It seems like it happened overnight. Artificial Intelligence (AI) went from something distant that would not typically come up in small talk between colleagues (unless you work in the field, maybe), to the next great game changer that promises to transform the way everything is done. ChatGPT is now already a household name that can write homework for students, find bugs in programmers’ code or even draft a basic contract according to your specification. Just two months after the release of ChatGPT by OpenAI in November 2022, it had already become the fastest-growing software application in history with well over 100 million users. Subsequently this led to massive investments by Google, Baidu, Meta and many others to develop competing technologies to maintain their market shares.

Every time a new technology or concept is the subject of such interest, the media spends an incredible amount of resources theorizing all the different ways in which the world will be made different by this new shiny thing. Yet very few of these promised changes end up making a lasting impact. Blockchain was supposed to revolutionize the world of finance and decentralize the entire system, yet it remains a niche technology with a damaged reputation from the crypto craze.

The metaverse was sold as something that would be part of our everyday life with most households having their own VR headset, much like everyone had their own PC. We’re not quite there yet, although Apple now seems to believe this is the next big thing.

Finally, 5G was meant to unlock so many opportunities with promised better connectivity, low latency and no pocket loss. Every company was mentioning some opportunities from the internet of things to cloud gaming. All these frenzies had something in common: actors that overpromise and underdeliver in spectacular fashion, at least in the short term.

Then comes the new buzzword: generative AI. Between the Q4 2022 and Q1 2023 earnings season, the mention of AI in earning calls more than doubled among S&P500 companies. Nvidia rallied almost 200% in 2023 as one of the most obvious potential beneficiaries and is now worth over $1 trillion while trading at 40x revenues. For reference, these are dotcom bubble multiples.

Artificial intelligence as a field of research goes back to the late 1950s, 15 years after the famous Turing test was first put forward. So how did it become all the rage overnight over 60 years later? Long story short, significant advances in Large Language Models (LLM) in the last decade paved the way to commercial use of generative AI. In a context where the global economy has needed new productivity catalysts to prevent GDP deceleration and to help reduce inflationary pressure in the post-COVID era, ChatGPT seems to be filling the void almost too perfectly. As a new productivity tool that could potentially impact almost every aspect of the service economy, it’s no wonder everyone is jumping on the hype train. Nonetheless, if the commercialization of the internet is any reference, and assuming the impact of AI is of a similar size, we are still at the beginning of the dotcom/AI bubble where euphoria is high, and every company is set to either benefit from AI or disappear into irrelevance. Seasoned investors who lived through the internet bubble may offer one or more of the following pieces of advice:

• Your internet/AI stock pick will likely prove wrong in the long term, as it will take years to fully realize the impact of the technology, while regulations can hinder companies’ plans.
• Your stock pick could be the right one, yet the current valuation may still not make sense.
• There are solid companies outside the tech/AI bubble that are being unfairly penalized as investors sell them to buy into the new hype stock.

Within this speculative environment, we identified an opportunity to initiate a position in a company that had been on our radar for a long time: Keywords Studios (KWS LN). Based in Ireland, Keywords is the dominant player in the fragmented market of video game outsourcing. With studios in over 26 countries, across eight different lines of business and three development divisions, Keywords operates at an unmatched scale three times larger than its closest competitor, yet with a market share of only 6%. The company offers services covering a wide range of developer requirements, including audio services, customer support for live games, marketing and social media management and bug testing.

Keywords had long been a darling in the video game small-cap space, commanding a valuation that made it challenging for us to justify an investment, despite its strong niche positioning and business model. However, near the end of April, the company appeared on an AI loser basket built by Bank of America, based on the belief that most of Keywords’ services would eventually be brought back in-house by game developers due the reduced need for labour caused by new AI technologies. This triggered a downward spiral in the share price. From that point on, negative momentum continued to feed on itself driven by index weight adjustments, loss cutting, quant signals and so on.

