Do you remember the first album you bought? The first CD album I ever bought was Guns N’ Roses’ Appetite for Destruction. Actually, this is a lie. It was the first decent album I bought. And no, I will never reveal the true answer. Never.
Do you remember the first MP3 file you downloaded illegally? Possibly not as memorable. But the ability to download any song you wanted, at any time, changed the music industry forever. Going to a shop and buying records or CDs was historically the only way to own music. But with the invention of MP3 files and the internet’s role in allowing these digital files to be shared across the globe, music fans were getting songs for free. And the record industry was not happy.
Around the turn of the century there were two important legal cases, both involving the music industry’s trade organisation, the Recording Industry Association of America (RIAA). One of which was against Napster and one was against Diamond Multimedia Systems Inc, who were one of the early MP3 player manufacturers. You probably remember Napster, you may even have used their popular song-swap website. It is also fairly likely that you don’t remember Diamond. The Napster case in 2001 got a great deal of press coverage as many music artists publicly came out against Napster. The music industry claimed Napster were responsible for copyright infringement, whereas Napster claimed they just facilitated file sharing and never held any of the songs on their own servers. The RIAA won the case and the court ordered Napster to start charging for downloads or close down their service entirely.
Two years before the Napster court case, the record industry were less successful when they tried to prevent Diamond from manufacturing and shipping their Rio MP3 device. In this case, the court found that the Rio player was not primarily a recorder and the decision cleared the path for MP3 players to hit the market. A mere two years later Apple launched their first iPod, packing a mind-blowing 1,000 songs, and the rest is history.
7 Days
For the music industry this was perhaps a classic case of winning the battle but losing the war. It also shows that the events which attract the most press coverage are not always the most important in the long run.
Last week we saw volatility spike in markets across the world, and understandably these big swings in the market got a lot of coverage in the media. However, there is a big difference between short term volatility and a long term trend reversal. Is this the correct story to focus on?
What started with worries over slightly weaker US employment numbers, then became panic when the Bank of Japan marginally raised their interest rates which in turn unwound the yen carry trade (Hedge funds borrowing money in Japan at low interest rates to reinvest it into higher-yielding assets), which ultimately turned into full scale meltdown as higher volatility meant hedge funds has to unwind even profitable trades to cut their risk levels.
The market recovered quickly, but the way the situation unfolded so rapidly highlights both the difficulty the Bank of Japan will face in unwinding years of zero interest rates and also exposes how vulnerable markets are to the ‘carry trade’ strategy that hedge funds exploited to fund hundreds of billions of dollars of bets across the world.
If we look through the volatility, the US economy is certainly slowing, but are we about to see a sharp US economic slowdown which will spur the Fed to aggressively cut interest rates? In a word, not very likely. This has been a common pattern over the last few years. Any small misses on inflation, jobs, and growth data have disproportionately affected short-term interest rate expectations. Or to put it more simply, nobody has any idea what is going to happen with interest rates. Remember in January when there was supposedly a 100% probability of six rate cuts in the US in 2024, well, spoiler alert… Currently there have been zero!
Given what we saw last week, and given how crowded the trade in the biggest companies in world is, it is likely that increased volatility in markets will persist, and we are looking at ways to reduce the volatility in our portfolios.
But this is not the story to focus on.
Closing the Gap
We think the right story to focus on is what happened last month. The rotation story. In July, we had six straight days of rotation from large companies into small companies, which were the best six days for small caps, relative to large, since November 2020.
While this rotation has many potential causes, there are four main factors:
Firstly, increased expectations that the Fed will cut rates will favour small caps to a greater extent as small caps are more indebted (especially if you compare them to cash-rich big technology companies). A rate cut without imminent risk of a recession would be the cherry on the cake.
Secondly, the small cap market looks cheap. The Russell 2000 index (US small-cap stock market) was trading at its lowest valuation versus the S&P 500 since 1999, so any move to close this valuation gap will benefit small caps.
Thirdly, the equity market has become extremely top heavy. The vast majority of recent outperformance has been concentrated in the top 10 biggest companies and momentum may have run too far. With increased geopolitical risks surrounding the semiconductor industry and concern over the increasing capital expenditures related to AI, investors are starting to look at the broader market again.
Lastly, smaller companies tend to outperform larger companies in the long run. Over the last 25 years the world small cap market has outperformed main market by 2.3% per annum.*
In June we took a position in a global small caps fund as it looked like an attractive entry point and still feel there is some way to go to close the gap with the biggest, and most expensive, companies.
What’s the 411?
It wasn’t just small caps that were the beneficiary of renewed investor interest in July. Forgotten sectors such as utilities, consumer staples, industrials, and real estate all performed well.
There is also another market closer to home where we have noticed the sentiment improving of late. Yes, the prodigal son returns, UK equities, and in particular the domestically focused mid-caps are back on investors’ radars.
After winning 411 seats at the election in July, the Labour Party now has a sizeable majority which should bring some much needed stability to UK after the chaos of the last eight years. The early signs are helpful and a pragmatic, pro-business approach will help attract investment towards the UK, especially when compared to some other countries in Europe. Bank of America’s latest global fund manager survey showed that exposure to UK equities increased eight percentage points in July, which is the highest allocation in two years, but overall investors are still underweight the UK. International investors are not the only ones who have fallen out of love with the UK, domestic outflows from UK retail equity funds has been relentless.
From a valuation perspective UK still looks relatively cheap, especially the mid and small caps. The FTSE 250 has only traded at a discount to the FTSE 100 on three occasions in the last 20 years and hasn’t stayed there long. We recently entered the fourth occasion. Also, there are significant pension reforms anticipated later in the year, this should further stimulate investment in UK equities.
We have become more positive on the UK, and have recently increased our exposure to mid and small cap UK equities.
Pirate Legacy
Napster itself was not a commercial success but its legacy casts a long shadow. Facebook, iTunes and many other digital giants have flourished using elements pioneered by Napster’s original software.
Streaming services like Spotify and Apple Music are now ubiquitous, but in their day so were CD’s, or cassette tapes, or vinyl records. There was even a point in the late 90’s when mini-discs were going to be the future of music. They weren’t. Disruption is a common feature of the music industry. Tastes change, consumption changes. What was the song of the summer ends up being a one hit wonder. Last year, vinyl record sales outperformed CDs in the US for the first time since 1987. What seemed a dead and forgotten format is now growing every year. Vinyl is back, and it now costs £30 a record! Perhaps like vinyl albums, UK Equities and small caps can once again capture investors’ imaginations.
Before the iPod, Apple was really only known a computer manufacturer. When the music industry lost their case against Diamond, Steve Jobs spotted the opportunity to shake up the the whole music business which had become completely reliant on the money from selling CDs and unprepared for the change coming. The iPod was not only a cool product, but coupled with the iTunes store, Apple were able to become a digital music behemoth.
In any given week we are bombarded with news flow of what’s in and out of favour. It is important to identify which stories are important and which are noise. Which story will end up having the biggest impact? Which story will give us insight into the best opportunities (or greatest threats) in the market?
Our investment process is flexible and nimble, and just like the greatest music artists or innovators, we endeavour to adapt with the environment.
The objective is to identify when things change. We aim to be more like Apple and less like the record industry.
*Source: UBS Global Investment Returns Yearbook, 2024, Elroy Dimson, Paul Marsh, Mike Staunton
