Struc­tural change, dis­in­fla­tion and ‘Ama­zon­i­sa­tion’

Se­rial dis­rup­tors like Ama­zon are shap­ing the eco­nomic trans­for­ma­tion that is tak­ing place be­fore us. John Pat­tullo, co-fund man­ager of Hen­der­son Di­ver­si­fied In­come Trust, ex­plains how in­vestors can be on the right side of change.

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The long­est bull mar­ket of all-time was recog­nised on 22nd Au­gust by a num­ber of in­sti­tu­tions, in­clud­ing Bank of Amer­ica Mer­rill Lynch and S&P Dow Jones In­dices, edg­ing past the pre­vi­ous record set be­tween 1990 and 2000. Some dis­agree with the def­i­ni­tions of bull and bear mar­kets, so the goal­posts change de­pend­ing on your view, but either way it has been an ex­tra­or­di­nary pe­riod for US eq­ui­ties. Now, how­ever, there are clear signs that we are en­ter­ing the lat­ter stages of the busi­ness cy­cle, which means a bear mar­ket is prob­a­bly close.

For ex­am­ple, in Au­gust the S&P 500 In­dex broke its all-time record high of 2,872 set on 26 Jan­uary this year, as il­lus­trated in Chart 1. The pat­tern re­sem­bles what is known as a ‘dou­ble top’, which many an­a­lysts in­ter­pret as pre­ced­ing an im­me­di­ate or long-term re­ver­sal in price. That’s not al­ways the case, but you wouldn’t be alone in tak­ing on a bear­ish at­ti­tude as a re­sult of this in­for­ma­tion.

For in­vestors and the com­pa­nies they in­vest in, there is also an un­set­tling un­der­cur­rent of struc­tural changes in so­ci­ety to con­tend with, in­clud­ing chang­ing de­mo­graph­ics, con­sumer be­hav­iour, low-growth eco­nom­ics and tech­nol­ogy-driven dis­rup­tion. It might be fit­ting that this bull mar­ket breaks the record dur­ing one of the long­est and hottest sum­mers on record, but to quote the decade’s most pop­u­lar TV se­ries, ‘Game of Thrones’: “win­ter is com­ing”.

As bond and eq­uity in­vestors, we have to be very mind­ful of sec­u­lar trends and struc­tural changes, and be care­ful to ac­cept the dis­rup­tion that is go­ing on. Tech­nol­ogy is de­vel­op­ing at a phe­nom­e­nal rate and some of the num­bers around this are scary.

Ama­zon an­nounced it would en­ter the home se­cu­rity mar­ket with its Fe­bru­ary ac­qui­si­tion of Ring

turned start-ups into be­he­moths with al­most all of their valu­able as­sets be­ing in­tan­gi­ble, dig­i­tal and in­tel­lec­tu­ally-based.

In­for­ma­tion tech­nol­ogy has pow­ered al­most ev­ery form of growth and de­vel­op­ment in the past 10 years. There are so many bil­lion-dol­lar com­pa­nies that did not ex­ist 30 years ago, but the FANG stocks (Face­book, Ama­zon, Net­flix and Google – now Al­pha­bet) are prob­a­bly the most well-known. And among them, the story of Ama­zon is per­haps the most im­pres­sive.

The e-com­merce gi­ant started life in 1994 as an on­line book store and has evolved into the sec­ond-largest re­tailer in the US, af­ter Wal­mart. The com­pany has grad­u­ally eaten into the mar­ket share of tra­di­tional re­tail­ers and en­tered mar­kets no one would have thought about.

Its mem­ber­ship pro­gramme, Ama­zon Prime, is an awe­some cus­tomer ac­qui­si­tion tool with dis­counts on Ama­zon prod­ucts and dis­count part­ner­ships at var­i­ous other out­lets. Prime has a house­hold pen­e­tra­tion rate of be­tween 40% and 60% in the US, ac­cord­ing to Wall Street an­a­lysts, which only adds weight to Ama­zon’s fright­en­ing dis­rup­tive ca­pa­bil­ity.

For ex­am­ple, Ama­zon an­nounced it would en­ter the home se­cu­rity mar­ket with its Fe­bru­ary ac­qui­si­tion of Ring, which of­fers a do-it-your­self, state-of-the-art home se­cu­rity sys­tem, Ring Alarm, that un­der­cuts sim­i­lar prod­ucts of­fered by mar­ket leader ADT and Google’s Nest Se­cure prod­uct. ADT floated in Jan­uary with an ini­tial price of $14 per share, but fell as low as $7 in the af­ter­math of Ama­zon’s an­nounce­ment and now the com­pany faces a daunt­ing bat­tle against a se­rial dis­rup­tor.

We owned ADT bonds be­fore Ama­zon en­tered the mar­ket; and we thought the com­pany was a rel­a­tively un­ex­cit­ing, low-mar­gin, de­fen­sive busi­ness. We strug­gled to sell the bonds, which were long-dated, but we did buy pro­tec­tion against de­faults us­ing credit de­riv­a­tives. Even­tu­ally we found some­one more op­ti­mistic than us to buy the bonds from us, and now we are net short on ADT. That means we are now po­si­tioned for ADT to fail be­cause we would make more money for our clients should the spreads on ADT bonds widen.

