If you focus on the downside risk, the upside return will take care of itself




Thursday, 18 December 2014

US Macro policy - the theory and the practice

We follow the macro situation to be aware of potential big problems and to guide us on asset allocation. US macro policy can be defined as follows in the last few years:- (1) Keep rates low, this will encourage capex spending (2)Buy bonds to reduce the rate, this will force the market to take on more risk, increasing asset prices and increasing wealth, this will increase consumer spending (3) Growth will reduce the debt/GDP ratio. If GDP growth is greater than the cost of debt the country can deleverage It sounds great on paper. However, QE by itself does not improve the economy. Its aim is to increase
animal spirits
- so demand is created by businesses willing to take risks by investing and consumers willing to spend. However, we have found the following happen:- (1) Low rates have decreased the income from cash deposits. With a growing elderly population who have reduced their risk profile this may mute demand. (2) Capacity utilisation has been below average why should businesses invest? Especially if consumer spending has been affected by low real wage growth, little credit availablility, and low deposit rates. The demand has not been there. So why should companies borrow to invest in capex. Better to borrow and buy back stock where earnings yields are lower than borrowing costs. However, higher asset prices only benefit those who are shareholders. This is often those with excess savings, hence the wealthy. Hence QE exacerbates the difference between the haves and have nots which can create social tension. (3) Total debt has not decreased. It has shifted from the problem of a few companies or consumers, to a problem of the whole country (i.e. the government). However, it maybe possible that a critical point is being reached in the US. Employment may be reaching a critical mass where real wages may start increasing. This will boost consumer confidence which can increase consumer spending, this may explain what seems to be the strong start to the Christmas retail season. Credit is becoming more available as US banks are now well capitalised. If this increases spending in the economy and GDP growth increases such that the US economy can start deleveraging, the economy will be improving in almost all metrics. This could even start a slow and gradual increase in rates increasing the income of low risk investors. This would be a virtuos cycle indeed and would be an important moment for central bank policyholders - who would deserve to be congratulated. However, due to the success so far relative to other countries the USD has started to appreciate. Though the trade defecit is shrinking as foreign oil demand is weakening due to large energy reserves found inhouse, it may affect the export market. For the Americans however this may be benefited by weaker commodity prices, which often have a strong correlation to the USD as they are transacted in USD.

Technical investing and risk management

I must admit a certain innocence in the use of technical investing. A close friend and respectable investor continuosly highlights its usefulness in investing. For example, this individual would buy into a stock weighting the size of the investments on the volatility of the stock. More volatility, lower initial position. I find this approach incomplete. For example, why not size positions comparing volatility of the stock price on volatility of cash flows. If cash flows are volatile and the stock price is volatile this merits a smaller initial position than a company whose cash flows are quite stable historically, and we believe they should not become considerably more volatile in the future. This way we connect market prices to company value generation. His second rule is he would buy once, buy twice, three out. Another rule is setting a limit on how much lose you would take. This seems sensible and I try to ensure no single position can suffer a more than 1% loss on the portfolio in my worst case scenario (which of course can be wrong - and has been in the single case of Tesco so far). Indeed, this viewpoint is what finally deceides the position size of a stock. However we must be careful. A long term investment philsophy based on understanding a business should not apply a trading risk management strategy - each process is built for a different strategy and combining them is likely to not be an optimal manner to manage assets.

The market is always weighting different factors differently, this leads to volatility of stock prices

The markets are a curious place because pricing at different points in time are dominated by different factors. Often macro factors dominate over sector and company specific issues. This results in higher correlation between stock prices in different sectors. Sometimes the market over emphasises quarterly results, meaning an up or down surprise can lead to violent changes in stock prices. Some investors spend considerable time understanding the mood of the market and understanding quantitatively what factors it is focusing on. I dont do that because this takes considerable time and does not suggest a clear cut investment as an output. Instead we focus on businesses we understand, and appreciate in a qualitative manner when the market mood is different by the way it values the same businesses differently. This can provide opportunity. We often find unlucky or lucky timing of events can pay a large role in market pricing. A large acquisition that perhaps was expensive can lead to the stock price of the company declining. A bad patch in the market can then exacerbate this decline followed by a bad sector issue can lead to carnage on the stock price of a company that was initially driven by a company specific event and then taken further down with market and sector issues. This can lead to mis pricing due to herd behaviour. It should be noted with ETFs taking greater market share of stock market volume this pricing momentum may increase.

