevalent, as the on-board telematics

unit will log speed, location and G-force over a journey. In such a world, efficient, low-cost insurers will have the advantage as expenses become an increasingly larger proportion of total costs.

The insurance product may change. Telematics will open the door to a pay-as-you-go model under which insurance is purchased for a set number of miles with additional miles costing more – rather like minutes on a mobile phone.

Yet this may prove to be little more than fiddling while insurance burns. The real question is whether motor insurance will exist when self driving cars become a reality. The automated vehicle, by definition, will not be prone to human driving error and hence, in theory, accidents will reduce by 75-90%. Accidents will still occur through hardware/software malfunctions, pedestrian error and random events (the escaped zebra) though one can assume these will be negligible compared to the current accident rate. The likelihood that a driverless car begins to reduce the number of accidents seems inevitable.

Assuming accident frequency is reduced to negligible levels, this leaves only a small percentage of possible insurance needs for the typical motorist. According to Aviva, only 7% of claims are unrelated to road traffic accidents – theft (4%), windscreen (2%) and fire damage (1%). Moreover, as the future vehicle will be equipped with GPS and motion detection technology, it seems logical that theft of vehicles will continue its long decline to nonexistence.

In the world where cars drive themselves, there are further issues to consider. The obvious question for the

insurance industry is: which party is liable in the event of an accident – the passenger or the OEM? If we assume the technology is approved and driving laws are amended so the individual can devolve control of the vehicle to the on-board computer, it seems logical that liability resides with the OEM.

Does this mean a traditional motor insurance policy is no longer necessary? ‘Product liability’ policies for the OEM would appear more suitable. Rather than underwriting individual policies, insurers will be required to underwrite entire fleets of vehicles, meaning only the biggest will be able to provide adequate coverage and scale. Yet will traditional motor insurers want to offer a product liability policy that will give rise to claims no longer confined to a single incident but to defective classes of vehicles, which could result in significant product recalls and huge claims?

It is difficult to imagine a world – or even a street – in which cars drive themselves, and yet such an age is almost upon us. Advances in technology will materially improve the safety of vehicles over the next decade, meaning the consumer’s insurance needs will change dramatically. For the motor insurance companies it seems only the largest will survive or prosper in this new-look urban jungle.

David Bracewell

Reaching 100mph

will insurers offer product liability policies that give rise to claims no longer confined to an incident but to defective classes of vehicles?


Over the past several decades, shopping has become cheaper, easier and faster, and the trend is continuing.

However, if shoppers have never been better catered for, retailers are bearing the cost of these improvements. As a consequence, the high street is struggling. Town centre shop vacancy rates are above 10%. The status quo is untenable.

The most obvious benefit retailers have provided to consumers is access to a vast array of foodstuffs at ever cheaper prices. This is the result of grocers generating supply chain and operating efficiencies. The supermarket groups have passed on the gains to consumers rather than inflating profit margins – Tesco’s UK EBIT margin averaged 5.7% in the 1970s, 6.0% in the 2000s, and is 5.2% in its current fiscal year.

The savings made have partly funded the increase in household spending on leisure activities and discretionary items. The percentage of the UK household budget spent on Food & Drink has fallen by 1.5% over the last fifteen years, to just over 9% in 2011. By contrast, household spend on Recreation & Culture and Restaurants & Hotels in value terms has compounded at close to 4% pa over the same period.

Indeed, prices have become cheaper in virtually every Non-Food category. In clothing, outsourcing manufacturing – chiefly to Asia – enabled retailers to offer cheap, ‘fast’ fashion. Primark’s position as the UK clothing market leader by volume demonstrates the appeal. In general merchandise and electricals, the internet has allowed web-centric retailers to leverage lower fixed costs to undercut traditional store-based competitors and drive down prices in all commoditised products. The rise of Online has also ensured the range of products available has increased rapidly.

Shopping is not only getting cheaper, it is also becoming more convenient as retailers strive to differentiate through their home delivery options. One-hour slots are standard in Food and this will necessarily become the norm in Non-Food. Free next day delivery is also increasingly common. Indeed, one of the biggest changes we envisage in Non-Food Retail over the next few years is the rise of ‘near to home’ delivery. Business models such as Collect Plus, with myriad collection points for shoppers to pick up their purchases, will become more prevalent.

Online price and product comparisons have empowered consumers by providing 360-degree visibility and making it easier to shop around. Moreover, with peer reviews an important factor in many purchase decisions, the consumer’s voice, in praise or criticism, is increasingly shrill. The power of public perception is also evident in events such as the

Parliamentary Select Committee’s investigation into alleged shirkers of UK corporation tax. Starbucks’ commitment to pay an extra £20m in tax over the next two years was a direct response to public outcry and the risk of lost business, rather than political pressure.

It is not in doubt that shoppers have benefited. However, these benefits have not been cheap and the cost sits squarely upon the retailers. In short, the business of retailing has become considerably harder.

At the extreme, some businesses and models have proved unsustainable. Most have been stretched and profits margins are slimmer – not least because Amazon appears content to operate with a sub-1% EBIT margin in its markets outside North America. For virtually all, life is more complex. Issues ranging from how to incentivise staff fairly in a multi-channel world, to measuring the importance of product prominence on Google and offering functioning mobile and tablet apps, did not exist little over a decade ago.