An­other re­cent ex­am­ple of Ama­zon’s fright­en­ing reach across in­dus­try came in June when it re­vealed its in­ten­tion to ac­quire US on­line phar­macy Pil­lPack for a re­ported $1bn. Soon af­ter the an­nounce­ment, some $14bn was wiped from the mar­ket cap of the US drug distri­bu­tion in­dus­try, ac­cord­ing to an­a­lysts at Reuters. These are sim­ply the most re­cent ex­am­ples of Ama­zon’s dis­rup­tive rep­u­ta­tion, there are plenty more to tell and we’re pretty con­fi­dent there will be plenty more to come, too.

The point is that this is all mas­sively de­fla­tion­ary. Economies of scale, whereby be­he­moths like Ama­zon use their might to un­der­cut ri­vals in new mar­kets, means the prices of goods comes down. We are all used to see­ing re­duced prices or deals whereby you can buy a num­ber of goods for a sim­i­lar price to a prod­uct on its own.

We are used to dis­in­fla­tion (slow­ing down of in­fla­tion) and some­times de­fla­tion (op­po­site of in­fla­tion). We live in a world where peo­ple ex­pect a dis­count, are given a dis­count or where re­tail­ers will throw away their mar­gin and just give you a

dis­count some­times with­out any­one ask­ing for it; and that is a gen­er­a­tional change.

For these rea­sons, we are very wary of value in­vest­ing, which means in­vest­ing in as­sets that ap­pear un­der-priced; we think a lot of value busi­nesses are cheap for a rea­son – they are value traps and are prob­a­bly go­ing bust. Value man­agers will give you a dif­fer­ent take but we think there are struc­tural changes go­ing on in the econ­omy and dis­rup­tion is one of them, which would ex­plain why qual­ity growth, we think, will dom­i­nate for a few years. That’s an­other way of say­ing we think bond yields will re­main quite low go­ing for­ward and would favour a growth strat­egy.

If you’re in the other camp, you think re­fla­tion is com­ing, in other words in­fla­tion is ris­ing and in­ter­est rates are ris­ing in a cycli­cal up­turn and you would ex­pect value to start out­per­form­ing, but we see scant ev­i­dence of that. That’s a very im­por­tant point for how we frame our ar­gu­ments in the bond world – with an oc­ca­sional eq­uity hat on.

Hen­der­son Di­ver­si­fied In­come Trust’s (HDIV)

net as­set value per share (NAV) has come un­der pres­sure in 2018, which is typ­i­cal of the lat­ter stages of the busi­ness cy­cle. It’s a tough pe­riod for bond in­vestors with yields gen­er­ally low, but we are po­si­tion­ing the port­fo­lio to be re­silient un­der mar­ket stress.

That means we are avoid­ing in­dus­tries and sec­tors in the crosshairs of dis­rup­tive en­ter­prises; and com­pa­nies op­er­at­ing in the spa­ces where eco­nomic and de­mo­graphic shifts could pull the car­pet from un­der their feet.

The av­er­age ma­tu­rity of our fixed in­come port­fo­lio is be­tween 6.5 and 7 years, which is long rel­a­tive to his­toric lev­els but it’s what you want in a de­fla­tion­ary en­vi­ron­ment; and we have re­duced the port­fo­lio’s net gear­ing as we are mind­ful of be­ing too highly lever­aged head­ing into a bear mar­ket. Loans have out­per­formed high yield cor­po­rate bonds this year. About 9% of the port­fo­lio is in­vested in loans, but in­creas­ing that ex­po­sure would have meant cut­ting the Trust’s div­i­dend, and our pri­or­ity is pro­vid­ing a di­ver­si­fied in­come stream for our share­hold­ers.

Our strat­egy rests on buy­ing long du­ra­tions in high qual­ity com­pa­nies that have a good rea­son to ex­ist; which are typ­i­cally non-cycli­cal, large cap com­pa­nies that will pay a re­li­able, sus­tain­able and re­al­is­tic coupon. We are keep­ing our eyes open to the struc­tural changes shap­ing the world’s de­vel­oped economies and we are con­fi­dent the Trust is well po­si­tioned to thrive as these changes take ef­fect.


Bull mar­ket: A fi­nan­cial mar­ket in which the prices of se­cu­ri­ties are ris­ing, es­pe­cially over a long time. The op­po­site of a bear mar­ket.

Bear mar­ket: A fi­nan­cial mar­ket in which the prices of se­cu­ri­ties are fall­ing. A gen­er­ally ac­cepted def­i­ni­tion is a fall of 20% or more in an in­dex over at least a two-month pe­riod. The op­po­site of a bull mar­ket.

To hear more about the dis­rup­tive in­flu­ence of Ama­zon and the chang­ing shape of con­sumer eco­nom­ics, you can lis­ten to John’s lat­est pod­cast here.

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