In our view markets are currently being priced assuming an optimistic growth scenario for the economy in general. As a result, LTIM are now reducing positions in cyclical companies/sectors/industries. We should add we are finding it harder to purchase companies at good prices considering their stable earning power.
A good price is a rather subjective concept, confirmed by speaking to several investment advisors whom will give several different responses. For LTIM it has a rather precise concept. It means we pay a reasonable multiple for stable free cash flow generation, whereby the yield we expect to receive at the price paid is higher than the return we expect to achieve from our portfolios (which is cash rates + 3% over a three year average). As a result, any growth will effectively come for “free”. At current market prices, few companies are offering growth for free. Hence our difficulty in purchasing companies on a stable earning power basis.
However, we are not building up a cash position larger than 15-20% of the portfolio in an environment where inflation risks seems to be increasing. Whilst we are reducing cyclicals, we will not simply wait for the next market crash to occur. Whilst growth assumptions have to become more aggressive to purchase a stream of future earnings, companies trading at market prices below their net physical assets are still available in certain industries. This is the domain of the asset play strategy. In this domain, net physical assets are at least as important as future free cash flow.
Asset play strategies usually involve the purchase of companies that are currently unloved. Investor demand for visible earning growth ensures that earnings, rather than assets, is the variable markets are most sensitive to when placing a price on a company that is publically traded on a stock exchange. We see this from the way stock prices shift aggressively if reported earnings are greater or less than estimated, by the format of analyst reports that emphasis the earnings evolution of a company in the next 12 months, as well as the way companies are crudely valued by many market participants applying a multiple on estimated short term earnings.
This focus on short term earnings can be physically measured by viewing how investors are allocating capital in the equity markets. For example, in the US the average holding period of a common stock in 1940 was around 7 years. In 2007, the average holding period was 7 months. It seems no one wants to forecast a companies earnings beyond 2 quarters. That seems to fit in well with what my hedge fund buddies say, and do.
The aim of the asset play is to try and take advantage of this “time arbitrage” that seems to exist in publically traded securities. It is common knowledge that certain asset heavy companies that suffer cyclical stress or poor news can be bought on the secondary market at a price considerably cheaper than their net real assets. However, assets plays can remain asset plays for a considerable period of time, which can dilute the potential return of the investment strategy.
In LTIM asset plays we therefore look for a specific catalyst that can reveal the hidden value within a companies balance sheet. In this environment, for a short period of time, the assets can lead the stock price, as opposed to the earnings. Marty Whitman would refer to such a catalyst as resource conversion, an important source of return for the value investor. The catalyst usually comes in the form of a new owner holding the asset. Hence relevant market transactions would be a new aggressive passive or majority shareholder, a merger or acquisition, or the selling of assets. Such a market based transaction can make visible the discrepancy between the price of the asset on the balance sheet and its true value in the market. As a result, the price to book ratio expands.
Asset plays are an interesting diversifiaction in a portfolio when growth assumptions become too aggressive, as is the case now for many companies we would like to own, but are not happy with the prices they are currently available. Furthermore, for those investors who fear inflation, such asset plays are an interesting way to gain access to physical assets at a relatively good price, which does not seem to be available via purchasing commodities via spot or futures markets at the moment.
In practice, we often combine an asset backing with a stable earning power assumption. As a result we feel comfortable the potential for a permanent loss of capital is minimal due to the net assets behind the company if a liquidation was to occur, whilst any growth in future earnings will come for free. As a result returns are likely to come from earnings, but a resource conversion event is a possible bonus. We like the risk -return characteristics of such investments when the price is right. Many opportunities are being provided in such unloved sectors as real estate - a sector much loved by everyone only a few short years ago...
Monday 27 December 2010
Monday 15 November 2010
A sovereign crisis
The words have been so frequently used over the last 18 months that they have lost much of their weight.
A sovereign crisis, for those who need reminding, is a very serious issue indeed.
When a country continuously uses capital it has accumulated from successful ventures in the past in an unproductive manner, the return on that capital is lower than what it once was. This creates a difference between the liquidity expected and the liquidity you have. This creates an incentive to borrow. Often, at this stage of the evolution of an economy, few are aware of where in the cycle this once great economy is at. Historians such as Giovanni Arrighi have discussed such “supercycles” in great detail, describing the evolution of an economy, an evolution that is eerily similar irrespective of the economy or the period we look at.
An economy with a great recent history ensures that borrowed funds are easily accessible, even from those economies that are currently generating higher returns. However, without a change in behavior, attitude, management etc, these funds also generate below average historic returns. This continues whilst lenders/investors belief this is a blip from the continuation of the growth of a great economy. However, at one point, the game changes. Though we are strong believers in mean reversion, understanding the drivers of an economy, market, industry, company, are vital to identify when the dynamics of the game changes. Looking at figures is simply not enough.
At this point there is an understanding that returns on capital are potentially lower for these economies, and may be permanently so without change. This realization in itself makes it harder to fight this tendency. The market will adjust their sentiment by increasing the cost of borrowing for this economy, by reducing the flow of capital towards it. These changes will make it harder with the same resources to generate returns that were achievable in the past. We have feedback loops appearing that are so inherent to market based systems. It is these feedback loops that make the transition from bubble to bust so rapid, and therefore, so dangerous.
So how can this economy grow itself out of trouble?
By using the same capital to generate more return. This can come from 4 prinicipal ways, which are not mutually exclusive:-
1. Reducing costs to generate the same product
2. Being innovative and generating a new product that can offer higher margins
3. Being more organized to develop the same product than your competitors. As a result, you are more efficient
4. Develop the same product at the same cost but have a weaker currency
Unfortunately, points 1 aqnd 4 have been making the headlines recently. The worst solutions.
When investors realise that growth is weak, cost management becomes the focus to try and increase margins. However, this is to the detriment of everyone, as the quality of life will decrease as wages fall and the number of unemployed increase. It is at this moment in time that innovation, a culture to learn, explore and develop must come to the fore to develop new solutions so that capital can flow into these economies again - not because they make the same product cheaper.
Conclusion
The lack of growth from the unproductive usage of capital in developed economies created a heavy debt burden that, for a moment in time, masked the structural growth problems inherent in these economies that resulted from globalisation. Now that debt is a heavy burden which forces the same economies to focus on cost cutting to reduce that burden. This will lead to a transfer of wealth from developed to developing countries.
It is an uncomfortable position to experience, but it must be done. The debt burden must be reduced so new capital can be available to chase new, more productive, projects. Ideally it should be done via creation, by value generation. Having new projects today to invest in. However, inevitably, pain must also be suffered via the reduction in the quality of life for many as consumer spending is replaced by greater savings to pay down debt.
There are some signs, however, that are creating even more fear within me. Negative real interest rates are providing a strong incentive to move from cash to real assets. There is an opinion that this could carry on for an "extended period of time". It is understandable, debt was the straw that broke the camels back, and the authorities do not want to increase the cost of that burden whilst the economy is so fragile. It is this reasoning that led us to believe that rates would stay low in 2009 for many years, as we wrote to our clients back then.
However, it seems there is appearing a 5th option in how to increase the return of an economy, and it has little to do with the real economy, it has to do with the role of asset markets. I fear that asset markets are being used as a transmission channel to inject liquidity into the economy, particularly so in the US, as the financial system has yet to recover from its shock in 2008 (as detailed in many recent blogs).
The distortional rising of asset markets and weakening of a currency are an interesting mix that generate the desired results on paper, in theory. However, in theory there is no difference between theory and practice. In practice there is...
PS. History suggests all great economies die eventually from the unproductive usage of capital; be it for war, lack of innovation or poor spending. Developments in the financial system over the last 300 years has meant once great economies can go a little bit longer by using other peoples money via borrowing. Modern economies therefore often die from being bloated in debt, taking on more than their economy can handle. Once the cost of debt is consistentñly greater than the GDP growth of an economy, it is the beginning of the end. In a market based system, destruction would be swift and fatel.
A sovereign crisis, for those who need reminding, is a very serious issue indeed.
When a country continuously uses capital it has accumulated from successful ventures in the past in an unproductive manner, the return on that capital is lower than what it once was. This creates a difference between the liquidity expected and the liquidity you have. This creates an incentive to borrow. Often, at this stage of the evolution of an economy, few are aware of where in the cycle this once great economy is at. Historians such as Giovanni Arrighi have discussed such “supercycles” in great detail, describing the evolution of an economy, an evolution that is eerily similar irrespective of the economy or the period we look at.
An economy with a great recent history ensures that borrowed funds are easily accessible, even from those economies that are currently generating higher returns. However, without a change in behavior, attitude, management etc, these funds also generate below average historic returns. This continues whilst lenders/investors belief this is a blip from the continuation of the growth of a great economy. However, at one point, the game changes. Though we are strong believers in mean reversion, understanding the drivers of an economy, market, industry, company, are vital to identify when the dynamics of the game changes. Looking at figures is simply not enough.
At this point there is an understanding that returns on capital are potentially lower for these economies, and may be permanently so without change. This realization in itself makes it harder to fight this tendency. The market will adjust their sentiment by increasing the cost of borrowing for this economy, by reducing the flow of capital towards it. These changes will make it harder with the same resources to generate returns that were achievable in the past. We have feedback loops appearing that are so inherent to market based systems. It is these feedback loops that make the transition from bubble to bust so rapid, and therefore, so dangerous.
So how can this economy grow itself out of trouble?
By using the same capital to generate more return. This can come from 4 prinicipal ways, which are not mutually exclusive:-
1. Reducing costs to generate the same product
2. Being innovative and generating a new product that can offer higher margins
3. Being more organized to develop the same product than your competitors. As a result, you are more efficient
4. Develop the same product at the same cost but have a weaker currency
Unfortunately, points 1 aqnd 4 have been making the headlines recently. The worst solutions.
When investors realise that growth is weak, cost management becomes the focus to try and increase margins. However, this is to the detriment of everyone, as the quality of life will decrease as wages fall and the number of unemployed increase. It is at this moment in time that innovation, a culture to learn, explore and develop must come to the fore to develop new solutions so that capital can flow into these economies again - not because they make the same product cheaper.
Conclusion
The lack of growth from the unproductive usage of capital in developed economies created a heavy debt burden that, for a moment in time, masked the structural growth problems inherent in these economies that resulted from globalisation. Now that debt is a heavy burden which forces the same economies to focus on cost cutting to reduce that burden. This will lead to a transfer of wealth from developed to developing countries.
