4th Quarter 2018

January 15, 2019

Dear Client:

In the past quarterly letter, we spent some time analyzing the current macro environment. What we haven’t shared with you is where we think future opportunities are. With the recent market turmoil, you might wonder why we remain optimistic. As we have stated in the past, market volatility is our friend, not our foe. When we consider investment to be the ownership of good businesses, we use short-term market swings to reposition our portfolios, to participate in long-term opportunities, or to benefit from discrepancies between price and value. If all this sounds familiar, our past letters have been effective.

In the long run, the direction of the market should follow the same direction of the economy, which goes through normal cycles. Ideally, if we can craft our portfolios with perfect timing within the cycles, we would realize maximum returns. However, even the most renowned economists and simulation models cannot correctly predict the cycles most of the time. Our job should not be to identify the impossible-to-determine market bottom and peak, but to discover long-term trends, find good management teams, use discipline, and take advantage of market volatility. While we may not be immune to the market cyclicity, we are better prepared during uncertain times if we follow these approaches in building your portfolios.

Most uncertainties presented in front of us are short-term in nature and have insignificant long-term consequences. News outlets and market timers already spend a great deal of time discussing them; most are just noise that triggers anxiety.

We will now address some of these short-term issues, and then discuss some of the long-term favorable opportunities we can benefit from.


Short-term risks

Trade Dispute

Short-term risks are frequently associated with unexpected events. Apart from natural disasters such as the Japanese earthquake in 2011, unexpected events are mostly associated with government actions. The biggest unexpected event in 2018 was the trade negotiations between U.S. and China. Trade only happens when both the supply and the demand sides come to an agreement. “Fairness” is a subjective qualifier that evolves, which is why trade agreements must be revisited over time.

While markets reacted negatively to the trade headlines, there remain long-term opportunities with the shift of global supply chains. Without strong exports, China will be forced to accelerate the process of becoming a service-oriented economy, which provides great opportunities for the world’s best consumer names since China’s consumer base is four times the size of the United States. The highest expected incremental growth in consumption for the next 15 years will come from China and is larger than the U.S. and Western Europe combined.

Chart 1 – China’s Incremental Growth in Consumption, $ trillion

Source: Oxford Economics, McKinsey Global Institute Analysis

On purchase power parity measurement, China is already the largest economy in the world. This change of focus will force the Chinese government to invest more in healthcare, education, social welfare, and clean energy. In the meantime, if some of the manufacturing jobs can be moved back to the U.S., more domestic skilled workers will be trained and employed. Thus, more physical investment must be made to build manufacturing capacity, and the growth of productivity in the U.S. can be accelerated again.

Higher Interest Rate

Another factor that impacted the markets in the 4th quarter is interest rates. A sudden jump of 0.2% in the ten-year treasury yield triggered a couple of selloffs in October. We think the risk of increased borrowing cost mostly falls on the public sector. Together with the tax cut act in 2018, the higher rate increased the U.S. federal government’s interest payment and hindered its ability to build infrastructure and fulfill entitlement. As for the private sector, the overall leverage level has risen during the past decade; however, the ability to pay down debt is also higher. A big part of this borrowing was settled at historically low rates, and most companies can generate higher returns than the cost of capital.

Artificially low interest rates inflated asset prices and enabled unattractive projects to be disguised as investible ideas. Low interest rates also punish saving behavior and encourage unnecessary borrowing which helped lead to the Great Recession of 2008. A normalized interest rate is better for the economy and markets in the long run because it forces investors to demand reasonable returns and put pressure on managers to perform effectively and efficiently.

Changes in relative attractiveness of equities

Some equity investors worry that stocks are no longer attractive compared to fixed income since interest rates are higher now. As we have discussed in the past, the gap of returns between fixed income and equity has narrowed. The price decline in the stock market during the past quarter reversed this trend and equity remains more attractive (see Chart 2).

Chart 2 – S&P 500 Forward Earnings Yield – 10-year Treasury Yield (nominal)

Source: Bloomberg

Another cause of worry is the actions taken by investors to remove the excess equity allocation after a long bull run in the markets. With the past months’ correction in the market, the question that should be asked is how many of these reallocations to fixed income are triggered by fear rather than by rebalancing.