This squeeze is bad news for the UK economy. Retail is the largest private employer in the UK. With businesses such as Comet, Jessops, HMV and Blockbuster falling victim to market forces, the thousands of redundancies undermine an employment-led recovery. Retail is also a major tax contributor, directly via business rates and indirectly via VAT.

What, then, is ‘the answer’ to these entangled social and economic problems? Firstly, retailers must help themselves. Amazon has led the way in customer analytics, but others are catching up. Through tracking online journeys – what consumers look at and for how long, what they don’t – retailers have access to greater knowledge about shopping habits than ever before. Acquiring shopper details via sign-ups or memberships also provides information about demographics and taste.

This enables retailers to identify more quickly and accurately what is working, be it product, pricing or one-off initiatives. It also allows them to target individual customers. This generates footfall and clickfall, and offers ancillary benefits, such as greater choice and flexibility over promotions, e.g. prioritising own label over branded products. In short, they can exert more influence over shoppers, which should, in time, offer another tranche of efficiencies.

It may not be a task retailers can complete alone. They will require aid from external stakeholders. Landlords will continue to share the pain via rent reductions in order to avoid larger problems in the future. The government also has a role to

Shop Till They DropThe Balance of Power in Retailing


Life’s Like ThatPatricia McCormick, 18 November 1929 – 26 March 2013

It is a rare woman who takes on the men at their own game; rarer still when the game is bullfighting.

The Missouri-born Patricia McCormick was inspired to be a matadora while watching a corrida in Mexico City, aged seven. She practiced in her bedroom, corralling neighbourhood children as bulls, blankets for capes. At Texas Western University, she crossed the border to watch fights in the Plaza de Toros in Juárez. In an era when Texan women were destined for the hearth, McCormick persuaded a retired matador, Alejandro del Hierro, to become her mentor. When she announced her ambition, her mother burst into tears and forbade her, but the tyro matadora was unmoved: “I had a manager, a sponsor, an impresario, and a contract for nine fights. That’s hard to beat.”

She took her bow in Juárez in 1951, fighting on foot rather than horseback. Trampled twice and caught by the bull’s horns, her performance was nevertheless well received. Joining the Matadors’ Union, and becoming the first – and finest – female professional, she fought in border cities with elegance and skill.

Fighting bulls, of course, is not straightforward. McCormick was gored in Mexico City and Tijuana. In Villa Acuna in 1954, horns pierced deep into her stomach and she was carried around the ring by the half-ton animal. A priest administered the last rites and commanded: “Carry her across the border and let her die in her own country.”

If many observers were stunned by her bravery – the bullfighting critic Rafael Solana described her as “the most courageous woman I’ve ever seen” – others were less generous: “I’m sorry the bull didn’t kill you”, one aficionado wrote, his attitude redolent of the sexism that disfigured the sport.

Despite her success and celebrity, and fighting 300 corridas, McCormick remained an outsider. Amongst other snubs, she was required to wear the severe traje corte rather than the ornate traje de luces of the male matador and was unable to rise above the rank of novillera (apprentice) as no matador would sponsor her. In an age of inequality, dancing with death is no match for the pettiness of life.

New deal

play. Corporation tax cuts have helped, but there is a strong case, proposed by the British Retail Consortium, that further business rate hikes should be sidelined. Of course, if retailers sidestep the business rate adjustment, households, as taxpayers, will become liable. There may be some rough justice in this, for shoppers owe something to the retailers who have served them so well.

There is another industry that subsidised its customers: Airlines. Like Retail, it was fragmented, with low barriers to entry, and competition meant cheap fares and cut-throat discounts were offered even as the oil price soared from $10 to a back-breaking $100 in a decade. Something had to give. In the end, a mixture of consolidation and capacity exit, cost cutting and remorseless discipline on routes and fares, has turned the industry around. It, of course, doesn’t have Amazon flying on every route. Nevertheless, the lesson is clear: if an industry or business is to prosper in the long term, it has to find a way of charging an economic rent for its services. After all, the one thing we know about human nature is the more it is offered, the more it takes.

Andrew Mobbs


Gangnam StyleThe Samsung Motive

A Korean friend observed that in her country one either became a doctor, an accountant or worked for Samsung.

Such is the power of this silent giant, the world’s largest supplier of TVs, smartphones, air-conditioners, memory chips and, soon, tablets and smart cameras, that it has become the ne plus ultra of the ‘Miracle on the Han River’. The stats are mesmerising: Samsung produces roughly one-fifth of South Korea’s total exports, its revenue is equivalent to 17% of GDP and, besides being one the largest IT companies in the world, it is also one of the dominant players in, inter alia, shipbuilding, heavy engineering, insurance, and advertising.

Although ‘Samsung Electronics’ has existed for more than eight decades, its brand is contemporary and powerful. It has maintained a leading position in consumer electronics and semiconductors despite ferocious competition from American innovators and Taiwanese low-cost manufacturers.

Samsung’s continued success, and its capacity for reinvention, is the subject of innumerable case studies and articles – and awe. Founded in 1938 as a grocery trader, it entered the tech industry in the 1960s as a consumer electronics manufacturer and graduated to manufacturing telecom switching equipment in the 1980s.