It is an uncomfortable position to experience, but it must be done. The debt burden must be reduced so new capital can be available to chase new, more productive, projects. Ideally it should be done via creation, by value generation. Having new projects today to invest in. However, inevitably, pain must also be suffered via the reduction in the quality of life for many as consumer spending is replaced by greater savings to pay down debt.
There are some signs, however, that are creating even more fear within me. Negative real interest rates are providing a strong incentive to move from cash to real assets. There is an opinion that this could carry on for an "extended period of time". It is understandable, debt was the straw that broke the camels back, and the authorities do not want to increase the cost of that burden whilst the economy is so fragile. It is this reasoning that led us to believe that rates would stay low in 2009 for many years, as we wrote to our clients back then.
However, it seems there is appearing a 5th option in how to increase the return of an economy, and it has little to do with the real economy, it has to do with the role of asset markets. I fear that asset markets are being used as a transmission channel to inject liquidity into the economy, particularly so in the US, as the financial system has yet to recover from its shock in 2008 (as detailed in many recent blogs).
The distortional rising of asset markets and weakening of a currency are an interesting mix that generate the desired results on paper, in theory. However, in theory there is no difference between theory and practice. In practice there is...
PS. History suggests all great economies die eventually from the unproductive usage of capital; be it for war, lack of innovation or poor spending. Developments in the financial system over the last 300 years has meant once great economies can go a little bit longer by using other peoples money via borrowing. Modern economies therefore often die from being bloated in debt, taking on more than their economy can handle. Once the cost of debt is consistentñly greater than the GDP growth of an economy, it is the beginning of the end. In a market based system, destruction would be swift and fatel.
Saturday 6 November 2010
Want to work, forget it, let someone else work for you!
Dear Reader,
Today’s message has no doubt been better transmitted from daily experience than a few words from me.
Globalisation has meant that developed countries have experienced weak wage growth over the last 10 years, as developing countries have offered a considerably cheaper option.
This has not meant that prices for products have fallen. It has meant we had to borrow to keep the same quality of life and that companies have enjoyed larger profit margins.
It is likely that wage declines in developed countries will continue if globalisation continues in its current state.
If we combine the top heavy population structure that many developed economies are experiencing (i.e. larger proportion of population greater than 50 than less), then we are also likely to have an increasing tax burden. This will reduce further the purchasing power of consumers.
--It is for this reason that I often say the principal drivers of an economy are the education of its people (hence its innovation output, new companies generated, greater exports etc) and its demographics. In its purest form, this is macroeconomics . Everything else is mere detail. Good politicians must always be aware of these variables and the affect they have on a country (of course the output may not be measured for years and a particular party may never be recognised for policies that created a positive long term economic environment. Hence, few politicians practice this otherwise logical strategy until disaster happens).--
In such a difficult environment, the incentive to work for a wage will decline relative to what we have experienced during the 80s and 90s. This will no doubt cause political and economic tension, as we have already started to experience.
It is in this respect that investing in the business of high quality corporate seems more fruitful, and offers a nice hedge, against simply earning a wage. Let the corporate do the work for you! Clearly, for this to work, you need to have the capital. Start saving before there won´t be anything left of your wage to save!
Of course, investing is not something you just decide to do one day (you can, but the probability of it being successful are likely to be slim). Furthermore, if you decide to develop a criteria to become a continuously better investor, the returns will not offer the stability of a wage. Furthermore, it is important to note that from the data I receive more people have been burnt from investing than working for a wage....
Yours sincerely,
Alessandro Sajwani
Today’s message has no doubt been better transmitted from daily experience than a few words from me.
Globalisation has meant that developed countries have experienced weak wage growth over the last 10 years, as developing countries have offered a considerably cheaper option.
This has not meant that prices for products have fallen. It has meant we had to borrow to keep the same quality of life and that companies have enjoyed larger profit margins.
It is likely that wage declines in developed countries will continue if globalisation continues in its current state.
If we combine the top heavy population structure that many developed economies are experiencing (i.e. larger proportion of population greater than 50 than less), then we are also likely to have an increasing tax burden. This will reduce further the purchasing power of consumers.
--It is for this reason that I often say the principal drivers of an economy are the education of its people (hence its innovation output, new companies generated, greater exports etc) and its demographics. In its purest form, this is macroeconomics . Everything else is mere detail. Good politicians must always be aware of these variables and the affect they have on a country (of course the output may not be measured for years and a particular party may never be recognised for policies that created a positive long term economic environment. Hence, few politicians practice this otherwise logical strategy until disaster happens).--
In such a difficult environment, the incentive to work for a wage will decline relative to what we have experienced during the 80s and 90s. This will no doubt cause political and economic tension, as we have already started to experience.
It is in this respect that investing in the business of high quality corporate seems more fruitful, and offers a nice hedge, against simply earning a wage. Let the corporate do the work for you! Clearly, for this to work, you need to have the capital. Start saving before there won´t be anything left of your wage to save!
Of course, investing is not something you just decide to do one day (you can, but the probability of it being successful are likely to be slim). Furthermore, if you decide to develop a criteria to become a continuously better investor, the returns will not offer the stability of a wage. Furthermore, it is important to note that from the data I receive more people have been burnt from investing than working for a wage....
Yours sincerely,
Alessandro Sajwani
A Glorious Time to Enjoy Risk Assets...
Dear Reader,
Well, it looks like we passed 1,200 on the S&P 500, the FTSE 100 passed 5,800 and just about every equity market is rallying, presumably because investors have decided that central banks will try and inflate asset prices to help boost "consumer confidence".
Many of you have increased equity exposure to 40%, a suitable exposure to this asset class at the moment. I must admit, personally, I am starting to put on my selling hat. We suggest you consider getting that hat out of the cupboard and dusting it off.
Though recent news is a powerful boost to asset prices, we seriously doubt pumping asset prices with morphine (i.e. increasing the price of a piece of paper), will be the long term solution to slow growth in developed economies. These are structural problems that depend on the cost of labour, the skills of a countries people (i.e. education, attitude etc) and their demographics. The debt burden is of course an important issue. As a consequence, the role of morphine is most uncertain.
Investors are suggesting enjoy the party, don't fight the FED, overload on risk assets. In the short term, this may well prove to be the most lucrative strategy. However, we express a sound of caution. It is a probable event that the drop will be faster than the rise if:-
1. The last drop of morphine is injected and their has been no "perceived positive outcome". Furthermore, It still is not clear to me what the criteria is to deem the project a success
2. Your body has after effects on the morphine....inflation...other central banks react....
3. You become addicted.............Markets drop unless QE keeps continuing...
The environment is being created where speculation is the game, not investment. The best predictor of an investments performance is its entry price relative to its underlying value (clearly a subjective concept). However, I believe that is as good as it gets. Understanding that Mr. Market has mood swings is beneficial to getting the right price, attempting to predict them, is a more dangerous game.
Though it seems likely that within the next 6 months the S&P 500 could reach 1,300, if this occurs, your return will have little to do with company valuation relative to political meddling.
This distortion of asset markets is most worrying. Though with valuations as they are I would be normally making a louder noise to sell risk assets, the continuous intervention by politicians means there could well be room for further distortional rises in pricing. However, I suggest to all that your selling hats should be close to hand and that cyclical or capital intensive companies you have bought over the last 12 – 18 months, you should consider taking at least the profits. Being dependent on your local politician for a quick buck....need I say more....is not a dependent strategy. Only high quality companies, as an equity category, offer a relatively sound valuation at the moment.
Apologies for my bickering, but everyone has become so positive that I feel obliged to remind us that we quite possibily living in an illusionary world.. it may last longer than a honey moon, but buyer beware.......
Yours sincerely,
Alessandro Sajwani
Well, it looks like we passed 1,200 on the S&P 500, the FTSE 100 passed 5,800 and just about every equity market is rallying, presumably because investors have decided that central banks will try and inflate asset prices to help boost "consumer confidence".
Many of you have increased equity exposure to 40%, a suitable exposure to this asset class at the moment. I must admit, personally, I am starting to put on my selling hat. We suggest you consider getting that hat out of the cupboard and dusting it off.
Though recent news is a powerful boost to asset prices, we seriously doubt pumping asset prices with morphine (i.e. increasing the price of a piece of paper), will be the long term solution to slow growth in developed economies. These are structural problems that depend on the cost of labour, the skills of a countries people (i.e. education, attitude etc) and their demographics. The debt burden is of course an important issue. As a consequence, the role of morphine is most uncertain.
Investors are suggesting enjoy the party, don't fight the FED, overload on risk assets. In the short term, this may well prove to be the most lucrative strategy. However, we express a sound of caution. It is a probable event that the drop will be faster than the rise if:-
1. The last drop of morphine is injected and their has been no "perceived positive outcome". Furthermore, It still is not clear to me what the criteria is to deem the project a success
2. Your body has after effects on the morphine....inflation...other central banks react....
3. You become addicted.............Markets drop unless QE keeps continuing...
The environment is being created where speculation is the game, not investment. The best predictor of an investments performance is its entry price relative to its underlying value (clearly a subjective concept). However, I believe that is as good as it gets. Understanding that Mr. Market has mood swings is beneficial to getting the right price, attempting to predict them, is a more dangerous game.
Though it seems likely that within the next 6 months the S&P 500 could reach 1,300, if this occurs, your return will have little to do with company valuation relative to political meddling.
This distortion of asset markets is most worrying. Though with valuations as they are I would be normally making a louder noise to sell risk assets, the continuous intervention by politicians means there could well be room for further distortional rises in pricing. However, I suggest to all that your selling hats should be close to hand and that cyclical or capital intensive companies you have bought over the last 12 – 18 months, you should consider taking at least the profits. Being dependent on your local politician for a quick buck....need I say more....is not a dependent strategy. Only high quality companies, as an equity category, offer a relatively sound valuation at the moment.
Apologies for my bickering, but everyone has become so positive that I feel obliged to remind us that we quite possibily living in an illusionary world.. it may last longer than a honey moon, but buyer beware.......
Yours sincerely,
Alessandro Sajwani
Friday 5 November 2010
The Politicisation of Asset Markets
Dear Reader,
Extract from a private letter issued 29.09.10
We aim to achieve 8% compounded annual growth rate in the long term (5 year measure). However, in a year like 2010, where my expectation was that developed equity markets would be flat, we were aiming to achieve 6%. We are slightly over performing, but as usual, the forecast was wrong (I could argue only slightly, at least for the moment!).