On closer examination, it became clear to us that the story was being misunderstood and that investors were selling services companies like Keywords indiscriminately. In fact, Keywords had already been making acquisitions and investments in AI technologies for at least a year before ChatGPT became a household name. It was already using this technology to enhance its localization services (Kantan AI), customer support business line (Helpshift), and to improve on its quality testing expertise (Mighty Games), among other things. Furthermore, Keywords is uniquely positioned to benefit from exposing its machine learning systems to a variety of games, languages and codes. It has a scale advantage that individual video game developers cannot match.

So why did we choose to invest in Keywords and not a game developer that owns its own intellectual property (IP)? The global video game market is highly hit-driven, which introduces risks and revenue lumpiness for developers, especially in the small-cap space where the number of IPs a company holds is usually limited and few games are released each year. Additionally, there is a significant ramp-up time when a new project is undertaken, as the game developer’s workload is not consistently aligned with that of the audio or functional testing teams, meaning employees may not always have the necessary workload to keep them on payroll.

In this environment, it is easy to understand why video game companies of all sizes are increasingly turning to outsourcing various stages of development. This is where Keywords excels. By working with virtually all the top gaming companies in the world, the company can leverage its scale to provide a consistent workload to its studios. Furthermore, by working across an unparalleled variety of games, Keywords builds a unique breadth of expertise without the need to manage its own IP or take on the risks associated with the release of a single title. Keywords is a great way of betting on the growth of the video game industry without making a call on specific titles or the medium on which it is consumed. The company represents most of what we would look for in a core portfolio holding: a leader in a niche market with pricing power, strong secular tailwinds and a good track record. And we got to buy it at a discount to its average valuation, thanks to investors that fell for this new AI mania.

The transportation industry has undergone significant change in recent years due to the impact of COVID-19 and technological advancements. Last mile deliveries and car sharing have emerged as important ways of reducing transportation costs. However, it’s worth noting that Uber is now more expensive than taxis in many cases. The industry is continuously transforming, with autonomous driving being a prominent example.

COVID-19 disrupted personal transportation as people avoided public transit and stayed home. But now, as we move forward, consumers are faced with hard choices to balance their budgets, and corporations are demanding increased presence in the workplace. 

According to the American Public Transportation Association (APTA), t​he average household spends 16 cents of every dollar on transportation and 93% of this amount is allocated to buying, maintaining and operating cars. This makes transportation the second-largest expenditure after housing. By opting for public transportation and reducing car ownership, households can save nearly $10,000. This saving becomes substantial when considering the average household income of $67,521 in the United States, especially if housing costs are considered fixed. 

There are several secular trends driving the growth of the public transportation market regardless of economic downturns. One such trend is the cost disparity between operating a new bus route and expanding road lanes, which continues to widen as land availability diminishes. Recent studies have also shown that road expansion leads to lower real estate prices compared to improvements in bus transit. Hence, municipalities become important stakeholders for bus transit as real estate prices directly correlate with property taxes. 

To support public transportation, governments typically provide subsidies for its operations and passenger ticketing often represents the service rather than a revenue source. In the US alone, the government has subsidized public transport with up to $108 billion, including $91 billion in guaranteed funding until 2026 under the 2021 Bipartisan Infrastructure Law. This represents the most significant federal investment in transit in the country’s history.

Demographically, millennials initiated a shift away from youth car ownership a decade ago. Accelerating immigration and rising housing costs further indicate an increased reliance on public transportation.

The global public transportation market was valued at USD214.54 billion in 2022 and is expected to grow at a compound annual growth rate (CAGR) of 3.7% from 2023 to 2030. 

During our recent travels to Australia, we observed the noticeable effects of accelerating immigration. Sydney and Melbourne suburbs are well-positioned for population growth thanks to their organized infrastructure and pleasant weather. The country is now attracting immigrants from beyond Southeast Asia and Melbourne in particular is a vibrant cultural hub poised for multi-year urban expansion.

We visited several real estate developments that are unaffected by slowdowns due to high immigration levels and lack of housing.