However, while its product range has diversified dramatically, its management style has remained constant. This is largely because Chairman Lee’s family continues to own more than 15% of the $180bn giant, a situation which has played its part in accusations of bribery, embezzlement, tax evasion and undue political influence. It has also fostered a culture of stringent top-down control.

Despite the potential for rigidity and hidebound thinking, Samsung has transformed. In the late 1980s it was primarily a low-cost manufacturer squeezed between even lower-cost Chinese competitors and premium European/American brands. So Chairman Lee, who famously opined you should “Change everything except your wife and kids,” shuffled his pack, introducing foreigners into the Seoul HQ and shipping rising stars abroad to gain international experience. Within a decade, Samsung was converted from a Korean budget name to a premium international player.

Next, the company perfected the art of being a ‘fast follower’, particularly in consumer electronics. Rather than risking new products, it ‘copied’ the latest designs, turning out lookalike products within weeks, thereby suffocating competitors’ first mover advantage and negating their R&D investment. It was

also brutal, culling unsuccessful products rapidly.This strategy enabled Samsung to gain share from Sony

and Sharp in the television and chips industries and from Nokia in mobile phones. Yet it, like everyone else, was wrong-footed when Apple introduced the iPhone. Fortunately, being perpetually in ‘crisis mode’ meant Samsung was first to release a competitive design. Adopting Google’s Android system, it even managed to become the largest mobile phone manufacturer by units in 2012.

The resulting lawsuit struck at the heart of Samsung’s ‘fast follower’ strategy. In August 2012, a US court fined it $1.05bn for infringing Apple’s smartphone technology patents – effectively characterising it as a cheap, knock-off manufacturer. Questions have been asked of its hierarchical decision-making process amidst accusations it stifles creativity. Compared to Apple’s brainstorming sessions, Samsung’s ‘innovation department’ appears riddled with cliché as it seeks to deliver ‘customer focus’ or ‘change the world’ and ‘create the future’. Steve Jobs believed that customers needed to be “taught what was cool”; Samsung researches ‘cool’.

The perpetual ‘crisis mode’ in which Samsung has been managed has served the company well but returns are diminishing. Chairman Lee admits most products and businesses that represent Samsung today will not exist in ten years’ time. Yet the group is being ‘innovative’ by introducing new products that are incrementally updated versions of previous ones. With smartphone prices falling and Samsung geared for scale and low cost, it may again win the numbers game in smartphones, at least until another innovator appears. In a world of increasingly tight and contested patents, being a fast follower of IP may not bring the same reward.

Nevertheless, Samsung is well positioned. It is dominant in the memory, chip and plasma screen industry, rendering it strategically better placed than Apple. Being the only vertically integrated company, it has the capacity to compete with any OEM. However, it must become more innovative, and improve its technology, strategy and management style, if it is ever to woo customers in true Gangnam style.

Sumant Wahi


If the 1980s are remembered by most people for Michael Jackson, Rubik’s

Cubes and rah-rah skirts, we technical analysts also recall the start of a long-term trend for which the psychological characteristics are fascinating.

Most investors treat new price highs with caution. Buying price lows, on the other hand, offers the comfort others have bought higher up. Technical analysts are sometimes faced with resistance as investors consider the risk appearing foolish often counts for more than their investment performance. In reality, the most profitable course is to follow the trend until the evidence demostrates it is over.

Buyers are outstripping sellers and will drive prices higher on account of their greater demand. Humans also tend to convince themselves assets are worth more if someone else is also buying them, while confirmation bias means we do not change our minds immediately if new information suggests we are mistaken. Thus trends tend to persist longer than we imagine and are often propelled by counterintuitive sectors.

There are five phases in an investment cycle or secular trend. In the transition between a downtrend and an uptrend, the initial bounce is deemed no more than another correction. The bears are still confident. This is followed by another down-move generally assumed to be a continuation of the downtrend, although there is less conviction. This culminates in a higher low as buyers return above the previous lows. Questions about a new trend emerge. Thirdly, as buyers start to build confidence, the rally exceeds the previous high. Given continued scepticism, this leg often offers steady improvement over a decent duration. It is invariably accompanied by increasing breadth as the bullish crowd expands. There is inevitably then a correction, although the ‘buy the dips’ mentality has become widespread. Finally, there is euphoria, excitement and mania culminating in great gains and finally in greater volatility and a reduction in breadth as fewer stocks participate and the foundations of the trend finally start to weaken.

ThrillerThe Decade that Paved the Way

Born in the Eighties

The 1980s exemplify these principles. The 1970s may have had spacehoppers and chopper bikes, Star Wars and the Sony Walkman, but they also offered a poisonous brew of rampant inflation, soaring interest rates, oil shocks, recession, political scandals, power cuts, three-day weeks, strikes and social unrest. The Japanese equity market emerged as a relative safe haven, the Japanese economy recovering and powering ahead of other regions.