YTD performance of major equity market indices (remember, this is NOT net of fees):-
FTSE 100 + 4.89%
Eurostoxx 50 - 4.02%
S&P 500 + 6.15%
Nikkei 225 - 12.74%
Hang Seng China + 2.49%
Brazil Bovespa + 2.52%
NSE Nifty (India) Index + 15.22%
However, if we assume that you had converted EUR to USD on 31st December 2009 to
invest in the S&P 500 on the same day, your performance would actually be very close to 0.0%!
The aim of this perhaps rather long letter is to inform you, the client, of my deepest fears and highest hopes. Unfortunately, there is rather more of the former than the latter. It is a market that makes no real economic sense, but one which is heavily distorted by political forces. We must appreciate what those drivers are and how they can affect risk asset valuations.
IS THE MARKET CHEAP?
No.
Let us use the Shiller cyclically adjusted price/earnings ratio as a reference for valuation. This takes the index value and divides by the average 10 year earnings of the index. It is a means to remove cyclical factors that affect earnings such as variations in profit margins. The average Shiller price/earning ratio is 16.5. The graph below (no graph included) shows that the S&P 500 is currently trading at a 21.17 price/earnings. This is a 25% premium to fair value. Indeed, the graph below shows that market was only trading at fair value for a period of a few months, mainly from end 2008 to mid 2009. In all other periods during the last 15 years
the market has been over valued using this valuation reference. I tend to agree. Our estimation of fair value for the S&P 500 is between 930 – 950, as we have suggested over the last 12 months. It closed on the 28th October 2010 on 1183.78.
One could conclude that if markets are not cheap, then they should not be bought as
aggressively. This would make sense, and indeed, would agree with our 30 - 35%
weighting on equities for clients, However, I have come to believe that the markets may continue to trend in a non rational manner due to political influence.
Is the US market expensive for EUR based investors if the S&P 500 is trading at 1183 in 6 months time, but the USD has meanwhile dropped 20%?
PROTECTIONISM, A LA SOPHISTIACTED
Much fear has been projected by various economic participants including governments,
investors and consumers on the potential damage protectionism could have on the
global economy. Others are more optimistic by the fact that people are talking about it in a negative way rather than cheering it. Hence, they see it as difficult for it to become a reality. Whatever you think, the reality is protectionism is already here as far as I am concerned, but a la sophisticated.
When the asset markets in the US go up as they have, providing the perception that
investors and consumers are richer, whilst your currency becomes weaker, it becomes
more difficult to spend that “perceived wealth” abroad. Hence you are effectively being told to buy American!
What a clever and tacit way of achieving your objective of increasing consumer
confidence in the hope that 70% of the US economy can be steered back to life. However, there is a catch. If every economy plays the same trick it is a total waste of money! This is because it becomes harder to reduce your currency value by “creating money” to dilute its purchasing power, because everyone else is doing it as well!
QUANTITATIVE EASING (QE), WHY DO IT?
As a result, the much discussed QE2 has led the USD to weaken, but risk assets to go up. Why is the latter happening?
When the government buys bonds, they are not buying it from me and you, they are
buying them from large financial institutions. Hence these institutions will have large lumps of cash in their hands. They will not use this cash to buy shoes (i.e. to consume) they will invest it in risk assets. We have seen over the last 18 to 24 months yields on bonds effectively converge to zero as a result, and money being moved into other risk assets with the same consequence, reducing their yield.
Remember, as we have written in past letters, consumer spending is 70% of developed
economies GDP, and, in my opinion, supported by three important pillars:-
1. Wages; with unemployment so high they are unlikely to go up on average
2. Credit expansion; de leveraging is so prominent amongst banks that credit
growth is likely to remain weak for years to come
3. Asset prices; with risk assets relatively expensive considering weak GDP growth
for developed economies and the potential for inflation, this should not to go up
drastically
If you were the FED, which one of these variables is the easiest to manipulate in the hope of increasing consumer spending, the bed rock of developed economies?
They tried to increase credit expansion by capitalising the banks, no luck.
They tried to create jobs by proposing to create new projects, no luck so far.
This leaves us with asset prices. If they could create enough liquidity that would get into asset markets, we could increase their value in USD terms and give the perception that consumers are richer then they really are, hopefully boosting consumer confidence (does this sound familiar? It should do, we have been living off this model since the 90s). However, if the USD weakens, in global purchasing power, you are no richer.
QE therefore has the consequence of weakening the USD and increasing the price of risk assets. And it will have the same affect on any other country that applies the same strategy. However, if everyone done it, no one is getting richer, we are just wasting money, hence reducing its value, hence reducing the purchasing power of a unit of currency.
WHO WINS?
In such an environment, there is one economic participant, I believe, that can gain over others.
These are the participants that use the capital markets to receive money. i.e.
CORPORATES. If Pfizer, Microsoft and Johnson and Johnson’s can issue 10 year bonds and pay 2% for that money, we are effectively transferring wealth from consumers (who need the income, especially retirees) to corporates.
Furthermore, this advantage can be exacerbated if:-
1. They have low leverage to start, hence they can borrow to buy their leveraged
competitors and buy them at attractive prices as they suffer paying large interest
payments from bonds issued with much higher rates
2. They have pricing power, so can partially protect their operating margin if
inflation becomes an issue
3. Have low capital expenditures relative to revenues. If there is inflation, then
capex costs will increase. If you have little capex (i.e. are not a capital intensive
business) then you are less affected by inflation via input costs, but if you have
pricing power, can enjoy increasing your selling price.
4. Stable market share and high and stable returns on capital
The points above mentioned are what I subjectively call HIGH QUALITY COMPANIES.
I strongly believe this classification of companies have the cheapest equity in town, and are the companies that can do best in a difficult economic environment. It is for this reason we have been buying throughout the year these companies.
Below I include a table (no table included) to summarise some of our larger holdings of companies I classify in this category, and whose price is close to the past buying price. If you don’t hold them, I suggest you consider them as an investment solution. I can assure you I hold the vast majority myself.
CONCLUSIONS
I summarise below the asset allocation, on average, for portfolios during 2010:-
START 2010 CURRENTLY DIFFERENCE
CASH 30% 25% -5%
BONDS 30% 25% -5%
EQUITIES 30% 35% +5%
ALTERNATIVES 10% 15% +5%
Throughout the year we have:-
1. Continued using cash to buy the equity of high quality companies
2. Started selling bonds and buying Phoenix notes (we have discussed these
structured products in past letters. If you need further information please let us
know)
3. Bought exposure to emerging market debt via the Templeton Global Bond Fund.
However, we have not continued with this in the second half of the year
Due to my fears of continuous government intervention I would suggest reducing the
cash further. Hence cash should edge closer to 20%, and equities closer to 40%. This could also be supplemented by using cash to buying Phoenix notes. We do not suggest holding more than 15 – 20% of the portfolio in such securities.
We also like the idea of buying commodity exposure via oil and gas and tree growing
companies. However, the vast majority are now too expensive. To the above list we would be happy buyers of EXXON MOBIL at 65 USD or less.
There is no doubt that markets will eventually correct themselves. They are simply
becoming too expensive. However, it becomes harder and harder to ignore the loud
signals Mr. Bernanke is making: TAKE MY PUT OPTION. We slowly heed his statement but
refuse to have more than 40% equity exposure at current market pricing.
May I end with a point on many investors minds: currencies. My own personal portfolio
has a Q3 performance of approx. -5.0%. Stock picking contributed +2.5%, but currency
losses where -7.5% on a marked to market basis during that period. Currencies do matter!
As you may have guessed, 60% of this account is denominated in USD, which has been
destroyed during the Jul – Sep period. However, if I was to make one bet today as a
prediction for 2011, it would be that the EURO would weaken relative to the USD, edging closer to the 1.20 rate from its current 1.40 level. Though quantitative easing in the US will not disappear, I honestly do not believe that this is the main point, because everyone is doing it, or will do it, directly or indirectly.
What is important is to have a certain degree of currency diversification. We have
suggested to pure EURO investors that they should consider holding at least 20 - 25% in USD. The same would be true of other pure currency portfolios. Personally, I have an equal split amongst Euros and USD, as well as a range of other currencies such as CAD,HKD and GBP.
Furthermore, many of the high quality companies we have mentioned above are also
generating profits outside of their home country. As a result, they also offer a partial currency hedge. It is also worth noting that if a countries currency weakens, the exporters of that country enjoy a competitive advantage over a similar manufacturer whose home currency is increasing. It is for this reason that Siemens, Europe’s largest exporter, has a stock price that enjoys appreciation as the EURO weakens.
We thank you for your continued support in us, and look forward to discuss the above
mentioned ideas, or others you may have.
Yours sincerely,
Alessandro Sajwani
Extract from a private letter issued 29.09.10
We aim to achieve 8% compounded annual growth rate in the long term (5 year measure). However, in a year like 2010, where my expectation was that developed equity markets would be flat, we were aiming to achieve 6%. We are slightly over performing, but as usual, the forecast was wrong (I could argue only slightly, at least for the moment!).
YTD performance of major equity market indices (remember, this is NOT net of fees):-
FTSE 100 + 4.89%
Eurostoxx 50 - 4.02%
S&P 500 + 6.15%
Nikkei 225 - 12.74%
Hang Seng China + 2.49%
Brazil Bovespa + 2.52%
NSE Nifty (India) Index + 15.22%
However, if we assume that you had converted EUR to USD on 31st December 2009 to
invest in the S&P 500 on the same day, your performance would actually be very close to 0.0%!
The aim of this perhaps rather long letter is to inform you, the client, of my deepest fears and highest hopes. Unfortunately, there is rather more of the former than the latter. It is a market that makes no real economic sense, but one which is heavily distorted by political forces. We must appreciate what those drivers are and how they can affect risk asset valuations.
IS THE MARKET CHEAP?
No.
Let us use the Shiller cyclically adjusted price/earnings ratio as a reference for valuation. This takes the index value and divides by the average 10 year earnings of the index. It is a means to remove cyclical factors that affect earnings such as variations in profit margins. The average Shiller price/earning ratio is 16.5. The graph below (no graph included) shows that the S&P 500 is currently trading at a 21.17 price/earnings. This is a 25% premium to fair value. Indeed, the graph below shows that market was only trading at fair value for a period of a few months, mainly from end 2008 to mid 2009. In all other periods during the last 15 years
the market has been over valued using this valuation reference. I tend to agree. Our estimation of fair value for the S&P 500 is between 930 – 950, as we have suggested over the last 12 months. It closed on the 28th October 2010 on 1183.78.