When it comes to sustainability, public transit is surpassed only by bicycles. According to the Environmental Protection Agency, transportation is responsible for 28% of greenhouse gas emissions. Whether using electric, biogas or hydrogen-powered vehicles, implementing green public transportation is crucial for controlling greenhouse gas emissions, especially as emerging markets catch up with urbanization levels. 

In the realm of public transportation, Global Alpha holds the Kelsian Group (KLS:AU). 

Headquartered in Adelaide since 1989, the Kelsian Group has emerged as a leader in public bus, marine transport and tourism operations. It consists of Australia’s most experienced providers of multi-modal public transport services and tourism experiences, operating ferry, bus and light rail services domestically and internationally. 

In 2022, the Kelsian Group transported more than 257 million customers, employing around 9,000 people and operating approximately 4,000 buses, 113 vessels and 24 light rail vehicles. 

Earlier this year, the company acquired the US-based All Aboard America to establish a presence in the US sunbelt region, which has favourable demographics. The founder of Kelsian personally relocated to Denver to ensure successful acquisition integration. 

The US bus transportation industry remains fragmented and as the market becomes more complex with the need for new technologies and multi-engine platform expertise (such as biogas, electric and hydrogen), smaller operators will struggle to compete. 

The public transportation industry qualifies as defensive growth. Bus operators typically work under multi-year agreements, often lasting seven years, with inflation adjustment clauses to protect them from cost accelerations. Their compensation is typically based on the quality of their route execution rather than the number of passengers, making low-volume routes still profitable.

Kelsian operates a best-in-class technology platform to optimize its routes and its comprehensive bus driver acquisition and training programs result in low turnover rates. Additionally, it leads the way in offering electrified biogas and hydrogen-powered transportation solutions. As we redesign transit for a greener and more connected society, the future holds tremendous opportunities.

Our Emerging Markets team recently returned from an insightful trip to Poland, where we explored its dynamic investment landscape. Since emerging from its communist past and establishing itself as a democratic state in 1989, Poland has achieved remarkable progress. It has not only become one of the major economies in the European Union (EU), ranking after Germany, France, Italy, Spain and the Netherlands, but is also one of the region’s fastest growing.

With a population of over 38 million, Poland boasts one of the largest consumer markets in Central and Eastern Europe. The country is known for its highly educated and skilled workforce. Polish universities tend to produce graduates in the fields of science, technology, engineering and mathematics. It’s no wonder Poland has attracted major players in the EV battery and semiconductor industries, such as LG Energy Solution, SK Inc. and Intel, further cementing its reputation as an attractive investment destination. Cities like Warsaw, Krakow and Wroclaw offer a vibrant startup environment, presenting excellent investment opportunities in technology, gaming and entrepreneurship. Notably, Poland is home to nearly 500 gaming companies employing over 14,000 people.

The country has also benefited from the recent settlement of 1.5 million Ukrainians fleeing Russia’s invasion who are expected to make Poland their permanent home, providing a significant boost to the local economy. Ukrainian can be heard on almost every major Polish street.

Poland’s accession to the EU in 2004 played a pivotal role in its development, granting Polish businesses unprecedented access to a vast market and creating abundant opportunities for growth. The EU membership also facilitated access to funds for infrastructure development, research and other strategic projects, contributing to Poland’s progress.

During our visit, we engaged with our holding companies, explored potential ideas and attended a consumer and technology conference. Key takeaways from our meetings include Polish companies rapidly expanding across Europe, intense competition in the grocery sector (especially from discounters), Polish consumers dealing with high inflation and negative wage growth (but that situation has likely bottomed), concerns surrounding the upcoming Fall parliamentary elections and the hope that the resolution of the war in Ukraine will open up vast opportunities for Polish companies.

