Occasionally we are reminded that cybersecurity decisions have real-world impacts. In early 2021, news of a cyber attack at a water treatment plant in Florida was made public, in which one of the employees lost control of his mouse and watched as the hacker increased the level of sodium hydroxide 111 times from its intended level, making it dangerous to even touch the water. Luckily, the computer’s owner was proactive in rectifying the situation and escalating the case to the FBI. Even though many security checks were in place, making it unlikely that the contaminated water would reach the population, this case illustrates how ill equipped modern infrastructure is to deal with cybersecurity threats.

On May 7, Colonial Pipeline announced that it became the victim of a ransomware cyber attack that forced the company to halt all pipeline operations for a full week, making it the largest successful cyberattack on an oil infrastructure target to date. As the largest refined oil pipeline system in the eastern United States (US), the consequences were felt immediately. An estimated 12,000 gas stations faced shortages, fuel prices rose to more than $3/gallon, and panic buying surged to levels not seen since the toilet paper mania at the onset of the pandemic last year. As is usually the case with ransomware attacks, management did not know exactly how severe the breach was or how long it would take to have the systems work again on their own. As such, the company went ahead and paid the full ransom of 75 bitcoins, worth roughly US$4.4 million, and its operations were able to resume several days later.

Ransomware and other forms of cyber attacks are much more frequent than one would expect. In its annual “State of Email Security” report, Mimecast Ltd. found that 61% of organizations surveyed had been impacted by ransomware in 2020, an increase of 20% over 2019. On average, these companies lost six working days of system downtime and for 37%, the downtime lasted a week or more. One of the worst parts is that more than half of the victims paid the ransom demand but only 66% of them were able to retrieve their data afterward. This means one third never saw their data again despite paying the ransom.

In past commentaries we discussed how email is the most frequent and vulnerable attack vector, even more so since work from home became the norm. Since the beginning of the pandemic, it has been found that employees are three times more likely to click on malicious emails than they had before, while the number of email threats rose 64% year over year. This implies that working from home is also leading to employees being less vigilant about potential threats. Meanwhile, companies have been slow to adapt. Cybersecurity training is provided by only one out of five companies, despite almost half of technology chiefs believing that their biggest weakness stems from their employees’ lack of cybersecurity knowledge. Furthermore, one in ten companies do not even have an email security system.

With this in mind, it is not difficult to understand why Global Alpha has maintained continuous exposure to the cybersecurity sector over the years. In the past, we owned names such as Sophos, Nice Systems, and we currently own Mimecast Ltd. (MIME US).

Business Overview

Mimecast is a cloud-based platform that offers email security solutions. They provide a range of services, including targeted threat protection, encryption, large file sending services, and data leak prevention. Peter Bauer is one of the co-founders of the firm and has been CEO since its inception in 2003. Insiders own about 7% of the shares outstanding.

Competitive Advantages

Given the sticky nature of the business, Mimecast enjoys very high retention rates. They also have the fastest search service-level agreement in the industry because their service architecture was designed for the cloud from the beginning.

Mimecast processes over 400 million emails every day, and has more than 300 billion emails under management. They are the only email security provider to guarantee 100% continuity on Office 365.

Growth Strategy

• Cross sell opportunities as the average customer owns around 3.5 products (up from 3.2 in 2019)
• New product launches (6 products at its IPO in 2015, currently 11)
• Increased penetration in the enterprise business

We are always on the lookout for new investment opportunities with secular growth opportunities. Our ability to be highly selective and nimble in our portfolio holdings leaves us well positioned to add some exposure to the online security industry at attractive valuations.

As most of you know, fundamental research informs Global Alpha’s stock selection, as it identifies equities with growing earnings that will meet or exceed our expectations. The pandemic challenged this philosophy in 2020, due to the volatile and unpredictable nature of corporate earnings. With low rates and subsidies, cashed-up investors looked elsewhere and flocked to non-earning companies, sending the Nasdaq 45.1% higher versus the S&P 500 at 18.4%.