One could conclude that if markets are not cheap, then they should not be bought as
aggressively. This would make sense, and indeed, would agree with our 30 - 35%
weighting on equities for clients, However, I have come to believe that the markets may continue to trend in a non rational manner due to political influence.
Is the US market expensive for EUR based investors if the S&P 500 is trading at 1183 in 6 months time, but the USD has meanwhile dropped 20%?
PROTECTIONISM, A LA SOPHISTIACTED
Much fear has been projected by various economic participants including governments,
investors and consumers on the potential damage protectionism could have on the
global economy. Others are more optimistic by the fact that people are talking about it in a negative way rather than cheering it. Hence, they see it as difficult for it to become a reality. Whatever you think, the reality is protectionism is already here as far as I am concerned, but a la sophisticated.
When the asset markets in the US go up as they have, providing the perception that
investors and consumers are richer, whilst your currency becomes weaker, it becomes
more difficult to spend that “perceived wealth” abroad. Hence you are effectively being told to buy American!
What a clever and tacit way of achieving your objective of increasing consumer
confidence in the hope that 70% of the US economy can be steered back to life. However, there is a catch. If every economy plays the same trick it is a total waste of money! This is because it becomes harder to reduce your currency value by “creating money” to dilute its purchasing power, because everyone else is doing it as well!
QUANTITATIVE EASING (QE), WHY DO IT?
As a result, the much discussed QE2 has led the USD to weaken, but risk assets to go up. Why is the latter happening?
When the government buys bonds, they are not buying it from me and you, they are
buying them from large financial institutions. Hence these institutions will have large lumps of cash in their hands. They will not use this cash to buy shoes (i.e. to consume) they will invest it in risk assets. We have seen over the last 18 to 24 months yields on bonds effectively converge to zero as a result, and money being moved into other risk assets with the same consequence, reducing their yield.
Remember, as we have written in past letters, consumer spending is 70% of developed
economies GDP, and, in my opinion, supported by three important pillars:-
1. Wages; with unemployment so high they are unlikely to go up on average
2. Credit expansion; de leveraging is so prominent amongst banks that credit
growth is likely to remain weak for years to come
3. Asset prices; with risk assets relatively expensive considering weak GDP growth
for developed economies and the potential for inflation, this should not to go up
drastically
If you were the FED, which one of these variables is the easiest to manipulate in the hope of increasing consumer spending, the bed rock of developed economies?
They tried to increase credit expansion by capitalising the banks, no luck.
They tried to create jobs by proposing to create new projects, no luck so far.
This leaves us with asset prices. If they could create enough liquidity that would get into asset markets, we could increase their value in USD terms and give the perception that consumers are richer then they really are, hopefully boosting consumer confidence (does this sound familiar? It should do, we have been living off this model since the 90s). However, if the USD weakens, in global purchasing power, you are no richer.
QE therefore has the consequence of weakening the USD and increasing the price of risk assets. And it will have the same affect on any other country that applies the same strategy. However, if everyone done it, no one is getting richer, we are just wasting money, hence reducing its value, hence reducing the purchasing power of a unit of currency.
WHO WINS?
In such an environment, there is one economic participant, I believe, that can gain over others.
These are the participants that use the capital markets to receive money. i.e.
CORPORATES. If Pfizer, Microsoft and Johnson and Johnson’s can issue 10 year bonds and pay 2% for that money, we are effectively transferring wealth from consumers (who need the income, especially retirees) to corporates.
Furthermore, this advantage can be exacerbated if:-
1. They have low leverage to start, hence they can borrow to buy their leveraged
competitors and buy them at attractive prices as they suffer paying large interest
payments from bonds issued with much higher rates
2. They have pricing power, so can partially protect their operating margin if
inflation becomes an issue
3. Have low capital expenditures relative to revenues. If there is inflation, then
capex costs will increase. If you have little capex (i.e. are not a capital intensive
business) then you are less affected by inflation via input costs, but if you have
pricing power, can enjoy increasing your selling price.
4. Stable market share and high and stable returns on capital
The points above mentioned are what I subjectively call HIGH QUALITY COMPANIES.
I strongly believe this classification of companies have the cheapest equity in town, and are the companies that can do best in a difficult economic environment. It is for this reason we have been buying throughout the year these companies.
Below I include a table (no table included) to summarise some of our larger holdings of companies I classify in this category, and whose price is close to the past buying price. If you don’t hold them, I suggest you consider them as an investment solution. I can assure you I hold the vast majority myself.
CONCLUSIONS
I summarise below the asset allocation, on average, for portfolios during 2010:-
START 2010 CURRENTLY DIFFERENCE
CASH 30% 25% -5%
BONDS 30% 25% -5%
EQUITIES 30% 35% +5%
ALTERNATIVES 10% 15% +5%
Throughout the year we have:-
1. Continued using cash to buy the equity of high quality companies
2. Started selling bonds and buying Phoenix notes (we have discussed these
structured products in past letters. If you need further information please let us
know)
3. Bought exposure to emerging market debt via the Templeton Global Bond Fund.
However, we have not continued with this in the second half of the year
Due to my fears of continuous government intervention I would suggest reducing the
cash further. Hence cash should edge closer to 20%, and equities closer to 40%. This could also be supplemented by using cash to buying Phoenix notes. We do not suggest holding more than 15 – 20% of the portfolio in such securities.
We also like the idea of buying commodity exposure via oil and gas and tree growing
companies. However, the vast majority are now too expensive. To the above list we would be happy buyers of EXXON MOBIL at 65 USD or less.
There is no doubt that markets will eventually correct themselves. They are simply
becoming too expensive. However, it becomes harder and harder to ignore the loud
signals Mr. Bernanke is making: TAKE MY PUT OPTION. We slowly heed his statement but
refuse to have more than 40% equity exposure at current market pricing.
May I end with a point on many investors minds: currencies. My own personal portfolio
has a Q3 performance of approx. -5.0%. Stock picking contributed +2.5%, but currency
losses where -7.5% on a marked to market basis during that period. Currencies do matter!
As you may have guessed, 60% of this account is denominated in USD, which has been
destroyed during the Jul – Sep period. However, if I was to make one bet today as a
prediction for 2011, it would be that the EURO would weaken relative to the USD, edging closer to the 1.20 rate from its current 1.40 level. Though quantitative easing in the US will not disappear, I honestly do not believe that this is the main point, because everyone is doing it, or will do it, directly or indirectly.
What is important is to have a certain degree of currency diversification. We have
suggested to pure EURO investors that they should consider holding at least 20 - 25% in USD. The same would be true of other pure currency portfolios. Personally, I have an equal split amongst Euros and USD, as well as a range of other currencies such as CAD,HKD and GBP.
Furthermore, many of the high quality companies we have mentioned above are also
generating profits outside of their home country. As a result, they also offer a partial currency hedge. It is also worth noting that if a countries currency weakens, the exporters of that country enjoy a competitive advantage over a similar manufacturer whose home currency is increasing. It is for this reason that Siemens, Europe’s largest exporter, has a stock price that enjoys appreciation as the EURO weakens.
We thank you for your continued support in us, and look forward to discuss the above
mentioned ideas, or others you may have.
Yours sincerely,
Alessandro Sajwani
Wednesday 27 October 2010
Love the Americans, they love us
Dear Reader,
Protectionism...what a cold and unwanted word.
Many media sources are warning on its impending impact, whilst others are more optimistic by the fact many are already worrying about it, rather than cheering it.
However, I do believe we have a fine tonic of protectionism already going on, a la sophisticated.
By promoting equity markets and weakening the USD by promising more quantitative easing, effectively, you boost the wealth of Americans (in USD terms), but it is harder to spend that abroad, due to the weaker USD. Hence, it makes buying American the best option.
This seems like a fantastic idea to increase US consumer confidence. As we have discussed in previous blogs, consumer spending can increase when one, or all, of the following pillars are positive:-
1. Wages are increasing, unlikely with high unemployment
2. Credit is expanding, unlikely with the financial and consumer sector de leveraging
3. Asset prices are increasing: quantitative easing is trying to boost this factor
Let me repeat, what a fantastic and tacit way of increasing the "wealth perception" snd hence confidence of Americans.
However, there is one problem. When every country trys to play the same trick! The solution then becomes a problem. A many trillion USD problem. Because if all countries apply the same strategy, everyone wastes money, because no value is created and no permenant relative loss in currency will be achieved. It is this road that we seem to be going: and what an awful road it can be. Hold on steady chaps its going to be a rough ride, and as each day passes, it becomes harder to turn back!
It is for this reason we must apply inflation protected strategies in portfolios, to help us from having our portfolio potentially permenantly de valued from reckless money creation. Remember, financial instruments are priced in currency: the currency issue cannot be ignored.
Yours sincerely,
Alessandro Sajwani
Protectionism...what a cold and unwanted word.
Many media sources are warning on its impending impact, whilst others are more optimistic by the fact many are already worrying about it, rather than cheering it.
However, I do believe we have a fine tonic of protectionism already going on, a la sophisticated.
By promoting equity markets and weakening the USD by promising more quantitative easing, effectively, you boost the wealth of Americans (in USD terms), but it is harder to spend that abroad, due to the weaker USD. Hence, it makes buying American the best option.
This seems like a fantastic idea to increase US consumer confidence. As we have discussed in previous blogs, consumer spending can increase when one, or all, of the following pillars are positive:-
1. Wages are increasing, unlikely with high unemployment
2. Credit is expanding, unlikely with the financial and consumer sector de leveraging
3. Asset prices are increasing: quantitative easing is trying to boost this factor
Let me repeat, what a fantastic and tacit way of increasing the "wealth perception" snd hence confidence of Americans.
However, there is one problem. When every country trys to play the same trick! The solution then becomes a problem. A many trillion USD problem. Because if all countries apply the same strategy, everyone wastes money, because no value is created and no permenant relative loss in currency will be achieved. It is this road that we seem to be going: and what an awful road it can be. Hold on steady chaps its going to be a rough ride, and as each day passes, it becomes harder to turn back!
It is for this reason we must apply inflation protected strategies in portfolios, to help us from having our portfolio potentially permenantly de valued from reckless money creation. Remember, financial instruments are priced in currency: the currency issue cannot be ignored.
Yours sincerely,
Alessandro Sajwani
Tuesday 19 October 2010
The Telecom Sector
Dear Reader,
Recently we have been attracted by the relatively stable market structure, high dividends and continuously decreasing stock price over the last decade of the telecom sector. The latter, combined with a lack of growth from such companies in developed economies over the years, has reduced interest from investors and speculators. It is for this reason that we went to have a look.