Sunday, 4 August 2013

Behind asset allocation decisions, lies inflation

Buying bonds just to (1) reduce volatility in the portfolio (buy 5 year bonds of high quality company) and (2) generate an attractive income over cash, or to have (3) capital appreciation when interest rates fall, these sources of returns for bonds have been taken away. Only real source available now is the (4) credit profile of a company increases so the yield decreases, hence the price goes up. I guess this is why many investors are in high yield and high risk bond investments at the moment. An increase in interest rates can create marked to market losses from a decline in prices. Yields are in absolute terms low. There is little opportunity cost to cash and the risk/reward seems poor. Risk of interest rates increasing, default, regulatory risk if have low capital structure securities of banks or telecom and utility companies, inflation risk, having equities being cheaper offering a higher return (but can always sell the bond with a 10% loss and buy the equity which would have dropped much more). Meanwhile if you dont know what is happening may be better to be invested in bonds and generating the income? The reward is 2 or 3%. I guess it is still 1.5% more than cash. But for how long will cash stay there. I guess that is the final question which will determine whether you buy bonds, or be underweight bonds and overweight cash. I have been the latter. So far it has been wrong as it has detracted from returns. The equities have done well, but the bonds should have helped more to contribute to returns. We are in a period where both bonds and equities are performing positively. This correlation will eventually break down. Increasing inflation is usually the factor that makes this relationship break down. Decreasing or steady inflation allows the conditions for there to be a positive correlation between bonds and equities. Inflation is the great unknown, and one should always try to hedge against it and have a minimal exposure to companies that can be hurt harshly by it.

Bonds: careful on how its role in many portfolios is changing

When I started investing, my vision for the role of bonds in a portfolio was to help produce a steady source of income greater than the cash rate, whilst providing only a small increase in risk relative to the cash position (i.e. we did not see the risk of the issuer we bought being greater than the average bank that is holding your deposits! In fact, we would only buy the bond if we felt the bankruptcy risk was quite remote). Hence a 40% allocation to bonds offering a 5 to 6% source of income (in those good old "normal" times) supported a 60% exposure to equities that were expected to generate around a 10% return per annum over the business cycle. This would allow a portfolio to credibly generate around 8% per annum over the business cycle with the bonds reducing the volatility in the portfolio, which many clients are so afriad of (at this moment I don´t chose my clients, but deal with clients from private banks, many who are lead to believe that volatility is risk in investing: a fact that would be ridiculous for them to consider if it was applied in there family/corporate businesses). However, today this role of bonds is quite limited. Rates are so low for the senior bonds of high quality corporates with duration less than 6 years that the small premium to cash rates today are substantially below the average cash rates for the currencies we deal with (for hard currencies you can assume the average cash rate over the last 100 years is around 4.5%). It is not silly to think that current cash rates will converge to the average over the next 6 years. So to generate that 5 to 6% in bonds today one must buy fixed income securities that are lower in the capital structure. This introduces the world of subordinated and perpetual bonds, as well as preferred shares, contingent convertible securities and the like. In a sentence: you are forced to increase risk to generate the same income. However, since in your portfolio statement all these securities fall under the BONDS section, many still assume it to be near risk free, or at least considerably less risky than equities. Again, as is often the case, the problem is how we define risk. The word risk without an adjective is meaningless. Are you afraid of the size of price risk (i.e. volatility), duration risk (the affect interest rates may have on the price of your investment security), bankruptcy risk, lack of income being generated in your portfolio etc. Depending on what your objective is, it will affect which risks you will be willing to take. For me, my view of bonds has changed, at least for the moment. When I look at great investors I see many don`t buy high quality bonds, but buy junk bonds. I guess if you focus on high quality companies to buy their equity, their is some logic to take advantage of the seniority of debt and focus on the average companies. When you buy a quality stock you often ask will the company prosper. But when you buy a bond, since you do not share in the profits, you only need to ask the question, will they survive. Indeed, I compare this strategy to buying net nets. These are companies that often have deteriorating operating results, but often have no debt on their balance sheet. Hence buying the equity is effectively equivalent to buying the bond. However, in this case you have the potential of a strong capital appreciation as well as any income that may be offered to shareholders. The question would be, is it more fruitful to invest in net nets of poor companies, or the senior debt of poor companies; which historically offers the more attractive return. Note should your analysis be wrong and the company goes through chaper 11 (in the US), as a bond holder you then become the shareholder of effectively a net net company (so you get a second chance!). With a net net unexpected costs may accrue leading to a lower return of capital than expected (book value is often much less in bankruptcy than it is stated on the balance sheet). However, junk bonds role in the portfolio will not be to reduce volatility! But will be there because the risk/reward is attractive and merits its position over cash. This is the only way I think it makes sense to build portfolios. Not to assume what correlations between asset classes may be, or make macro assumptions the pillar of your asset or security selection. You focus on the risk/reward of each investment. If the potential risk adjusted return is offering a satisfactory return greater than cash, it should be considered a worthy investment. Unfortunately client facing institutions rarely think like this. Instead their aim is to make money every year, every quarter, every day. Indeed, it is for this reason value investing continues to make above average returns. The vital ingrediant of patience is simply lacking from our important financial institutions. As a side note, if it was up to me I would focus on working with clients that (1) define risk as the potential of permenantly losing capital, (2) are keen on buying the securities of good companies at good prices, and (3) assess the performance of there investments over a three year period (over apprx. half the business cycle). A client who understands and agrees with the investment philosophy of their investment manager is more likely to have a fruitful relationship in terms of results, and to be more aware when the situation requires patience, or if their manager is sub par. If you cannot explain an idea to a client in a few minutes, it is not worth investing in their portfolio. Transparency and understanding leads to loyalty, and the best possibility of generating good results.