A company with no earnings typically supports its stock price with material events that can de-risk future earnings. Investors gravitate to this approach as it can provide substantial short-term returns given the timelines around material events are well understood. Global Alpha tends to focus more on the entire capex cycle, smoothing out the volatility of a single event. For example, the technology and biotechnologies industries hold many event-driven companies. 

Hedge funds are a class of investors that commonly use event-driven strategies. According to the Hedge Fund Research (HFR) Database, the highest-returning hedge fund strategies in 2020 were event-driven funds, which gained 9.3% for the year. Macro hedge funds returned 5.2% for the year, while HFR’s own relative value index ended 2020 up 3.3%. The hedge fund industry’s total assets stand at $3.8 trillion, a 21% growth in one year. This occurred while the industry has had net outflows of -1.9% in 2020, according to Opalesque, a hedge fund publication.^[1]

Interestingly, the Financial Industry Regulatory Authority (FINRA) reports that margin debt has jumped 51% since February 2020, to $823 billion in March 2021.^[2] The $340 billion change is three times greater than any annual change in the last decade. It is therefore arguable that hedge funds, as well as many investors, are highly levered and exposed to event-driven companies.

Following the debacle of Archegos Capital Management, which faced massive margin calls from its prime brokers, Federal Reserve Governor Lael Brainard stated, “The Archegos event illustrates the limited visibility into hedge fund exposures and serves as a reminder that available measures of hedge fund leverage may not be capturing important risks.”

Where is all the new levered money (or at least part of it)?

According to PWC, the United States (US) equity and IPO capital markets in Q1 kicked off with yet another record, driven by the continued SPAC attack, with 389 IPOs raising $125 billion; 2020 raised $150 billion in total. A lot of this money is in newly issued, event driven, technology and biotechnology companies. The money is used to develop new products and services at an accelerated pace to catch up to their rich IPO valuations.  

These amounts materialize as capex and revenues to the subcontractors of technology or biotechnology companies, commonly known as the picks and shovel of an industry. Global Alpha is invested in these types of companies, which stand to benefit from the capital exuberance described above.

Additionally, our companies are profitable and diversified. They also are of lesser interest to event-driven hedge funds. These companies could be at a lesser risk of mass sell-off due to an Archegos Capital Management type liquidity crunch. Rich in pharmaceutical history, Europe holds many excellent contract research organizations that appear in our investment universe and have the biopharma industry as clients.

Evotec (EVT:GR)

Based in Hamburg, Germany, Evotec operates multiple scientifically driven contract research centers for the biopharma industry. The company has extensive scientific knowledge to assist in genetic and biochemical drug development programs.

With the large biopharma market growing at a compound annual growth rate (CAGR) of 13.5%, Evotec has been gaining market share with a 20% growth rate. The company recently launched a low cost biological drug production platform that is expected to grow revenues considerably in the mid-term. Evotec also signed an agreement with the Japanese giant Takeda for the development of RNAi drugs.

Oxford Biomedica (OXB:LN)

Global Alpha also owns Oxford BioMedica, a biopharmaceutical company engaged in the production of viral vectors, a key component of delivering a genetic drug.  Without vectors or other delivery systems, genetic material decays extremely quickly in the body. Oxford BioMedica offers a variety of vectors, including adenoviruses that are used in the present coronavirus vaccination program with AstraZeneca. However, it specializes in lentivirals, which have proven very efficient with biologics.

The FDA is predicting a wave of cell and gene therapies coming to market in the next few years, which is set to drive the overall end market to exceed $20 billion in the mid-term. The lentivirus vector market is expected to grow in excess of $1 billion by 2026, from $350-400 million today.

[1] https://www.opalesque.com/

[2] https://www.finra.org/

Governments around the world are incurring record deficits to sustain their economies during the COVID-19 pandemic. These deficits are expected to persist, as revenue will be needed to rebuild infrastructure and support an aging population.