Generally, we have veered away from this sector due to our lack of in depth understanding of; 1. the technology, 2. the regulation. As a result, though we were aware free cash flow yields relative to market capitalisation were high recently, we were not confident in determining the earning power of such companies, or valuing their fixed assets, hence mainly stayed away.
Currently we are familiarising ourselves with the sector. Let me summarise our recent findings:-
1. The telecom sector is asset heavy. It requires much capex, and therefore incurs large depreciation charges on the income statement. We find different companies approach this non cash accounting term with various degrees of aggression. We find this to be true also for amortisation. As a result, our modified owner earnings can be quite different from accounting net income
2. Large fixed costs exist, hence economies of scale are relevant. We find dominant players in a market have noticeably larger margins
3. Dominance in one market does not help dominance in another. Economies of scale are only relevant locally. Telefonica understood this very well. Deutsche Telekom less so. However, the latter is making positive developments
4. We have always worried on the size of capex requirements in the telecom sector. However, the question is irrelevant if economies of scale is relevant and you have a monopoly of a technology. Hence if capex is 10 bln, but profits over 10 years are 300bln, what does it matter what the capex is? What matters is what you get out of the capex in terms of profit. If market structure is stable, there may be opportunities
5. Our second fear has been a company invests large sums to make a technology, as a result it belongs only to them, but then regulation forces them to open the technology such that competitors can use it at a minimum cost (to ensure there is no monopoly in a strategic sector). This implies the cost of one are enjoyed by all. This is not a highly profitable endeaver
6. Regulation, technological change and the continuous erosion of technological advantages and hence forced capex spending. These are our fears in this sector. If everyone has access to the technology due to regulation enforements, only the consumer gains, not the industry in terms of profit
7. In theory, the owner of the network always makes money, whether they are providing the service, or allowing someone else to use their network to provide the service (which may be forced by the regulator). BT is an example, in the UK, But you must be aware of the ranges of their margin, and hence the affect on valuation
8. There has been a powerful price war in the UK. This is evident from decreasing margins recently, and the services provided by wireless and wireline network providers. Recently, T mobile and Orange in the UK have said they will form a joint venture. This is an interesting development. Is it a signal that they don’t want to carry on with a price war. Their size being the weapon they can unleash if someone decides to go against them? We were curious to see in London adverts promoting the joint venture was focused on a higher quality of service rather than a lower price. We believe they are signaling to competitors that prices have reached a bottom, they want to have price stability and focus on making money rather than simply stealing market share
We look forward to update our clients in greater detail with regards to the conclusion of our study of the telecom sector.
Yours sincerely,
Alessandro Sajwani
Recently we have been attracted by the relatively stable market structure, high dividends and continuously decreasing stock price over the last decade of the telecom sector. The latter, combined with a lack of growth from such companies in developed economies over the years, has reduced interest from investors and speculators. It is for this reason that we went to have a look.
Generally, we have veered away from this sector due to our lack of in depth understanding of; 1. the technology, 2. the regulation. As a result, though we were aware free cash flow yields relative to market capitalisation were high recently, we were not confident in determining the earning power of such companies, or valuing their fixed assets, hence mainly stayed away.
Currently we are familiarising ourselves with the sector. Let me summarise our recent findings:-
1. The telecom sector is asset heavy. It requires much capex, and therefore incurs large depreciation charges on the income statement. We find different companies approach this non cash accounting term with various degrees of aggression. We find this to be true also for amortisation. As a result, our modified owner earnings can be quite different from accounting net income
2. Large fixed costs exist, hence economies of scale are relevant. We find dominant players in a market have noticeably larger margins
3. Dominance in one market does not help dominance in another. Economies of scale are only relevant locally. Telefonica understood this very well. Deutsche Telekom less so. However, the latter is making positive developments
4. We have always worried on the size of capex requirements in the telecom sector. However, the question is irrelevant if economies of scale is relevant and you have a monopoly of a technology. Hence if capex is 10 bln, but profits over 10 years are 300bln, what does it matter what the capex is? What matters is what you get out of the capex in terms of profit. If market structure is stable, there may be opportunities
5. Our second fear has been a company invests large sums to make a technology, as a result it belongs only to them, but then regulation forces them to open the technology such that competitors can use it at a minimum cost (to ensure there is no monopoly in a strategic sector). This implies the cost of one are enjoyed by all. This is not a highly profitable endeaver
6. Regulation, technological change and the continuous erosion of technological advantages and hence forced capex spending. These are our fears in this sector. If everyone has access to the technology due to regulation enforements, only the consumer gains, not the industry in terms of profit
7. In theory, the owner of the network always makes money, whether they are providing the service, or allowing someone else to use their network to provide the service (which may be forced by the regulator). BT is an example, in the UK, But you must be aware of the ranges of their margin, and hence the affect on valuation
8. There has been a powerful price war in the UK. This is evident from decreasing margins recently, and the services provided by wireless and wireline network providers. Recently, T mobile and Orange in the UK have said they will form a joint venture. This is an interesting development. Is it a signal that they don’t want to carry on with a price war. Their size being the weapon they can unleash if someone decides to go against them? We were curious to see in London adverts promoting the joint venture was focused on a higher quality of service rather than a lower price. We believe they are signaling to competitors that prices have reached a bottom, they want to have price stability and focus on making money rather than simply stealing market share
We look forward to update our clients in greater detail with regards to the conclusion of our study of the telecom sector.
Yours sincerely,
Alessandro Sajwani
Saturday 9 October 2010
More dependence on external funding, more volatility
Dear Reader,
We compose this short article to commit to paper an idea we feel is non negliable.
There may be a common thread that connects a number of large, long term price trends. We feel that connection is the changing reliance from an internal to an external supplier or demand: or vice versa.
Let us use an example, and the see what consequences we can extrapolate from the current economic environment.
Oil in the US was mainly supplied internally until the early 1970s. However, since the early 1970s the US became more and more dependent on importing oil from abroad (indeed, it contributes almost half of the US trade deficit to this day). This made it possible for OPEC to be born and indeed led to more US demand to be supplied externally. To this day, the oil price has never reached the price when the US was primarily an exporter rather than importer of oil.
Many feel that the increasing Chinese demand for agricultural products and the increasing percentage of basic foodstock being imported will have the same effect on soft commodities.
We also ask whether economies that are more dependent on external funding are the currencies which will depreciate more and have higher borrowing costs. Foreign investors will demand a higher rate of return to convert currency from their base country to a foreign unit in what is perceived an uncertain macro world.
Your sincerely,
Alessandro Sajwani
We compose this short article to commit to paper an idea we feel is non negliable.
There may be a common thread that connects a number of large, long term price trends. We feel that connection is the changing reliance from an internal to an external supplier or demand: or vice versa.
Let us use an example, and the see what consequences we can extrapolate from the current economic environment.
Oil in the US was mainly supplied internally until the early 1970s. However, since the early 1970s the US became more and more dependent on importing oil from abroad (indeed, it contributes almost half of the US trade deficit to this day). This made it possible for OPEC to be born and indeed led to more US demand to be supplied externally. To this day, the oil price has never reached the price when the US was primarily an exporter rather than importer of oil.
Many feel that the increasing Chinese demand for agricultural products and the increasing percentage of basic foodstock being imported will have the same effect on soft commodities.
We also ask whether economies that are more dependent on external funding are the currencies which will depreciate more and have higher borrowing costs. Foreign investors will demand a higher rate of return to convert currency from their base country to a foreign unit in what is perceived an uncertain macro world.
Your sincerely,
Alessandro Sajwani
Friday 8 October 2010
Excesses in the system, can they keep building up?
Dear Reader,
I continue with a little armchair thinking that was fuelled by a discussion this morning with an apt portfolio manager.
"Get me out of the USD and convert it to GBP and AUD", he said. I went through the argument presented in a recent blog discussing the potential of the AUD weakening due to its historic strength, and the tendency for currencies to move in a sinusoidal manner in the long term.
"Sure", he says. "But this currency has high interest rates, its economy is fighting inflation, and rates are likely to rise more. Furthermore, the Chinese are not going to de value their currency soon (he believed), and the exports will not fall. Meanwhile, their domestic market is growing. I want AUD. In 6 to 9 months, we can talk again". He was a little less convinced about GBP, but wanted out of USD. The client, for curiosity, also has a good position in Canadian dollars (CAD).
It seems that the low interest rates and quantitative easing in developed economies have incentivised investors to move to currencies such as the AUD and CAD. These capital movements can therefore be concluded to be supported by government distortions. Or are they not distortions, but the often quoted "new normal?". Gold is another asset that is profiting handsomely from such dynamics.
Perhaps governments will continue to behave in such a way, such that these trends are likely to continue, the excesses will build up until...bang. What will be that bang? If we feel it is being fuelled by governments, then we have to appreciate what can stop their tap flowing. For any person that has been overleveraged will know, debt has the properties of cancer. When it grows to a certain size, there is very little you can do to stop it from killing you. Prevention, and early treatment, is the best cure, if not the only one. Lets use an example of two countries with economy A and B:-
Country A has debt to GDP of 100%, which is expected to grow GDP at 5% nominal in the next few years. Country B has debt to GDP of 65%, but is expected to grow at only 3% nominal.
If initially both governments can borrow at 3% for 10 years, then interest payments will make up 3% of country A, and only 1.95% of country B. Both are less than annual GDP growth, so the GDP of each economy is growing over time (in nominal terms) in this scenario.
If however both countries start large quantitative easing programs because national banks have poorly allocated capital in their lending programs, foreign investors may be more reluctant to lend money to these governments due to these added pressures. Such problems could be amplified. For example, in country B the banking sector is twice the size of the countries economy. As a result, 10 year government bond yields increase to 4.5% and 5.5% respectively for countries A and B. If this scenario was to remain for a number of years, we will see that interest payments will become 4.5% and 3.6% of GDP for countries A and B. As a consequence of these results, economy B is now in negative GDP growth, as interest payments are larger than the annual increase in economic activity. This has the consequence of making foreign investors more fearful, making interest payments higher, and hence making GDP decline larger. This is a terrible positive feedback loop which becomes more probable as an economy takes on more debt, because the cost of the debt has to be lower to activate this feedback loop.
You may say in that scenario, the country that was issuing the debt, you should get out of their currency. As they accumulate more debt, the day of the big bang, or the positive feedback loop, becomes closer. This gives more reason to move to currencies such as the AUD, as the leveraged country is likely to see risk asset pricing fall as money is moved out of their currency, as well as the currency depreciate and the cost of borrowing rise. This is a non linear and unpredictable event as it is triggered by a lack of confidence, i.e. human emotion. However, once it happens, it is very difficult to stop because of this powerful positive feedback loop that appears. This event, for a trader, is as close to a sure bet as you can get. The feedback loop will push this process with such might that only a unique major event can stop it.