Although the current level of inflation remains high, it meaningfully declined to 13% in May from 18.4% in February, mainly driven by moderating food and energy prices. Poland’s central bank has kept its key policy rate unchanged at 6.75% since September 2022, with the governor mentioning the possibility of rate cuts later this year under certain conditions. Meanwhile, the Polish labour market remains robust, with a record low unemployment rate of 5.2% as of April 2023.

A historic mass protest in Warsaw on June 4 that saw as many as 500,000 demonstrators gathering was primarily driven by a controversial law proposed by the ruling party, raising concerns about potential misuse against opposition leaders. The demonstrations also highlighted such issues as inflation and women’s rights.

We anticipate that inflation in Poland will likely persist at a high single-digit level through to 2024. The outcome of the parliamentary elections could either maintain the current political status quo or unlock the flow of EU funds to the country. Additionally, there is potential for a gradual decline in the country risk premium as geopolitical factors become less disruptive.

Considering the current situation, Poland’s equity market looks attractively valued. The WIG20 Index, consisting of the 20 largest Polish companies, trades at a forward P/E ratio of 8.3x, below its 10-year average of 10.9x and the broader MSCI Emerging Markets Index of 11.3x. Foreign investors and operators have shown increased interest in both Polish public and private companies, with notable examples including UK Entain’s acquisition of STS Holdings, German Mutares’ acquisition of Arriva Poland and Czech PPF’s acquisition of a 15% stake in InPost (INPST), an e-commerce logistics company with a strong ESG profile.

Taking advantage of what we believe to be a temporary dislocation in Poland-based equities, we initiated positions in InPost and Grupa Kety SA (KTY), a manufacturer of aluminum products and flexible packaging.

InPost specializes in out-of-home parcel delivery services primarily in Poland, as well as France, the UK, Spain, Portugal and Italy. Through a network of approximately 30,000 automated parcel machines (APM) and 27,000 pick-up and drop-off points, InPost offers a cost-efficient alternative with a significantly reduced carbon footprint compared to traditional door-to-door delivery. The company’s logistics infrastructure in Poland, supported by an efficient technology platform, covers first, middle and last-mile capabilities. We are impressed by InPost’s dominant market position in the rapidly growing Polish market, aided by attractive business economics. Its first-mover advantage in Poland provides a solid foundation for international expansion, further amplified by the acquisition of Mondial Relay in 2021, which unlocked substantial opportunities in Western Europe. Notably, InPost is still guided by its visionary founder, who retains a significant ownership stake in the company.

Grupa Kety is the leading Polish producer of aluminum products used in construction, automotive industries and flexible packaging for household products, confectioneries, pharmaceuticals and cosmetics. With a consistent track record of revenue growth and profitability, Grupa Kety holds a strong market-leading position. The company is led by a stable and professional management team with an impressive track record. We believe Grupa Kety is well-positioned to increase its market share within the EU and expand into higher-margin hard alloys.

Despite visible challenges, Poland presents compelling investment opportunities in various sectors. The country’s economic potential, combined with its strategic advantages and ongoing developments, make it an attractive prospect for investors looking to capitalize on its growth trajectory.

Digitalization has been a driving force behind growth in many industries, creating new opportunities and increasing efficiencies. The benefits of a thriving digital society are immense, including improved productivity and cost reduction. Unsurprisingly, the global market for digital transformation is enormous and rapidly growing. In 2022, this market was valued at close to US$750 billion and is projected to experience a compound annual growth rate of 26.7% from 2023 to 2030. 

The IMD World Digital Competitiveness ranking evaluates the capacity and readiness of 63 countries to adopt and explore digital technologies for societal enhancement using 54 different criteria. Denmark was named the most digitally advanced country in the world by the International Institute for Management Development (IMD) last year, marking the first time a Scandinavian country surpassed the US in this ranking. The US secured a respectable second place, thanks to its large and expanding tech industry and robust digital infrastructure. Denmark’s top position can be attributed to its readiness to embrace digital transformation, business agility and IT integration. The country also excels in delivering online public services and a remarkable 94% of its citizen are connected and considered tech-savvy.