Benjamin Franklin, the inventor, philosopher, politician, and one of the founding fathers of the United States, famously said: “In this world, nothing can be said to be certain, except death and taxes.” Yet, in 2018, a record year for corporate profits levels, 91 Fortune 500 companies paid no federal income tax; among them, companies such as Amazon, Netflix, Chevron, GM, and Delta.  Even more, their tax rate was -5%, meaning they got a tax refund. The 379 profitable Fortune 500 members paid an effective federal tax rate of 11.3%, almost half of the 21% tax rate established in the 2017 tax revamp. That represented a missing $73.9 billion worth of tax revenue for the federal government. As a result, in 2019, the Organisation for Economic Co-operation and Development (OECD) formally established base erosion and profit shifting (BEPS).

What is BEPS?

“BEPS refers to tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity or to erode tax bases through deductible payments, such as interest or royalties. Although some of the schemes used are illegal, most are not. This undermines the fairness and integrity of tax systems because businesses that operate across borders can use BEPS to gain a competitive advantage over enterprises that operate at a domestic level.  Moreover, when taxpayers see multinational corporations legally avoiding income tax, it undermines voluntary compliance by all taxpayers.”

“BEPS is of major significance for developing countries due to their heavy reliance on corporate income tax, particularly from multinational enterprises. Engaging developing countries in the international tax agenda is important to ensure that they receive support to address their specific needs and can effectively participate in the process of standard-setting on international tax.”

The digital economy giants have been very apt at using BEPS. Looking at cash taxes paid globally by FAANG stocks in 2019/2020, according to Global Alpha’s estimates, Facebook paid 12.75%, Apple 14.4%, Amazon 7%, Netflix 7.3%, and Google 11.9%. As an example of BEPS, Google declared $23 billion in revenues in Bermuda in 2017. Until 2015, Amazon was able to declare all its European revenues in Luxembourg.

The significant tax drag caused by these large multinationals was a major issue in negotiations over tax reforms at the OECD, since they were largely US corporations. The stalemate brought many local governments, such as Australia, the United Kingdom (UK), and France, to impose a local tax based on revenues earned in their respective country. That brought retaliation from the US by taxing imports from these countries.

This graph shows that in the 1970s, the largest corporation paid slightly higher tax rates than smaller ones. By the early 80s, the situation reversed, and the unfair advantage of larger companies has amplified since.

Why should we care? The tax system encourages businesses to consolidate and grow bigger. With a risk, they may abuse their market dominant position. The discussion until recently was concentrating on anti-trust measures. Companies like Amazon, Google and Facebook are currently being investigated by various government entities using anti-trust laws. As the case against Microsoft in 2001 demonstrated, it is hard to win a case against multinationals as current anti-trust regulations focus on the price paid by consumers. Anti-trust cases are overly complex and may take years before reaching a conclusion. Studies show that a minimum corporate tax would be a more effective way to ensure fairness and stable government revenues.

In the last few weeks, US President Joe Biden and his secretary of the Treasury, Janet Yellen, former Federal Reserve chairwoman, have proposed an ambitious plan to arrive at a global framework on taxation, which would stop the race to the bottom and allow countries to fund their needed services to their population.

The Biden tax plan includes the following proposed business tax changes:

• Increase the corporate income tax rate, from 21 to 28 percent.
  • Create a minimum tax of at least 15% on corporations with book profits of $100 million or higher.
  • Double the tax rate on global income earned by subsidiaries of U.S. firms, from 10.5 percent to 21 percent.

Immediately, countries around the world, like France, Canada, Germany, Japan and many others, welcomed the idea. President Biden went further in supporting the idea of a local tax based on local revenues. There is a high likelihood that OECD negotiations may finally reach a new global tax accord by the end of this summer.

What would be the impact on stock markets?

First, we think the large cap US benchmarks would be most negatively affected, as they incorporate most of the large digital companies, which as explained above, have been the biggest users of BEPS.  The S&P500 sells at a record price-to-sale ratio and at an extremely high 24x 2021 earnings.  Increasing the tax on these earnings by 25% would mean a ratio above 30 times, which is unprecedented. That compares with a ratio of 17 times for the MSCI EAFE index (ex: North America).