The question is, how big an event requires the current trade to stop? I believe it just needs bad news from China. The lack of transparency and free floating currencies in many emerging markets is a bonus for developed countries: it allows more investment capital to be denominated in their currencies. As a result, we see large fluctations amongst the major currencies as a means to let out the tensions in global economies.
In conclusion, the bet on AUD is implicitly assuming that China news flow will be good, or at least less worse, than news from developed countries. If you are confident on that bet, then its makes sense to join the late bandwagon.
Though we feel the positive feedback loop can happen, it cannot happen, by definition, everywhere. In terms of debt accumulation it is most likely to happen in Europe, in terms of increasing the money supply, it comes from the USA.
As non macro economists, we use such reasoning in a very limited manner. We have considered going short the JPY, AUD and EUR. However, have not acted on such thoughts due to a lack of conviction. What we try and do is buy companies from all over the world that are cheap and generate earnings all over the world. Hence a weakening currency in one country, will benefit that company by making its pricing more competitive, hence offering a limited "hedge" on the currency the company is denominated. As a result, at best, we want to be neutral currencies in our portfolios and want returns to come from our security selection and asset allocation.
Yours sincerely,
Alessandro Sajwani
I continue with a little armchair thinking that was fuelled by a discussion this morning with an apt portfolio manager.
"Get me out of the USD and convert it to GBP and AUD", he said. I went through the argument presented in a recent blog discussing the potential of the AUD weakening due to its historic strength, and the tendency for currencies to move in a sinusoidal manner in the long term.
"Sure", he says. "But this currency has high interest rates, its economy is fighting inflation, and rates are likely to rise more. Furthermore, the Chinese are not going to de value their currency soon (he believed), and the exports will not fall. Meanwhile, their domestic market is growing. I want AUD. In 6 to 9 months, we can talk again". He was a little less convinced about GBP, but wanted out of USD. The client, for curiosity, also has a good position in Canadian dollars (CAD).
It seems that the low interest rates and quantitative easing in developed economies have incentivised investors to move to currencies such as the AUD and CAD. These capital movements can therefore be concluded to be supported by government distortions. Or are they not distortions, but the often quoted "new normal?". Gold is another asset that is profiting handsomely from such dynamics.
Perhaps governments will continue to behave in such a way, such that these trends are likely to continue, the excesses will build up until...bang. What will be that bang? If we feel it is being fuelled by governments, then we have to appreciate what can stop their tap flowing. For any person that has been overleveraged will know, debt has the properties of cancer. When it grows to a certain size, there is very little you can do to stop it from killing you. Prevention, and early treatment, is the best cure, if not the only one. Lets use an example of two countries with economy A and B:-
Country A has debt to GDP of 100%, which is expected to grow GDP at 5% nominal in the next few years. Country B has debt to GDP of 65%, but is expected to grow at only 3% nominal.
If initially both governments can borrow at 3% for 10 years, then interest payments will make up 3% of country A, and only 1.95% of country B. Both are less than annual GDP growth, so the GDP of each economy is growing over time (in nominal terms) in this scenario.
If however both countries start large quantitative easing programs because national banks have poorly allocated capital in their lending programs, foreign investors may be more reluctant to lend money to these governments due to these added pressures. Such problems could be amplified. For example, in country B the banking sector is twice the size of the countries economy. As a result, 10 year government bond yields increase to 4.5% and 5.5% respectively for countries A and B. If this scenario was to remain for a number of years, we will see that interest payments will become 4.5% and 3.6% of GDP for countries A and B. As a consequence of these results, economy B is now in negative GDP growth, as interest payments are larger than the annual increase in economic activity. This has the consequence of making foreign investors more fearful, making interest payments higher, and hence making GDP decline larger. This is a terrible positive feedback loop which becomes more probable as an economy takes on more debt, because the cost of the debt has to be lower to activate this feedback loop.
You may say in that scenario, the country that was issuing the debt, you should get out of their currency. As they accumulate more debt, the day of the big bang, or the positive feedback loop, becomes closer. This gives more reason to move to currencies such as the AUD, as the leveraged country is likely to see risk asset pricing fall as money is moved out of their currency, as well as the currency depreciate and the cost of borrowing rise. This is a non linear and unpredictable event as it is triggered by a lack of confidence, i.e. human emotion. However, once it happens, it is very difficult to stop because of this powerful positive feedback loop that appears. This event, for a trader, is as close to a sure bet as you can get. The feedback loop will push this process with such might that only a unique major event can stop it.
The question is, how big an event requires the current trade to stop? I believe it just needs bad news from China. The lack of transparency and free floating currencies in many emerging markets is a bonus for developed countries: it allows more investment capital to be denominated in their currencies. As a result, we see large fluctations amongst the major currencies as a means to let out the tensions in global economies.
In conclusion, the bet on AUD is implicitly assuming that China news flow will be good, or at least less worse, than news from developed countries. If you are confident on that bet, then its makes sense to join the late bandwagon.
Though we feel the positive feedback loop can happen, it cannot happen, by definition, everywhere. In terms of debt accumulation it is most likely to happen in Europe, in terms of increasing the money supply, it comes from the USA.
As non macro economists, we use such reasoning in a very limited manner. We have considered going short the JPY, AUD and EUR. However, have not acted on such thoughts due to a lack of conviction. What we try and do is buy companies from all over the world that are cheap and generate earnings all over the world. Hence a weakening currency in one country, will benefit that company by making its pricing more competitive, hence offering a limited "hedge" on the currency the company is denominated. As a result, at best, we want to be neutral currencies in our portfolios and want returns to come from our security selection and asset allocation.
Yours sincerely,
Alessandro Sajwani
Wednesday 6 October 2010
Value has a role to play
Dear Reader,
This article attempts to identify a connection between several recent buzzwords hanging around newspaper pages that have caught my attention: bond bubble, and mergers and acquisition (M&A) frenzy.
The UK government has been punished harshly by the media and, many perceive, by voters, due to the nationalisation of several large UK financial institutions. The US government has seemingly played a better game.
By providing very cheap money to banks who can then buy government bonds without committing any equity, we have a risk free trade that can allow banks to earn their way out of trouble. Indeed, taking such an argument to its logical conclusion, it is no wonder government bond yields are seen to converge to zero; they may will be converging to the cost of money that banks have to pay. Unless that occurs, money can be made, virtually RISK FREE, with this trade under current regulation.
Can this be an important driver for the large tightening in credit spreads we have seen?
I also emphasis at this point a belief we have presented regularly in this blog; that financing cycles shift from debt to equity to debt continuously over time. After the sudden reduction in bank financing from 2008, equity financing started its cyclical up turn again. However, due to the lowering credit spreads on corporate debt, financing is also becoming abundant from bond issues. We may better call this stage in the financing cycle, “capital market financing”. Indeed, recently, a number of very low leverage, high quality companies such as Johnson & Johnson’s and Microsoft have issued debt at 2 to 3% for maturities at, or greater, than 10 years. This is whilst they both sit on very large cash balances. Such a low cost of capital, which we feel is being fuelled by a loose monetary policy, provides an incentive for companies to accumulate cash, and then, an incentive to do something with this cash. Indeed, newspapers are continuously highlighting the historically high cash balances corporates have relative to market capitalisation. What to do?
With capital market financing only available to corporates, as opposed to consumers, it is unlikely to help the latter increase spending. Hence, is not likely to result in economic growth, as consumer spending is often 70% of the GDP of a developed economy.
So what do corporates do with this cash? Buy a company with the incentive to reduce costs: or buy a company that is trading at the market for less than the cost it takes to replicate its assets (as BHP Billiton did by bidding for Potash).
By reducing costs, they provide the opportunity to increase margins, hence profitability, without relying on growth. If a M&A frenzy was to start, it is likely to be driven by cost cutting rather than expansion. This implies pricing is likely to be disciplined, and may not be the catalyst which will start the price/earning multiple for the market to expand (it has been contracting since 2000). Indeed, few players actually have access to this source of financing. As a result, we feel the stronger may become stronger. This may be a catalyst for the revaluation of dominant, high margin and high return on capital companies that have experienced modest growth over the last decade, but their share prices have done nothing during that same period. It is in this category of companies that our portfolio is heavily positioned.
An interesting question would be, which market structures would be most suitable for such activity? In recent months we have seen most M&A activity in healthcare, technology and commodities (at least at a short glance it seems like that, please correct me if you feel I am wrong, I have no data to back the statement).
I feel healthcare is a wonderful candidate, especially pharmaceuticals. Here we have markets that generally are concentrated with a few dominant players who are experiencing declining growth, and a score of small players with break through products. Usually, when growth was wanted, the big company would buy a small one for the potential of increasing future revenue, and save time and costs on researching for a particular new product. If cost cutting was the aim, would we not see larger companies merge? So cost synergies can really be made? The financing cycle we are in may therefore provide interesting investment opportunities for markets with certain characteristics.
We also note that such transactions are management driven, not investor driven. Hence, if you agree with the above mentioned arguments in concept, you will agree that business dynamics will heavily influence market pricing, not necessarily investor sentiment; at least at the start. Management decisions should be, in a cost cutting environment, more determined by earning yield relative to the cost of financing. In such an environment, value investing will have a role to play in generating good investment results. We strongly feel that value matters, and is the “gravity” that affects the performance of markets in the long run.
Yours sincerely,
Alessandro Sajwani
This article attempts to identify a connection between several recent buzzwords hanging around newspaper pages that have caught my attention: bond bubble, and mergers and acquisition (M&A) frenzy.
The UK government has been punished harshly by the media and, many perceive, by voters, due to the nationalisation of several large UK financial institutions. The US government has seemingly played a better game.
By providing very cheap money to banks who can then buy government bonds without committing any equity, we have a risk free trade that can allow banks to earn their way out of trouble. Indeed, taking such an argument to its logical conclusion, it is no wonder government bond yields are seen to converge to zero; they may will be converging to the cost of money that banks have to pay. Unless that occurs, money can be made, virtually RISK FREE, with this trade under current regulation.
Can this be an important driver for the large tightening in credit spreads we have seen?