In other parts of Europe, the digital landscape is uneven, with varying levels of digital readiness, infrastructure availability and digital skills among countries. However, efforts are underway to bridge the digital divide and drive transformation across the European Union (EU).

The European Commission has long been working on the “digital single market” and, in 2020, unveiled the Recovery and Resilience Facility (RFF). This €750 billion initiative aims to address the economic and social consequences of the COVID-19 pandemic and will be distributed among member states. At least 20% of the recovery funds must be allocated to projects that digitize economies and societies. 

The initiative’s goal is to expand digital infrastructure, support digital skills and education, promote digital innovation and entrepreneurship, and enhance digital public services. The EU’s vision is to become the most connected continent globally by 2030, ensuring every household has access to high-speed internet coverage by 2025 and gigabit connectivity by 2030. The EU is also committed to supporting the expansion and improvement of 5G infrastructure across its member states. For instance, Greece’s recovery and resilience plan includes €1.3 billion allocated to the digital transformation of the public sector and €500 million for promoting digital transformation in the education and health systems.

We believe that Netcompany, a recent addition to our international portfolios, is well-positioned to benefit from Europe’s digitalization. 

Netcompany, a Scandinavian provider of next-generation IT services for public and private customers, aims to support its clients in gaining competitive advantages and enhancing efficiency through digitalization, customized application development and business process re-engineering. The company has established a highly differentiated business model that is repeatable and scalable, enabling the delivery of projects on time and within budget. In its most recent fiscal year, Netcompany reported revenues of DKK 5,545 million (US$797 million) and an EBIT of DKK 839 million (US$121 million).

Originally based in Denmark, Netcompany has expanded its operations to Norway, the Netherlands and the UK. In 2021, it further expanded into Continental Europe through the acquisition of Intrasoft, gaining access to EU institutions and government tenders. By leveraging the combined platforms, competencies and strengths of both companies, we believe Netcompany is well-equipped to capture market share in Europe’s digitalization journey. 

Here we are, almost halfway through 2023, and we’re seeing many of the same investment themes we saw last year. Large-cap stocks continue to outperform, driven by the usual suspects. The Federal Reserve (the Fed) has continued to raise rates at the fastest pace in history. The US debt ceiling still looms. Meanwhile, weak economic data and a tight lending cycle point towards a recession. Given these factors, it may seem like large-cap investments are a safer choice than small caps. But there’s another side to the story.

What’s really driving the so-called large-cap performance? 

Under the surface, a handful of stocks are responsible for driving most of the S&P 500 Index’s outperformance, which also happen to be the same names driving the Nasdaq Composite Index’s performance. The year-to-date return of an equally weighted S&P 500 stands at a mere 0.57%, nowhere near the 7.28% performance for the S&P 500. As for the Nasdaq, Microsoft, Apple and Meta alone account for approximately 30% of the Index, thus driving its results. We believe large-cap indices currently lack adequate diversification to provide safety in a downturn. Their heavy dependence on a single industry, namely tech, is a vulnerability.

As at May 9, 2023

Large caps seem ready to disappoint 

As of March 8, 2023 (the day before the Silicon Valley Bank failure came to light), the Russell 2000 Index was outperforming the S&P 500 by 274 basis points (bps). Understandably, the bank crisis led to significant outflows from small-cap ETFs into large caps, which seemed safer given the circumstances. Consequently, large caps are currently outperforming. However, it’s crucial to bear in mind two key factors. Firstly, the Russell 2000 is still far more diversified (and therefore safer in our view) than the tech-heavy large-cap index. Secondly, we believe patient investors will be rewarded as valuations normalize. 

In fact, we anticipate that small caps will make a powerful comeback as large caps lose momentum, driven by the following reasons.

1. De-globalization leading to lower margins for large caps: According to Goldman Sachs research, S&P 500 margins have risen by 700 bps since 1990, with 70% of the increase attributed to cost savings on goods and the balance to lower taxes and interest rates. However, with de-globalization on the horizon, we believe it’s just a matter of time before investors reduce their overweight positions in large-cap stocks as their margins dwindle. Instead, they’ll turn to smaller caps, which are poised to benefit from local economies. 