There were shifts in power and trade owing to the strength of the Japanese economy. Its share of global GDP rose 70% and the Nikkei reached new peaks in 1978. It then rose in fourteen of the next sixteen years, becoming the world’s largest stock market – albeit the US remained the global superpower – until faltering in the 1990s amidst the Tech boom. Elsewhere, the 1980s started on a more bearish note with a severe global recession and debt crises in the developing world. Unemployment remained high but the US exited its recession early in the decade.

The 1980s became synonymous with financial markets. They were glamorised in a way not seen since the roaring Twenties. Yuppies were invented and greed was, if not good, at least permissible. Soon global equity markets were enjoying major gains and the S&P Composite reached an all-time high in August 1980 and the Dow in late 1982.

These all-time highs kickstarted a steady period of gains for global equity markets which ran – with minor hiccups such as the 1987 crash, albeit the S&P ended the year up 2% – through to the peak of the Tech boom on 24 March 2000. For us, though, this long rise should be seen as two distinct moves. The first was the slow, steady, reliable


grind higher that characterised the 1980s, the latter the frothy excitement of the late 1990s. Then, fewer stocks powered the gains, which was less consistent if no less tradable.

Though the US equity market underperformed other global markets in the 1980s, it nevertheless enjoyed consistent gains with only one ‘down’ year on the S&P before the end of the decade. This suggests there were new reasons continually appearing to propel prices higher. In short, the buyers remained in charge. In the context of today, for investors unwilling to buy the recent highs, the duration and reliability of these moves should offer genuine pause for thought. The US enjoyed gains of 266% from its breakout high until the end of that decade, and even adjusted for inflation (historically high, though not when compared to the 1970s), the average annual gain was 7.5%. Equities outperformed both bonds and gold over the period. Including the technology bubble, the average annual performance for the S&P was an impressive 14.8%. Meanwhile, European markets returned over 20% absolute gains per year on average over this period, performing consistently well.

Throughout the period, many long-term trends helped equities to be seen as an increasingly attractive asset class. Macro and sector themes pointed to a clear economic picture, a situation bound to arouse investor interest.

After the huge inflation of the 1970s, it is no surprise commodity-heavy markets were amongst the big losers in the following decade. Whilst there were absolute gains in all three of the gold-heavy equity markets of Australia, Canada and South Africa, individual stocks were more volatile, the gains of shorter duration and there was significant underperformance from oil stocks, given the rotation away from them in major markets. In the US, the market cap of the oil sector dropped from 17% of the market to 9%, and in the UK from 23.3% to 11.8%. The sector

the sector fell from 9% to sub-5% during the decade.

Regardless of 1980s fashions – the big hair, the chunky jackets – the decade’s place in history is secure as it culminated in the invention of the World Wide Web by Tim Berners Lee. This led directly to the Tech boom of the subsequent decade. Yet although the 1990s are perceived as the ‘technology decade’, the 1980s created the foundation on which technology could flourish, and is more significant from today’s economic and stock trend perspective. Bubbles and manias just grab the headlines.

One of investors’ primary fears is that markets cannot be propelled higher by the current leadership. Yet history’s lesson is that investable long-term economic trends are accompanied initially by short-term scepticism. The risk on/risk off trading of the last years is not a sign of investor confidence. Rather, as the 1980s demonstrate, it is better to see strong, consistent sector and asset allocation trends in order to maintain a clear, sustainable market trend.

Nicola Merrell

shrunk further in both markets during the next upswing.

Financials were a winner during the 1980s, with Japanese financial sectors increasing from 8.9% of the market by market cap to 15.8% in 1990. In the US, Banks and Financial Services doubled to 6% of the market – a significant moment in their global domination. The healthcare sectors also prospered during this period of equity market strength, growing from 12.8% of the US market to 18.3% by 1990, and in the UK from 13% to 16.3% by market cap. Surprisingly, investors seem unwilling to make the same bet now. Our position is that one should always follow clear trends of stocks and markets; there seem to be clear historical parallels too.

One sector that fell from favour during this period was global Autos. This offers counter-balancing evidence to investors who assume that simply because a sector has underperformed for a long time it is ‘due’ a trend reversal. In the US, Autos represented almost 5% of the market in 1982 before slipping to 3% by the end of the decade and 0.1% in 2008, after a brief moment in the sun in 1991/93. In Japan,

Fig 1: S&P composite today (yellow line) transposed and overlaid on the 1970s (circled)

Source: Bloomberg


to $8,000 when a big bet on Nortel went wrong. After the losses, he put his money into a tax-free savings account and high dividend stocks. He now owns an investment property in Queens and shares in Citigroup and Bank of America. His tip was that I should buy into advertising billboards as LED displays are seeing huge cost deflation, while the number of high-resolution ads they can show via LED has jumped with only modest price cuts per ad. Not bad, but he felt like the exception that proves the rule.

The bank teller at the Park Avenue branch of a big retail bank said he didn’t follow the market but 30-50% of the bank’s staff did trade stocks. They tend to act when financial advisors have something hot. I asked him what was ‘hot’ at the moment. He answered the property market, because rates were so low.

If hardly a material survey, I was nevertheless surprised by the lack of interest in the stock market expressed by those I asked. Neither the market rally nor ‘The Great Gatsby’ showing in Manhattan theatres has ignited 1928-style excitement. The wounds of the financial crisis were livid and they are taking time to heal. If he was alive, Joe Kennedy would still be buying.