I also emphasis at this point a belief we have presented regularly in this blog; that financing cycles shift from debt to equity to debt continuously over time. After the sudden reduction in bank financing from 2008, equity financing started its cyclical up turn again. However, due to the lowering credit spreads on corporate debt, financing is also becoming abundant from bond issues. We may better call this stage in the financing cycle, “capital market financing”. Indeed, recently, a number of very low leverage, high quality companies such as Johnson & Johnson’s and Microsoft have issued debt at 2 to 3% for maturities at, or greater, than 10 years. This is whilst they both sit on very large cash balances. Such a low cost of capital, which we feel is being fuelled by a loose monetary policy, provides an incentive for companies to accumulate cash, and then, an incentive to do something with this cash. Indeed, newspapers are continuously highlighting the historically high cash balances corporates have relative to market capitalisation. What to do?
With capital market financing only available to corporates, as opposed to consumers, it is unlikely to help the latter increase spending. Hence, is not likely to result in economic growth, as consumer spending is often 70% of the GDP of a developed economy.
So what do corporates do with this cash? Buy a company with the incentive to reduce costs: or buy a company that is trading at the market for less than the cost it takes to replicate its assets (as BHP Billiton did by bidding for Potash).
By reducing costs, they provide the opportunity to increase margins, hence profitability, without relying on growth. If a M&A frenzy was to start, it is likely to be driven by cost cutting rather than expansion. This implies pricing is likely to be disciplined, and may not be the catalyst which will start the price/earning multiple for the market to expand (it has been contracting since 2000). Indeed, few players actually have access to this source of financing. As a result, we feel the stronger may become stronger. This may be a catalyst for the revaluation of dominant, high margin and high return on capital companies that have experienced modest growth over the last decade, but their share prices have done nothing during that same period. It is in this category of companies that our portfolio is heavily positioned.
An interesting question would be, which market structures would be most suitable for such activity? In recent months we have seen most M&A activity in healthcare, technology and commodities (at least at a short glance it seems like that, please correct me if you feel I am wrong, I have no data to back the statement).
I feel healthcare is a wonderful candidate, especially pharmaceuticals. Here we have markets that generally are concentrated with a few dominant players who are experiencing declining growth, and a score of small players with break through products. Usually, when growth was wanted, the big company would buy a small one for the potential of increasing future revenue, and save time and costs on researching for a particular new product. If cost cutting was the aim, would we not see larger companies merge? So cost synergies can really be made? The financing cycle we are in may therefore provide interesting investment opportunities for markets with certain characteristics.
We also note that such transactions are management driven, not investor driven. Hence, if you agree with the above mentioned arguments in concept, you will agree that business dynamics will heavily influence market pricing, not necessarily investor sentiment; at least at the start. Management decisions should be, in a cost cutting environment, more determined by earning yield relative to the cost of financing. In such an environment, value investing will have a role to play in generating good investment results. We strongly feel that value matters, and is the “gravity” that affects the performance of markets in the long run.
Yours sincerely,
Alessandro Sajwani
Stick to what your good at, or else...
Dear Reader,
It is a most unfortunate position we are in.
Of the many people I have the pleasure of calling friends who are professional money managers, I find many are currently frightened. I believe this is being driven by many departing from their past approach to investing, which has led them to achieve impressive records, to become the dreaded “macro market timer”, which we have discussed in past articles.
“Value won’t help you in this market, everything is driven by macro”
“Buy and hold is dead, this is a traders market”
“Buy a stock, when you gain 8%, sell it”
“Momentum is where it’s at, markets are more efficient now, value won’t help”
These are some extracts of the kindly advice I have received over the last few weeks. Well, my only piece of advise to the world regarding such matters is the following:-
“The more the market becomes concerned with macro, the more stock opportunities appear, as individual business dynamics become less relevant for buyers”
“The more value you receive for free from an investment purchase, the less dependent you are on profiting from that value on macro issues”
These are basic tenets I hold to be self evident from historic data. When someone has a basic skill, the worst thing they should do is drift away from using it because it is not today’s fad. It is exactly in moments like these that people that stick to what they do best, that I believe, do best.
Yours sincerely,
Alessandro Sajwani
It is a most unfortunate position we are in.
Of the many people I have the pleasure of calling friends who are professional money managers, I find many are currently frightened. I believe this is being driven by many departing from their past approach to investing, which has led them to achieve impressive records, to become the dreaded “macro market timer”, which we have discussed in past articles.
“Value won’t help you in this market, everything is driven by macro”
“Buy and hold is dead, this is a traders market”
“Buy a stock, when you gain 8%, sell it”
“Momentum is where it’s at, markets are more efficient now, value won’t help”
These are some extracts of the kindly advice I have received over the last few weeks. Well, my only piece of advise to the world regarding such matters is the following:-
“The more the market becomes concerned with macro, the more stock opportunities appear, as individual business dynamics become less relevant for buyers”
“The more value you receive for free from an investment purchase, the less dependent you are on profiting from that value on macro issues”
These are basic tenets I hold to be self evident from historic data. When someone has a basic skill, the worst thing they should do is drift away from using it because it is not today’s fad. It is exactly in moments like these that people that stick to what they do best, that I believe, do best.
Yours sincerely,
Alessandro Sajwani
I was snow white, until I drifted
Dear Reader,
You will have noticed from our writings since this blog began in early 2010, various traits that define our view to investing:-
1. Understand the underlying business and the business model of the securities of the company you wish to buy. Without this, valuation is useless
2. Understand the market structure and its influence on the business model
3. We let valuation guide our investment approach. As a result, we are extremely price sensitive when purchasing, and will not buy an asset without a significant margin of safety attached
4. We believe in mean reversion (inflation adjusted)
5. Various cycles become dominant in influencing the pricing of risk assets at various moments in time. This includes the economic, business, market and financing cycle
6. If the underlying does not generate a cash flow, be wary of pricing
Well, Mae West said she was snow white, until she drifted; today we will drift a little too from our core competencies due to a clients request.
I have the pleasure of dealing with a client who has locked up a number of bonds that offer yields to maturity over 6%, were bought under par and mature within 3 to 4 years: my current concern, they were all in Australian Dollars (AUD). Since purchase this currency has appreciated significantly relative to the currency they were exchanged for. However, as believers of point 2 mentioned above, please note the following chart depicting the evolution of AUD versus the US dollar (USD).
Though you may have realised we are not currency players, we do become nervous when we see such large shifts occurring in such a short period of time, and such a powerful trend over such a long period of time (10 years, like gold). Many would say the current strengthening of the AUD simply takes it to where it was in 2008, a sign that the “China” story is still intact (as far as the market is concerned), not damaged by the economic slowdown suffered in developed economies from being over leveraged, and hence putting pressure on their consumers from spending.
I do not have a precise counter argument for the above mentioned statement to suggest it is wrong. A currency is a sign of the strength of its underlying economy. There can be no doubt that data over the last couple of years suggest the Australian economy is doing better than most developed economies, seemingly from its exposure to emerging market development, and hence their demand for Australian raw materials. As a result, it should not be a surprise that its currency has performed better than the USA, UK, Euroland and Japanese currencies, which are also widely traded. However, it does matter what the starting point of each currency exchange was when considering any period of time. It should also be noted that the AUD has the highest interest rates amongst developed economies.
However, I fear the AUD has become too closely intertwined with the “China” story. Not being fed solely by the above mentioned reasoning, but also because China does not have a freely accessible floating currency for foreign investors. Capital flows to the AUD have therefore, I believe, potentially gone out of hand, leading to the AUD to pass by a significant margin its average value over the last 10 years to other developed country currencies. Though I must repeat my confidence in such statements are not anywhere as close as my confidence in investments of company securities; the strengthening of the AUD is a fact shown in the above graph, which cannot be ignored.
For those who believe the future really will be different from the past, they may be willing to believe that trends such as the strength of the AUD will continue. We find it hard to fight the historical role of mean reversion, especially with assets such as currencies and commodities.
I therefore advise clients that do not have expenses in AUD or are not based in that country, and who have a greater than 10% exposure to this currency in their portfolios, that they consider hedging their AUD exposure relative to their base currency. For the client above mentioned, AUD/USD would be advised.
Yours sincerely,
Alessandro Sajwani
You will have noticed from our writings since this blog began in early 2010, various traits that define our view to investing:-
1. Understand the underlying business and the business model of the securities of the company you wish to buy. Without this, valuation is useless
2. Understand the market structure and its influence on the business model
3. We let valuation guide our investment approach. As a result, we are extremely price sensitive when purchasing, and will not buy an asset without a significant margin of safety attached
4. We believe in mean reversion (inflation adjusted)
5. Various cycles become dominant in influencing the pricing of risk assets at various moments in time. This includes the economic, business, market and financing cycle
6. If the underlying does not generate a cash flow, be wary of pricing
Well, Mae West said she was snow white, until she drifted; today we will drift a little too from our core competencies due to a clients request.
I have the pleasure of dealing with a client who has locked up a number of bonds that offer yields to maturity over 6%, were bought under par and mature within 3 to 4 years: my current concern, they were all in Australian Dollars (AUD). Since purchase this currency has appreciated significantly relative to the currency they were exchanged for. However, as believers of point 2 mentioned above, please note the following chart depicting the evolution of AUD versus the US dollar (USD).
Though you may have realised we are not currency players, we do become nervous when we see such large shifts occurring in such a short period of time, and such a powerful trend over such a long period of time (10 years, like gold). Many would say the current strengthening of the AUD simply takes it to where it was in 2008, a sign that the “China” story is still intact (as far as the market is concerned), not damaged by the economic slowdown suffered in developed economies from being over leveraged, and hence putting pressure on their consumers from spending.
I do not have a precise counter argument for the above mentioned statement to suggest it is wrong. A currency is a sign of the strength of its underlying economy. There can be no doubt that data over the last couple of years suggest the Australian economy is doing better than most developed economies, seemingly from its exposure to emerging market development, and hence their demand for Australian raw materials. As a result, it should not be a surprise that its currency has performed better than the USA, UK, Euroland and Japanese currencies, which are also widely traded. However, it does matter what the starting point of each currency exchange was when considering any period of time. It should also be noted that the AUD has the highest interest rates amongst developed economies.
However, I fear the AUD has become too closely intertwined with the “China” story. Not being fed solely by the above mentioned reasoning, but also because China does not have a freely accessible floating currency for foreign investors. Capital flows to the AUD have therefore, I believe, potentially gone out of hand, leading to the AUD to pass by a significant margin its average value over the last 10 years to other developed country currencies. Though I must repeat my confidence in such statements are not anywhere as close as my confidence in investments of company securities; the strengthening of the AUD is a fact shown in the above graph, which cannot be ignored.