2. Historical data shows that periods of high inflation often correlate with stagnant large-cap performance. Take the 1940s and 1970s – two of the worst decades for inflation in the 20th century.

During the post-WWII period, distortions across supply chains and labour markets fueled a 20% spike in US CPI. Large caps went nowhere for the next four years. Similarly, during the stagflation era of the 1970s, large-cap performance remained flat for over five years while quality small-cap stocks emerged as winners.

Large cap equities were flat for >42 months post-WWII

…and for >5 years during the 1970s inflation shock

If we look at recent large-cap performance amidst soaring inflation, we find a similar pattern across three different time periods. As Mark Twain famously said, “History doesn’t repeat itself, but it often rhymes.”

S&P 500 vs. CPI Change Index

3. Remember the Nifty Fifty stocks of the 1960s? These were the esteemed blue-chip companies of that era – expensive but deemed “safe.” The only problem was, when the tide turned, they plummeted to single-digit multiples almost overnight. Today, the five largest stocks account for 20% of the S&P 500, indicating even worse diversity than the dotcom bubble. It begs the question: where else can they go but down?

4. Analyst estimates for the S&P 500 call for earnings to increase from $204 to $225 (+10%) in 2024. Sounds impressive, right? Yet historically, large-cap earnings do not jump that high coming out of recessions (see chart below). In reality, it was the billions of dollars in stimulus during COVID that propelled S&P 500 earnings to grow at an unprecedented pace. Can we really rely on this trend continuing? 

S&P 500 TTM positive operating EPS (log scale) with exponential trend
Grey bars are negative y/y% “industrial production contractions” (R² = 0.9469)

Take advantage of cheap, high-quality small-cap stocks 

For some time now, low-quality stocks have been more expensive than their high-quality counterparts, primarily driven by inexperienced traders. Jefferies reports that lower return on equity (ROE) names are trading at 4.6x sales, a staggering 60% above their long-term average. In contrast, the highest ROE names are trading at 1.2x sales. In our view, this is a clear signal to avoid these low-quality stocks (which are poised to plummet in value) and focus on quality names with strong fundamentals that currently offer attractive buying opportunities. 

So, what exactly makes a quality company? While there may be varying definitions of quality among experts, we can turn to research done by Hsu, Kalesnik and Kose who identified seven metrics used by popular index providers to define quality. These metrics are: profitability, earnings stability, capital structure, growth in profitability, accounting quality, payouts and corporate investment. 

Quality stocks not only exhibit defensive characteristics but are typically less exposed to macroeconomic influences due to lower operational and business risks. Stronger balance sheets and a consistent track record of predictable profits help mitigate downside risk as well.

The secular case for small caps is intact, with a leadership shift to “old economy” stocks, capex beneficiaries and domestic-focused companies from large caps – all of which bode well for small caps. Valuations of small caps versus large caps currently remain near multi-decade lows, suggesting better returns for small caps over the next decade. 

M&A activity is also heating up. While the market overlooks quality small-cap companies, private equity and strategic corporate buyers are capitalizing on the market dislocation to acquire high-quality companies at attractive valuations.

What’s the impact on your portfolio? 

Large-cap and growth stocks have benefitted from the past decade’s zero-rate policy, low inflation and sluggish nominal growth. However, the current macro landscape is ripe for new leadership, which we believe will come from quality small-cap companies. As the chart below shows, large caps seem due to underperform, creating an opportune environment for small-cap leadership. We believe it’s only a matter of time before this transition happens.

Our portfolio consists of market leaders that are outpacing industry growth. These holdings fit the definition of “Quality Small Cap” with strong industry growth, little to no debt and faster earnings growth. Furthermore, they’re trading at a discount compared to their historical valuations.