Rowan Joseph

Letter from America1928 and All That

White flag

It is the stuff of legend. In 1928, at the peak of the bull market, the investment banker John Pierpont Morgan

sold his entire stock portfolio after the boy who shined his shoes started giving him market tips. In fact, the legend is just that: a legend. Morgan died in 1913. It seems the real life ‘J.P. Morgan’ was Joe Kennedy, the father of JFK. In late 1928, he stopped to have his shoes shined on his way to work. To his surprise, he received a stock tip from his shoeshine boy. Kennedy sold everything, claiming: “You know it’s time to sell when shoeshine boys give you stock tips. This bull market is over.”

Given, at the time of writing, the vertiginous rise in the market this year, and increasing rumblings about a bubble, I decided to put the old bootlegger’s theory to the test. Heaping together every pair of shoes I own, I set off to the shoeshiners in Grand Central Station. However, after five pairs of shoes there had been no stock tips. Both the boot polishers and their money-handling agents told me they did not care for the stock market. On my sixth, rather tatty-looking pair, I found a shoeshine girl who used to own stocks in the Dominican Republic. She sold them during the 2009 financial crisis.

I decided to try the NYPD. Surely New York’s finest would have some stock tips? A cop in Grand Central told me he had no interest in the market. However, he did offer the information that “a lot of the guys on the force day-trade on their iPhones” (and crime is going down?). I pressed him further: “The stock market used to be a big thing for many of us before Lehman went… now less of the guys are involved.” I approached another police officer, but the response was far from welcoming. I moved on rapidly, as advised.

The bellhops at one of the finest hotels in Midtown told me they couldn’t care less about the stock market. I asked if they ever asked for tips from the investment bankers across the street. They responded: “No, but you would think we would.”

I tried the night doorman of a major office building on 5th Avenue. It turned out he had been a financial advisor for ten years and follows the market when he has time (which is presumably all night). Apparently, chasing new clients and drumming up business became too difficult after the financial crisis. He left the industry in 2010 and enjoys the less demanding work environment on the nightshift. He asked me if I had any leads for a job in the market...

Still without any solid stock tips, I turned to the taxi drivers. Most had no interest. Finally, I found a driver who actively follows markets. In 1999, his $30,000 of savings collapsed


Scaling the CliffMaking Sense of Big Pharma

In life, as in the stock market, things often turn out better than they seem

at the time. Van Gogh may not have been able to give his work away while he was alive, but perceptions changed, values changed, comprehension changed and – indisputably – prices changed. Similarly, Glam Rock in the early 1970s may have specialised in men no longer of a tender age shoehorned into unwise trousers and stack heels (Mott the Hoople were once described as “hod-carriers in drag”), but it also gave the world David Bowie, indisputably one of the great artists of any era.

Such shifts in sentiment work both ways. In 2000, the Pharma sector was fêted for its ‘defensive growth’ and traded on a 30x multiple. This implied rapid growth would continue in perpetuity, which was not inconceivable at the time given the double-digit rate of sales expansion in the 1990s (although clearly one should question any assumption an already-large segment of the economy could grow above inflation for ever).

The market had got ahead of itself. It is not easy to pinpoint the moment it all went wrong. Certainly concerns were raised over R&D productivity a decade ago, when the FDA seemed paralysed by its lack of a commissioner, but the appointment of Mark McLennan in 2002 seemed to unblock the regulator. It was not until later in the decade that the dearth of pipeline drugs began to be viewed as a real structural problem. Equally, generic companies became more aggressive, with erosion post-expiration becoming more rapid and early challenges to spurious patents. The loss of legacy products for companies such as GlaxoSmithKline in 2002-04 therefore was not viewed as a harbinger of the period now known as the ‘patent cliff ’.

It was only as we approached 2007 that the peak expiration year of 2012 began to fall into analysts’ forecast horizons, which are typically 5-6 years forward. R&D had failed to deliver over the previous few years and it became clear that new launches would be unable to mitigate declining sales. This forced investors to consider the prospect of contracting top lines and lower profitability, as big generic losses would eat into sales without there necessarily being a similar quantum of costs to cut. Thus the concept of the ‘cliff ’ was born and the sector’s P/E multiple dropped off one too, eventually, amidst maximum bearishness, reaching a low of 9x in Europe and 8x in the US.

Inevitably, management teams and strategies began to evolve. In part, the companies tried to do what they were already doing better. They began to variabilise and trim the cost base, to maximise cash returns and prepare for possible sales declines. They realised R&D expenditure was better targeted at areas of medicine with high unmet medical need and where scientific advances mean risk should be commensurately lower.

An ever-decreasing exposure to ‘white pills in developed markets’ has also improved the outlook. Although US blockbusters are the most profitable drugs, they are also the shortest-duration assets owing to the efficient and competitive generic market. They remain attractive on account of their high margins and because they sell in other geographies, but essentially they are relatively low P/E income streams given their lack of longevity. Contrast the lower margin but longer-lived assets pharma companies have

been inexorably pursuing over the last five years: vaccines, consumer health, generics themselves, emerging markets businesses, eye-care and biologics. Longer life equates to a premium multiple, despite (for the most part) being less profitable than pills. The sector thus began to undergo a painful strategic shift towards the end of the last decade.