There is some worry that the tax cut this year has predicated a slowdown in earnings for 2019, since the benefit from tax saving in 2018 will not repeat in 2019. However, the impact of lower tax rates will continue to show on increasing capital expenditure, dividends, and share buybacks. All three are important to equity performance in the coming years.


Long term Opportunities

Economic growth is fueled by three main factors: working-age population growth, capital stock growth, and productivity improvement. For advanced economies, working-age population and capital stock growth are hard to come by due to maturing societies. However, the disappointing productivity growth could see a revival based on the themes we are seeing (see Chart 3).

Chart 3 – U.S. Productivity Growth Rate – 5-Year Moving Average

Source: U.S. Bureau of Labor Statistics, The Federal Reserve

Artificial Intelligence (AI) and Deep Learning (DL)

One of the key factors for productivity growth is technology advancement. We believe AI and DL will dominate the stage of technology for the next decade. The development in AI has increased dramatically in recent years, and applications of AI have started to show in our daily lives. Previously owned by universities or research labs and only understood by computer scientists, AI is now available for trained programmers to put into practical use. Helped by the increased computational power of graphics chips, AI technologies can enrich and assist real-time applications, such as autonomous driving and facial recognition.

Chart 4 – AI Adoption

Source: McKinsey Global Institute AI adoption and use survey; McKinsey Global Institute analysis

Chart 4 shows the demand trajectory of all end sectors. With the highest adoption rate currently at 32%, there is enormous potential for upside adoption of AI technology. The key ingredient of an AI application is the content or data being analyzed to produce an outcome. In this regard, whoever owns the data has the most assets in the future. If these entities also have a strong team of application developers, they will dominate the food chain of the AI industry. Most readers probably have a few names in mind about who these entities are in the private sector, but governments usually own the most data of every citizen.

Deep Learning is the advanced version of AI because the knowledge used in the application is no longer externally provided. The program itself generates the knowledge to solve issues. The program is the programmer.

Who will benefit from this new technology? How do we invest in this future? Content and data owners are a good starting point. Keep in mind the select few providers of infrastructure and key components which enable the speedy computation of immense data. There will be a new group of companies that utilize AI and their data to replace and create brand new services and business models. Investing in the software sector is a solid foundation for that future as well.

Ecommerce and subscription models

Around college campuses in the U.S. and China, students are using less cash than their predecessors. They rarely use cash for meals, laundry, or recreational activities. There are lockers on campus where students can order goods to be sent to without the need to visit physical stores. In China, Tencent’s WeChat Pay accounts can be used on and off campus and pay for food at street stands. The younger generation is well versed with ecommerce and epayment and it is hard to imagine that they would return to check writing and store shopping after graduation.

According to eMarketer, an online data research institute, worldwide ecommerce grew 24.8% from 2016 to 2017 and made up 10.2% of the total retail sales. The growth in shares is largely influenced by Asia Pacific where 14.6% of overall retail spend went toward ecommerce. Sales conducted on mobile devices, mcommerce, grew higher at a rate of 40.3%. China alone made up 67.1% of mcommerce sales worldwide in 2017, driven by its mobile-first internet audience.

The young generation also enjoys the freedom of choice at much lower upfront cost of subscription offerings. Music, movie, television, software, and cloud services can be purchased on-demand. In this set up, companies cannot rely on lock-in contracts without continuous improvement because the cancellation button is just one click away. Instead, consistent updates keep products relevant and competitive. As one CEO in the software industry said, “Retention is the new growth.”

Our long-term holding, Disney, has officially announced an on-demand subscription of its movie library and a separate streaming service for its sports program (ESPN). As one of the best content creators in the world, the subscription model brings its customers closer to its products. Clients can ultimately decide where and when to consume the content.

Emerging middle-class and Womenomics in Asia

There is no denying that the emerging middle-class around the world is the most exciting growth story in the twenty-first century. Especially for those in the Asia Pacific region, the total spending is expected to grow from $4.9 trillion USD in 2009 to $32.0 trillion in 2030.

The biggest emerging middle-class is in China. Due to its unique government structure, China’s growth strategy is well documented and long-term based. However, the Chinese version of socialism, which inevitably incorporated some capitalism, has not been replicated outside of China. The Western world will always scratch their heads on how China can maintain economic growth for decades without much democracy.