As the tide turns against large-cap stocks, these companies are poised to benefit. Not to mention, higher interest rates have the potential to benefit our portfolio holdings, enabling them to gain market share and continue to deliver strong and predictable earnings growth.

Large-cap buyers beware; small caps are coming for you.

The UK has historically been a region that attracts significant takeover interest. In this week’s commentary we look at the increase in activity this year, the reasons why and the potential long-term implications for the UK equity market. 

Several factors have contributed to foreign interest in the UK, including its strong presence in the financial and legal sectors, its industrial heritage, a sizeable consumer market and the widespread use of the English language.

Compared to other G7 economies, the UK government has historically been less inclined to intervene on national security grounds when faced with foreign bids for domestic assets. Between 1997 and 2017, despite accounting for only 3% of global GDP, the UK was involved in 25% of global cross-border merger activity. It is estimated that around 50 UK-based firms eligible for the FTSE 100 Index are now under foreign ownership.

For many years, UK equities have been trading at a larger discount compared to their US counterparts. This can be partly attributed to the differing composition of the respective stock markets. The UK has a larger allocation to lower price-to-earnings (PE) valuation sectors, such as energy and materials, which make up around 23% of the FTSE 100 compared to 7% of the S&P 500 Index. Conversely, information technology represents less than 1% of the FSTE 100 but accounts for 26% of the S&P 500. Even considering these factors, the discount had reached approximately 5% leading up to the Brexit referendum in 2016.

Following the momentous decision to leave the European Union, a “Brexit discount” was applied to UK companies to reflect the structural challenges they would face. Furthermore, recent political turmoil, including three prime ministers within a span of fewer than two months towards the end of 2022, has led to an increased risk premium. Consequently, the discount between UK and US stocks has surpassed 40%.

PE discount between UK and US stocks

It is evident that as the discount has grown, the frequency of foreign takeovers of UK companies has also increased significantly. According to the Office of National Statistics, the number of takeovers valued at £1 million or more was consistently between 100 and 300 annually for the 30-year period preceding the Brexit referendum. Since then, the number has exploded. 

This was evident in the first quarter of the year when the deal closed for one of our former UK holdings, Biffa plc (BIFF.LN). Another of our UK holdings, global flexible workspace provider IWG (IWG.LN), has previously attracted takeover interest, while Coats Co. (COA.LN), a global leader in threads, was acquired in the past and later delisted before being relisted a decade later.

A thriving stock exchange can benefit the economy and society as a whole. The capital provided by exchanges enables companies to grow which, in turn, means they employ more people and contribute more taxes for wider public services. However, the number of companies listed in London has almost halved from 2,101 in 2003 to 1,097 today. While this still leaves ample attractive opportunities for investment, the increase in takeovers is just one piece of the puzzle. Another factor has been the decline in new listings. Recognizing the need to adapt and attract more listings, the UK’s financial watchdog, the Financial Conduct Authority, has proposed measures aimed at enhancing the country’s appeal for domestic companies. This follows cases such as UK-based microchip giant Arm, owned by Softbank, opting to list in the US. While streamlining the listing process may remove certain barriers and improve competitiveness, it should not compromise shareholder rights.

The persistently low trading multiples of UK equities leave them susceptible to foreign takeovers. While Global Alpha does not base its investment theses solely on potential takeovers, we acknowledge that it has always been a potential tailwind for the small-cap asset class, and we anticipate heightened takeover activity in 2023. 

In recent years, the U.S. federal government’s debt and deficit have been hot topics in the news. The term “debt ceiling” has once again made headlines after Treasury Secretary Janet Yellen warned that the U.S. government could run out of money by June 1. It’s important to understand what the debt ceiling is, why it needs to be raised and how it can impact financial markets.

What is the debt ceiling?

The debt ceiling is the maximum amount the U.S. Treasury can borrow from the public and governmental accounts. Governments, like individuals, must borrow money when they spend more than they earn and they do so by issuing bonds.