Sunday, 4 November 2012

The role of inflation in valuation

Our simple approach to valuation was described in a recent blog. However, though simple, we find it to be effective in focusing on what really matters: long term corporate profitability - rather than terminal values, theoritical discount rates or the volatility of stock prices. We would like to show the power of this model by focusing on how high inflation can affect the pricing of the stock market. Many readers are aware that during the 70s inflation rates increased and the stock market reached a valuation close to x7 earnings, a large displacement from its historical average of x16 earnings. When the value of money is perceived to decrease over time, it is rational that investors want to pay less for future cash flows, hence the multiple of the market contracts. However, focusing on those companies that have more manageable costs (consider their cost structure, its operational efficiency to competitors and the margin of the business) and pricing power, inflation over the long term will cause little permenant damage. If anything, it can increase their market share as competitors have a more difficult time, allowing the strong to become stronger. Focusing on these companies means we do not need to alter our x15 multiple on free cash flow generated. We do not adjust our multiple on macro fears: because these class of companies have suffered a number of macro issues over their many decades of existence. Their flexible management team often handle the event better than competitors, and they have the resources, balance sheet and cash flow to overcome it. Hence when we see x7 multiples as market continue to go down, we have a lens to generate the strength to buy. Of course macro environments can change our margin of safety: rather than 35% in a high inflationary environment it will be 45%: but if our approach suggests a buy, we must be ready to fight our stomachs, the biggest problem of an investor.

Saturday, 3 November 2012

How we can lose money

There are several situations we try to avoid where we think the probability of loss is too high for us to find the return interesting, irrespective of how large it may be potentially. (1) High leverage, non consistent free cash flow and/or non liquid high quality assets combined (2) No revenue growth and declining margins, yet high FCF yield (3) Small FCF yield (overpaying) (4) Capex heavy cost base creating problems in an inflationary environment from high spending and high borrowing costs to fund the maintenance capex (5) Decreasing demand (i.e. product substitution) (6) Increasing supply (including changing market structure) (7) Quality of business model declining