At the P/E low, the stocks were demonstrably cheap, in some cases trading at levels justifiable on a DCF as ten years’ cashflow alone, without any terminal value. This coincided with the onset of the financial crisis. Thus, just as investors were casting around for reasonable-value defensive sectors, pharma fitted the bill.

Some element of multiple expansion was warranted. Many companies have moved through nearer-term cliffs and have greater visibility over less lumpy growth in the coming years. Thus, as their earnings mix has moved from soon-to-expire lower-P/E products towards longer-duration assets, there has naturally been an upward rerating. In addition, the industry’s self-improvement clearly justifies valuations above the ‘failure scenario’ levels of 2008/09. A couple of high-profile R&D successes have also helped.

We were thus gratified to see the sector move upwards, although this made it hard to find good, cheap valuation stories. By late 2012, pharma stocks had closed the valuation gap with our DCF models and were in line with our fair values. We wrote at the time: “We find it hard to justify a move into the mid-teens P/E region given growth rates have not moved sustainably higher and sector-specific risks have not receded.”

Since January, though, the sector is up a further 14%, making the STOXX 600


Health Care Index the best performing group in the broader European market (and this is after a sizeable pull-back in May). This performance was not driven by earnings upgrades – it was a further rerating, which propelled the stocks above 15x P/E at the peak. How, then, could we explain this further appreciation? And why were we not delighted at the market’s increasing infatuation with our sector?

Our gut feeling was it has been macroeconomic factors that make pharma look attractive. Investors perceive it to be defensive and, with uncertainty abounding over global growth, this renders it relatively desirable – albeit since indebted governments are the majority purchasers of drugs, this may not be quite as true as people believe. Furthermore, investors seemed to be positioning themselves for a protracted low interest rate environment, making equities desirable – particularly those with relatively high, well covered yields. Pharma ticks these boxes, particularly in light of the excellent performance of some FMCG stocks, which moved to high-teens multiples.

Rather than pre-judge why the market had fallen even further in love with pharma, we decided to gather empirical evidence of investors’ opinions. This was important in order to understand whether the move in the stocks was down to a perception of genuine improvement in their businesses or whether things might unwind in light of the somewhat stretched valuations if macroeconomic conditions turned against them. Have we reverted to a time when things will turn out to be worse than they appear?

Three, somewhat contradictory, answers stand out. Firstly, investors are focused on absolute valuation using ‘traditional’ metrics, which suggests they should view the world in a similar light to us. Secondly, they believe stocks are overvalued, by around 20% at the time of the survey (mid-May). Finally, paradoxically, despite its run the sector is still perceived as offering ‘value’.

How to resolve this dissonance? Market relative arguments seem to be the way. The ‘value’ thesis was more associated with generalists than sector specialists, and they are more likely to view pharma stocks in the context of a market in which Personal and Household Goods are trading on over 20x and Food and Beverages on 19x. Suddenly, maybe, pharma is a bastion of value – if qualified by the word ‘relative’.

Can pharma continue to appreciate from here? The answer should be: not without earnings upgrades or material R&D successes. It is hard to see why ratings would rise further without real improvements in underlying business performance. The rerating from 9x to 13-14x reflected the sector being unreasonably cheap and finally closing a valuation gap. However, we have been unnerved by the sector’s inexorable rise this year, when valuations required a meaningful rebasing of assumptions or, as occurred, a weakening of share prices.

Better than it seemed

Pharma is not like consumer goods. The re-invention imperative exists. Regulators can withdraw or not approve products, governments can cut prices or control utilisation and consumers can win large legal settlements from companies. Although things have improved over the last few years and the sector remains highly cash generative, a high-teens multiple remains hard to justify. Whilst macroeconomics and a lack of alternatives have kept the sector buoyant, investors should be cognisant of the reasons behind the good performance and be aware that things will not always be as good as they seem.

Andrew Kocen


IDEAS inhabits a simple world in which equity returns for investors have three interlocking drivers, acting in any

combination or all together: (1) operating growth (growth in market and/or market share, technology advantage, tapping social and demographic developments etc, reflected in growth in revenues, earnings, cash flow and assets); (2) changes in valuation (reflecting changing expectations for growth forecasts); and (3) new information (leading to the revisions to consensus forecasts that, in turn, affect valuations). A company with strong, undervalued growth potential and with better-than-average news flow and revisions is what all investors are looking for.

Sadly, the market is generally too efficient to leave many lying around for long. However, one of the market’s characteristics is gradualism and persistence – analysts do not raise forecasts sufficiently rapidly on earnings for successful companies or cut them sufficiently aggressively on less successful ones. Rather, the moves in both forecasts and prices tend to be incremental, over extended periods, sometimes years, as companies grow and surprise steadily, and as their valuations keep up with, or move ahead of, events. In this world, investors are rewarded for their ability to spot the growth drivers and opportunities, to analyse whether or not they are fully discounted, and to keep on the right side of new information.