Nevertheless, people always want to live a better life and the power of such drive should not be ignored. Chinese people’s desire to travel and to consume quality products and services have forced international companies to form a separate China strategy. Established global brands and quality domestic consumer companies are the key beneficiary of this trend. In our portfolios, we use cruise lines, global sports brands, and domestic market leaders to participate in this theme.

Another structural change is the growing number of working women in Japan. Women participation in the labor force has risen to a level similar to other developed countries. However, a big percentage of them are part-time workers. The Japanese government has set specific targets and implemented policies to encourage women to work longer hours. For example, they boosted the number of childcare facilities with the aim of eliminating daycare waitlists for children. The impact of such policies deserves attention because they could create new demand of consumer goods and services. According to Goldman Sachs’ estimates, closing the gender employment gap could boost Japan’s GDP by nearly 13%. In Germany, similar initiatives are taking place to increase women’s participation rate as full-time workers.

In our fourth quarter 2015 letter, we mentioned Womenomics happening in China and in Asia, which described how women have become the main consumption source and begun to dominate the purse string. Our investment ideas in this theme are focusing on consumer goods and services for which women are the main decision makers.


Demographic trends in developed countries support the secular demand for healthcare. The United Nations forecasts for developed regions (Europe, North America, Australia/New Zealand, and Japan) that the combined age cohorts of 65-74 and above 75 will grow around 21% over the next decade to 286 million people (see chart 5).

Chart 5 – Population Forecast for Developed Countries (millions)           

               Source: United Nations, Department of Economic and Social Affairs, Population Division (2017)


Chart 6 – Population Forecast for China (millions)

Source: United Nations, Department of Economic and Social Affairs, Population Division (2017)


In about five years, China’s demographic trends nearly mirror those of the developed countries (see charts 5 and 6). The combined age groups of 65-74 and above 75 are expected to grow by over 40% to 227 million people in the next decade. The Chinese government will be forced to spend more for healthcare and might open its domestic market further to Western and Japanese companies, thereby offering an attractive long-term growth opportunity.

Chart 7 – Healthcare Share of Household Expenditures

Source: U.S Bureau of Labor Statistics, 2016

As baby boomers around the world (currently between 55 to 73 years old) continue to age, a higher share of their spending will go towards healthcare expenditures. Data for the USA shows that up to 15% of household expenditure is currently dedicated for healthcare (see chart 7). The desire to maintain an active lifestyle is an understandable drive for their willingness to spend. In developed countries with a universal healthcare system this demographic might vote for better healthcare as their numbers and thus their political power grows. We participate in this trend through several companies in the medical device, pharmaceutical, and biotechnology industries and consider it an investment in longevity.

Future Energy

The world of energy based on fossil fuels is full of uncertainty due to key producers’ geopolitical situations as well as global warming and environmental issues. We must investigate alternatives. There is a new theme relevant to this discussion; how do we store energy generated from alternative sources safely and properly, so they can be used whenever needed? Battery storage is a mature and obvious solution. They enable the electric vehicle and mobile phone industries to function. Improving on battery technology enables people to travel far without refueling and to conduct uninterrupted connection to information on mobile devices. The technology and raw material to make batteries is dominated by a few players. Other areas of interest could be utility providers with a growing share in alternative energy, or companies who benefit from the upgrade of the electricity distribution network.

Long term risks

Investment also involves controlling risks, and there are long-term risks that require our attention. The debt levels in both private and public sectors are elevated in the top three economies. If growth slows or turns negative, the debt burden could become intolerant immediately. Another worrisome scenario is the continuous income inequality in major economies. The labor share of GDP in the U.S. continues to fall. Society unrest could deter pro-growth policies, which usually require patience and long-term planning to carry out.

As we enter a period of normalized economic cycle and monetary policy environment, our long-term vision will be the dominating factor for making investment decisions. It is the only clear guideline when the market continues to react to all sorts of noise.

We appreciate your trust and please contact us if you have any comments or questions regarding our services.

Sincerely yours,

Research Team



Changes in Portfolio Appraisal
Starting this quarter, the Communication Services sector will be added to your portfolio statements. This sector includes companies that provide communication services using fixed-line networks or those that provide wireless access and services. This sector also includes companies that provide internet services such as access, navigation, and internet. We thereby follow the changes to the index classification initiated by S&P Dow Jones Indices.

Also, we have updated our ADV form which can be downloaded from our website.