Smaller companies, as discussed, pay a much higher tax rate. The impact of revised tax rates will be much smaller.  The MSCI EAFE small-cap index sells at 17.9 times 2021 earnings. In addition, the MSCI World small-cap index, which includes the US and Canada, sells at 18.8 times 2021 earnings. The impact should be less for smaller companies, which should drive outperformance. Another aspect that we should mention is the increased importance of ESG in investment decisions.

The environmental impact and carbon footprint of companies is now an important topic for investors. We believe that aggressive tax planning and avoidance may very soon become another important factor that investors may look at.

When it comes to vaccination campaigns, the United States (US), United Kingdom (UK), and Israel continue to lead the way. Following the vaccination of some of the most vulnerable populations, the rate of hospitalizations are decreasing. Efficient vaccination campaigns in the US and UK have increased confidence that economic activity will continue to grow in the coming months. Many indications show strong pent-up demand from both consumers and corporates starting to increase.

In other parts of the world where vaccinations are taking longer, reopening will be slightly delayed. Despite the slow start in Europe, governments are intensifying their campaigns as the supply of vaccines increases. This should enable the economy to reopen and activity to rebound. As restrictions ease, we continue to expect the economy to recover rapidly beyond Q2.

There are some interesting data points that suggest a stronger economic activity as restrictions ease:

• Resilience: Similar to what we experienced in the second COVID-19 wave, economies are showing signs of resilience in this third COVID wave. 
  • Business optimism: Strong survey data for the industrial sector suggests that businesses are more optimistic.^[1] This could lead to better business activity for Q2. We noticed some businesses commenting on better than expected business trends. After huge cost cutting efforts during 2020, businesses are gradually returning to capex and IT spending.
  • Manufacturing momentum: Although the service component of the economy could still be impacted by government restrictions, the manufacturing side shows a strong business sentiment. Excluding some supply constraints, like the shortage of semi-conductors, or the disruption in Texas, global manufacturing shows positive momentum.
  • Pent-up demand: Global personal savings have soared rapidly over the past months, as expensive holidays were impossible. A portion of that extra money has been redeployed on near-term recreational goods, gardening and home spending. We believe that these product categories will remain strong even after the pandemic starts to retreat.

Some recreational and sports goods have become more popular in this pandemic as leisure options narrowed. Bicycle sales are enjoying phenomenal demand. Suppliers have indicated that stock levels in the supply chain are much too low and that the return to a more normal inventory level would already lead to a high double-digit market growth. RV manufacturers and RV rental marketplaces is another segment that cannot keep up with demand. Thanks to a tight supply chain, strong demand and low inventories, this segment should enjoy good order visibility for 2021 and beyond. 

Regarding travel, US domestic and international flights are at the highest levels since the end of March 2020. Europe, which relies more on intercontinental traffic, has not improved much yet, but there are positive signs starting to emerge. The European Commission presented a proposal to create a digital Green Certificate to facilitate the safe free movement of citizens within the EU. Another example is Iceland, which will open its borders this week to visitors who have received the vaccine without the need for testing or quarantine. Australia and New Zealand will also have a similar arrangement starting next week.

Restaurant bookings are soaring in some parts of the US, but also in the UK, as outdoor bars and restaurants opened earlier this week.[2] With a reduced supply of pubs and restaurants, the ones that operate should enjoy strong consumer traffic. Apparently, outdoor tables booked out several weeks in advance after the UK government announced its reopening framework this winter.  

These observations and data points are no surprise, as people look forward to leisure activities and travel after months of restrictions. The important variables now are how fast populations are being vaccinated and how efficient vaccines are in terms of preventing a person from carrying or passing on the virus.

[1] Bloomberg – EMEA WEEK AHEAD: ECB to Hold, Russia Hike, U.K. Jobs

[2] https://www.opentable.com/state-of-industry