One observable result is how the direction of equity markets over time tends to correlate with the direction of change of revisions: it is hard for share prices to rerate persistently into falling expectations unless something else counters that fact – prospective M&A activity, for instance, as in 1998-2000, or, more topically, extreme monetary conditions in the absence of economic growth. More normally, the momentum of operations tends to reinforce that of expectations, resulting, through increasing cognitive bias, in a ‘feedback loop’ with the market.

As with other aspects of capitalism, the emergence of such cognitive bias means this simple world can get out of control. In the wake of the war of the Spanish succession, an investment mania followed the formation of a London company granted exclusive but meaningless trade rights with the Spanish Americas, known to history as the South Sea Bubble, peaking in 1720. Disbelief was suspended in an environment where making money appeared a one-way bet. One company floated had as its objective the manufacture of cube-shaped cannon balls. Another was, notoriously, formed “For carrying out an undertaking of great advantage, but nobody to know what it is” (it still raised £2,000, over $300,000

Eventually“Feral Hogs” and Equities

in current terms). Expectations for rewards from the fusion of electronic technology with telecommunications services and media content in the late 1990s arose in much the same spirit, speculation over the benefits of input multipliers resulting in excessive market valuations. A few years later, Chuck Prince of Citigroup, with many others, went dancing.

Whether such episodes are the result of greed, delusion, incompetence or miscalculation, they upset the static and dynamic relationships on which IDEAS is based. Yet markets have always, in due course, returned to a state where they reflect the longer-term relationships that exist between operating fundamentals, price-setting and new information over time – as long as economic growth continues or resumes. In late 2008, following the failure of Lehman Brothers, low equity prices for non-financial companies discounted a halving of their ROCE into perpetuity, an overly negative response to that crisis, addressed by liquidity infusions of various types. The resulting 2009 market rally restored a more realistic scenario that again priced the growth in operating returns and assets that tend to justify equity investment expectations.

However, in Europe, even as this happened, the accompanying recession and hole in many government finances exposed the relationship between euro zone government debt and commercial banks; highlighted the structural fragility of the euro project, requiring greater monetary intervention, political assurances and German-led loans to bail out weaker members; and, in turn, upset the acquis established over half a century in the European Union – the relationship between institutions, and the pecking order of countries. The conditions attached to intervention have given rise to popular (and populist) antipathy and concerns over democratic accountability. With measures such as a move towards a banking union moving at glacial speed, these issues remain largely unresolved in practical terms, with only, ultimately, repeated assertions of political will and assurances of ‘funny money’ sustaining the Euro-edifice. Hardly the ‘normal’ we are looking for.

Given this, and the weak growth and structural uncertainty, it is still easy to be a bear. Earnings forecasts remain cut. Continuing recession in much of Europe clouds earnings trends just as forecasts for China are lowered. The advance in equities over the last twelve months suggests investor surrender, in Europe, to liquidity rather than any conviction over recovery prospects, making the market’s advance perhaps the most miserable rally in history. Even in the US, the developed world’s growth engine, 2013 GDP will be barely 2% above 2012, just


about sufficient to maintain employment levels. Perhaps, as the Irish travel advice has it, the advance by equities reflects where they started rather than where they are going. Even after rising over 25% in a year in Europe, ROCE-based valuations still discount no more than a continuation of ROCE achieved in 2012 into perpetuity, bond-like, with annual asset growth of barely 1%. Miserable, indeed.

However, it was clear even in 2008 that recovery would be different from those following the oil shocks of 1973 and 1981, from the recession of the early 1990s or that following the TMT boom. Monetary policy and dismal growth have altered perspectives on equities towards income and away from capital gain. While it is impossible to fit what is happening exactly to any previous template, 1993 is often looked at to provide some parallels, especially on the lack of growth visibility. In Europe, three years of slow growth had resulted in cuts to forecasts and high unemployment. Interest rates had been cut, notably in the UK following sterling’s 1992 expulsion from the ERM. European equities rose by 39% in 1993 – the ‘joyless recovery’ – while forecasts continued to be cut. The relationship between equities, EPS forecasts and ten-year bond yields is in Figs 1-4.

Growth did not resume and revisions did not begin to recover until late 1994, by which time bond yields had already begun to rise in anticipation. The Fed raised rates at the end of the previous January, doubling US bond yields and setting the equity market rally back for a year. The US ten-year bond yield has already breached key technical levels, raising questions over what could happen this time round. The prospect of tapering – let alone an end to – QE is regarded with fear in the short term; but to fear the resumption of growth is incoherent, from an equity perspective, when equities exist in order to enable investors explicitly to leverage themselves to that growth. More than that, equity markets do not currently price in any growth: the potential for further revaluation into an environment where growth appears set to bottom out remains very high indeed – as long as faith in capitalism remains intact, and we have a sense of what might be meant by ‘eventually’.

Robert Kerr

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Fig 2: 1993-95 – ten-year bond yields

Source: www.redburn.com/ideas

Fig 4: 2011-13 – ten-year bond yields

Fig 1: 1993-95 – STOXX 600 and Forecast EPS Index Fig 3: 2011-13 – STOXX 600 and Forecast EPS Index

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Volcker: The Triumph of Persistence William L. Silber

The establishment of price stability worldwide has been one of the

defining macroeconomic events of the past thirty years. In the 1970s, The Great Inflation threatened the economic and social fabric of the world’s major economies. The transition to low inflation has promoted stability, generated a multi-decade bull market in bonds and contributed to equity market returns. Quiescent inflation is well established and hysterical talk of hyperinflation generated by record fiscal deficits and QE in countries such as the US has come to nought.