The U.S. has had a debt ceiling for over 100 years, first established in 1917 at $11.5 billion. Prior to this, Congress authorized the government to borrow a fixed sum of money for a specified term. After the loans were repaid, the government could not borrow again without asking Congress for approval.

The debt ceiling was created in 1917 under the Second Liberty Bond Act to make it easier to finance WWI. It allowed for a continual rollover of debt without congressional approval. However, increasing government obligations have led to rising government debts to make up the shortfall between tax revenue and government spending.

What are the issues with raising the limit?

To issue more bonds, the U.S. Treasury must increase the debt ceiling. This has been done without incident for decades, with policymakers raising the limit 89 times since 1959. Most recently, in December 2021, the debt ceiling was raised by $2.5 trillion to $31.4 trillion, projected to fund obligations through mid-2023.

US debt ceiling raises keep pace with the growing national debt (in billions of US$)

Debates surrounding the debt ceiling have become more contentious in recent years. Disagreement has led to two federal government shutdowns in the late 1990s and a 2011 fight that resulted in volatile financial markets and Standard & Poor’s downgrading of the U.S. government’s credit rating for the first time in history. In addition to political reasons, resistance against raising the debt limit has often come from concerns about the sustainability of the massive government debt balance.

The current public debt outstanding is $31.457 trillion, with each U.S. citizen’s share being around $95,000. Economists and government officials often cite the debt-to-GDP ratio, which measures how much of the annual production would be required to pay off the public debt. The U.S. government’s debt-to-GDP ratio of 148% ranks the fourth highest globally, after Japan, Greece and Italy.

What is the likelihood of the U.S. repaying its debt?

In recent decades, the U.S. government has been in deficit almost every year, except for a surplus between 1998 and 2001. It is projected that the government will continue to run deficits until at least 2028, making it unlikely that the government will be able to repay any debt in the foreseeable future. Instead, more debt will likely be added.

US government surplus of deficit, 1993 – 2028 (dollar amounts in billions)

Until recently, the cost of issuing debt to finance federal operations was minimal. However, with rising interest rates, the average interest rate on federal debt has risen to 2.07% in 2022 from 1.6% in 2021. The Congressional Budget Office estimates that interest costs will triple to $1.3 trillion in 2032, becoming the largest federal budget item and surpassing Social Security and Medicare by the middle of the century.

These developments raise concerns that the world’s largest economy may not be able to meet its financial obligations. As a result, the credit default swap (CDS) against a U.S. government default has risen sharply since the beginning of 2023. On May 4, one-year U.S. government CDS reached 152 basis points (bps), up from 10 bps a year earlier and the highest since the 2008 financial crisis. Although the U.S. has never defaulted on its debt, investors are becoming increasingly anxious about the possibility.

What could happen if the U.S. debt ceiling is not raised?

The U.S. government would be unable to borrow money to finance critical obligations, such as Social Security, tax refunds and federal workers and military salaries. This would result in a severe stock market decline and could damage the reputation of the U.S. as a reliable business partner. Interest rates would skyrocket, potentially causing a U.S. or global recession. The dollar may lose its status as the global reserve currency and drop significantly in value.

While the government could resort to temporary financial measures, such as minting a $1 trillion platinum coin, a more sustainable solution is required to address the gap between revenue and spending. This could involve increasing tax rates, reducing expenditures or both.

The debt issue, combined with the tightening credit cycle following the banking crisis, means that borrowing to fuel growth will become increasingly challenging and expensive. Companies with high leverage may face higher interest burdens.

Evaluating financial health to deliver long-term value

We believe investing in companies with strong financial positions, diversified revenue streams, good profitability and no reliance on government subsidies for growth is essential. We take a disciplined approach to investing and carefully evaluate the financial health of the businesses we invest in. Half of the companies in our International Small Cap strategy and a third in our Global Small Cap strategy are in a net cash position. Our portfolios are well positioned to weather economic uncertainties, with a focus on delivering long-term value to our clients.