This is not an achievement that should be taken for granted. In the 1970s and 1980s, the ‘misery index’ – the sum of the unemployment and inflation rates – elevated unpleasantly from the supine levels of the 1950s and 1960s. Reducing inflation was a protracted struggle, one many financial market participants considered unwinnable. It wasn’t until the mid-1990s that, after many years of successive positive surprises, the belief low inflation was here to stay took root. The man responsible for this victory was Paul Volcker, Chairman of the US Federal Reserve for two terms from 1979 to 1987.

Since 1913, the Fed has been charged with ensuring financial stability in the US, in response, in large part, to the shortcomings exposed by the 1907 financial crisis. However, it has itself been guilty of egregious policy errors: the US banking system was allowed to fail in the early 1930s; the Great Inflation was allowed to gain traction in the late 1960s and early 1970s; the US housing boom of the late 1990s was allowed to escalate out of control, with the subsequent bust felling the

overall economy. On balance, though, the US Fed has acted as a powerful force promoting the general welfare of the economy, never more strongly than when Volcker was Chairman. Paul Volcker has enjoyed an extraordinarily lengthy career in policy-making and in the public eye. From August 1971, when he played a critical role in the Nixon administration’s decision to sever the greenback’s link with gold, thereby creating a truly fiat currency, until recently, when he was the author of the Obama administration’s ‘Volcker rule’, which sought to ban proprietary trading by investment banks, he has stood tall – and he is six feet seven inches in his socks – at the centre of every economic storm. While bearing down on anything is obviously easier from such a great height, slaying the US inflation dragon against considerable odds remains his signal achievement.

When Paul Volcker was appointed to run the Fed, double-digit consumer price inflation was entrenched. Despite widespread scepticism, he introduced a restrictive inflation-fighting monetary stance and stuck to it as the economy shrank during the 1980 and 1981-82 recessions. US unemployment rose to post-war highs and the newly elected Ronald Reagan introduced a large-scale tax cut in 1981, thereby establishing the US government deficit on an upward trajectory and leaving the Herculean task of disinflation wholly to the Volcker Fed. Despite misgivings about the hard-nosed approach to inflation, Reagan saw no option but to reappoint the Fed chairman for a second term in 1983.

‘Volcker: The Triumph of Persistence’ relates Volcker’s achievements and constitutes a compelling narrative. It is, in effect, the official biography,

Silber having enjoyed the cooperation of the subject and access to his private papers. If there is a flaw, it is that it inclines to the hagiographic and would have benefited from a steelier, more objective gaze. Nevertheless, ‘Volcker: The Triumph of Persistence’ covers a fascinating period of US economic and financial history without knowledge of which nobody can properly understand the challenges of the present. This book demonstrates, moreover, how much difference one principled and determined person – an economist at that – can make.

Ian Harwood

RecommendationsBuy: Redburn argues that the stock price will rise by at least 15% over one year. For high beta stocks the hurdle rate may be commensurately higher.Sell: Redburn argues that the stock price will be lower in 12 months than it is today.Neutral: Redburn currently has no strong opinion on the likely movement of this stock price.

Regulatory DisclosureThis report has been issued by Redburn Partners LLP (‘Redburn’), authorised and regulated by the Financial Conduct Authority and is intended for use by professional and business investors only. It is solely for the information of the addressee only and is not an offer, or solicitation of an offer, to sell, or buy, any securities or any derivative instruments or any other rights pertaining thereto. The information in this report has been compiled from sources believed to be reliable but neither Redburn, nor any of its partners, officers or employees makes any representations as to its accuracy or completeness. Any opinions, forecasts or estimates herein constitute a judgement, as at the date of this report, that is subject to change without notice. This report does not have regard to the specific instrument objectives, financial situation and the particular needs of any specific person who may receive this report. Redburn may have disseminated information contained in this report prior to its publication.

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Redburn Partners LLP, and its research analysts, are not members of the Financial Industry Regulatory Authority and are not subject to the FINRA Rules on Research Analysts and Research Reports and the attendant restrictions and required disclosures required by that rule. Redburn Partners LLP is a correspondent of Redburn Partners (USA) LP. All U.S. persons receiving this report and wishing to buy or sell the securities discussed herein should do so through a representative of Redburn Partners (USA) LP. Redburn Partners (USA) LP and its affiliates: do not own any class of equity securities issued by any of the companies discussed in this report; have not received, and do not intend to receive, any investment banking compensation from any of the issuers discussed in this report; and, have not acted as manager, or co-manager, of any public offering of securities issued by any of the companies discussed in this report. Neither Redburn Partners (USA) LP, nor any of its officers, own options, rights or warrants to purchase any of the securities of the issuers whose securities are discussed in this report. Neither Redburn Partners LLP, nor Redburn Partners (USA) LP, make a market in any securities, and do not stand ready to buy from or sell to any customers, as principal, any of the securities discussed in this report.

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