For those who believe the future really will be different from the past, they may be willing to believe that trends such as the strength of the AUD will continue. We find it hard to fight the historical role of mean reversion, especially with assets such as currencies and commodities.
I therefore advise clients that do not have expenses in AUD or are not based in that country, and who have a greater than 10% exposure to this currency in their portfolios, that they consider hedging their AUD exposure relative to their base currency. For the client above mentioned, AUD/USD would be advised.
Yours sincerely,
Alessandro Sajwani
Friday 1 October 2010
If you want to finish first, first you have to finish...
Dear Reader,
On this article I want to present the personal importance I place to its title by clarifying the role different financial statements place in our security selection.
During a period of slow economic growth and weak credit expansion, corporates that sell their products in that economy are likely to suffer operating margin and revenue growth headwinds.
In such an environment, many leveraged companies that depended heavily on renewing bank debt are likely to suffer from cutting costs significantly to be able to reduce debt or make interest payments (often losing market share as a result) and even potentially falling into bankruptcy. This allows the lower leveraged companies to take their market share. We are seeing this happen already with companies such as Best Buy, who are taking clients that previously went to circuit city, a large competitor that went bust in early 2009.
As a result, we see the leverage in different companies amongst certain market sectors shift in a manner that closely follows the economic cycle. Low leveraged companies become more leveraged as they take on market share from competitors that are down sizing, default or are bought out due to their misallocation of capital in past years, as the rate of return from investing capital in that sector increases. Investing in low leveraged companies that have the balance sheet to survive a crisis and hence reap the rewards of surviving is one investment strategy we are actively pursuing at Long Term Investment Management.
Yours sincerely,
Alessandro Sajwani
On this article I want to present the personal importance I place to its title by clarifying the role different financial statements place in our security selection.
During a period of slow economic growth and weak credit expansion, corporates that sell their products in that economy are likely to suffer operating margin and revenue growth headwinds.
In such an environment, many leveraged companies that depended heavily on renewing bank debt are likely to suffer from cutting costs significantly to be able to reduce debt or make interest payments (often losing market share as a result) and even potentially falling into bankruptcy. This allows the lower leveraged companies to take their market share. We are seeing this happen already with companies such as Best Buy, who are taking clients that previously went to circuit city, a large competitor that went bust in early 2009.
As a result, we see the leverage in different companies amongst certain market sectors shift in a manner that closely follows the economic cycle. Low leveraged companies become more leveraged as they take on market share from competitors that are down sizing, default or are bought out due to their misallocation of capital in past years, as the rate of return from investing capital in that sector increases. Investing in low leveraged companies that have the balance sheet to survive a crisis and hence reap the rewards of surviving is one investment strategy we are actively pursuing at Long Term Investment Management.
Yours sincerely,
Alessandro Sajwani
Tuesday 28 September 2010
Summary of recent fund managers presentations
Dear Reader,
Today I had the pleasure of meeting a number of fund managers who came to present their investment thesis to our bank.
This blog aims to summarise some of the more interesting points raised:-
1. There was an argument presented that European banks are under capitalised and UK banks are over capitalised (they are short the former and long the latter). The former are likely to be under pressure to raise equity to build core tier 1 over the next 6 - 12 months. This could develop into a competition of who will issue first, leading to a discount to appear for the late comers
2. Lloyds was presented as a UK bank that was over capitalised. When questioned, their principal metric was equity to debt, which had fallen significantly from past rights issues. There was also a belief that writedowns were over estimated to get the damage out of the way last year. There is a belief they will be buying back their shares from the government over the next 2 -3 years due to the fact they hold excess capital
3. Drax was seen as a company with irreplaceable assets in the UK. The cost of making another Drax is higher than the current market cap. We could not agree more. A similar argument has been presented by Potash to explain the reason for the BHP Billiton bid in the directors circular recommending rejection of the offer
4. There is a fear companies like Microsoft will use cash on the balance sheet to purchase another company. Fear arises from the current trend in the market for large IT companies to need to buy a smaller, but faster growth company to make it look sexier. Recently, we have seen Intel and Dell embark in such "red light" activities. Though this is a possibility, for the moment we give management the benefit of the doubt. They refused to overpay for Yahoo, hence seem to possess some discipline in empire building
5. As always, there was positive talk on emerging markets. Debt and equity securities were mentioned. Some mention was made of inflation protection, which was pursued by purchasing the stock of companies with pricing power (i.e. the creators of inflation as we know it)
6. Currency hedging for stock purchases was deemed unnecessary by one fundmanager. His answer to this question is that a currency will benefit a company by increasing its exports if it weakens, and punish you by the opposite if it strengthens. Though on paper, when read quickly, this makes sense, this argument may not be equally valid for industries with different market structures. It is, however, an interesting view
7. Corporates have too much capital on hand. They are likely to spend this in emerging markets (as we emphasised in the last two blogs where we discussed equity financing) or on merger and acquisition activity
8. There seems to be a strong belief that emerging countries will grow considerably faster than developed econmies, which will hardly grow at all in the next few years. Mention was made of a "bubble" in credit markets, and that inflation fears are many years into the future.
9. It was refreshing to see a fundmanager recite values I personally abide by: never lose money. Simple mathematics indicates that by dropping 50% in any period of time requires you to gain 100% to be where you started! Couple this with the power of compounding, and it is vital that you miss investments that lead to permenant loss of capital. These can only be avoided by doing your research and sticking to what you understand.
Yours sincerely,
Alessandro Sajwani
Today I had the pleasure of meeting a number of fund managers who came to present their investment thesis to our bank.
This blog aims to summarise some of the more interesting points raised:-
1. There was an argument presented that European banks are under capitalised and UK banks are over capitalised (they are short the former and long the latter). The former are likely to be under pressure to raise equity to build core tier 1 over the next 6 - 12 months. This could develop into a competition of who will issue first, leading to a discount to appear for the late comers
2. Lloyds was presented as a UK bank that was over capitalised. When questioned, their principal metric was equity to debt, which had fallen significantly from past rights issues. There was also a belief that writedowns were over estimated to get the damage out of the way last year. There is a belief they will be buying back their shares from the government over the next 2 -3 years due to the fact they hold excess capital
3. Drax was seen as a company with irreplaceable assets in the UK. The cost of making another Drax is higher than the current market cap. We could not agree more. A similar argument has been presented by Potash to explain the reason for the BHP Billiton bid in the directors circular recommending rejection of the offer
4. There is a fear companies like Microsoft will use cash on the balance sheet to purchase another company. Fear arises from the current trend in the market for large IT companies to need to buy a smaller, but faster growth company to make it look sexier. Recently, we have seen Intel and Dell embark in such "red light" activities. Though this is a possibility, for the moment we give management the benefit of the doubt. They refused to overpay for Yahoo, hence seem to possess some discipline in empire building
5. As always, there was positive talk on emerging markets. Debt and equity securities were mentioned. Some mention was made of inflation protection, which was pursued by purchasing the stock of companies with pricing power (i.e. the creators of inflation as we know it)
6. Currency hedging for stock purchases was deemed unnecessary by one fundmanager. His answer to this question is that a currency will benefit a company by increasing its exports if it weakens, and punish you by the opposite if it strengthens. Though on paper, when read quickly, this makes sense, this argument may not be equally valid for industries with different market structures. It is, however, an interesting view
7. Corporates have too much capital on hand. They are likely to spend this in emerging markets (as we emphasised in the last two blogs where we discussed equity financing) or on merger and acquisition activity
8. There seems to be a strong belief that emerging countries will grow considerably faster than developed econmies, which will hardly grow at all in the next few years. Mention was made of a "bubble" in credit markets, and that inflation fears are many years into the future.
9. It was refreshing to see a fundmanager recite values I personally abide by: never lose money. Simple mathematics indicates that by dropping 50% in any period of time requires you to gain 100% to be where you started! Couple this with the power of compounding, and it is vital that you miss investments that lead to permenant loss of capital. These can only be avoided by doing your research and sticking to what you understand.
Yours sincerely,
Alessandro Sajwani
Monday 27 September 2010
Turning ideas into investments
I write a small extension to my last article.
Working at a Private Bank I often find that nice stories, rather than nice results, are what are demanded from the industry: words, rather than probabilities and price awareness. Coming from a valuation slant to investing, I would like to break apart the words from my last article to an executable framework of action: which can allow the previously mentioned concepts to be used to generate portfolio results, rather than entertain wealthy friends at a (boring) party.
1 Banking regulation
1. Previously bought senior bonds yielding a greater return than years to maturity should be held. It is the securities that are lower in the capital structure that will be principally affected from Basle III changes
2. Selling perpetuals that are priced greater than a years coupon above par should be replaced with perpetuals trading below par. Ideally, you would want to buy a below par perpetual from the same issuer, hence have the same credit risk. We assume you are happy with the credit risk of the issuer you had previously and mention the strategy only to consider as a result of regulation change
3. There are a small number of preferred shares from RBS that continue to pay dividends, though the majority have been forced to stop by the European Commission due to the bank receiving extensive government funding. One in particular that could be of interest for an aggressive, sophisticated investor would be a certain RBS preferred that continues to pay because it was issued prior to Basle II, hence pays the coupon dependent on whether the bank has distributable reserves, not on, for example, the amount of annual profits. We can use retained earnings as a proxy for distributable reserves. If one looks at the retained earnings on the RBS balance sheet at the end of 2008 (a very terrible year for banks), they have close to 20 billion sterling. By year end 2009 they had almost double that amount. One could say this is an excellent investment prospect. However, in true “Sajwani” speak, I state a personal belief that a good security won’t stay good for long if the underlying company is bad. A company that keeps burning cash from unproductive use, doesn’t make profit for its shareholders, keeps relying on government funding to stay alive, and is majority held by the UK government; I wouldn’t want to bet against the government being upset from preferred shareholders making money from government funding that is keeping the banks doors open. They are likely to eventually restructure the security so payment is cancelled. The choice of investment depends on your thoughts on this issue (time before the government reacts, would they react, opportunity cost… etc). I have made my mind up
4. We state the belief that a large number of rights offerings from banks may be issued in the next 6 – 12 months as insufficiently capitalised financial institutions build up their core tier 1 capital in light of Basle III recommendations. Those banks that will not require further equity are likely to benefit, moving ahead, in stock performance, from those banks that remain over leveraged under new criteria. Though there are a number of banks your author trusts considerably more than its competitors, it is an area I will not divulge further. I admit incompetency in unravelling the exotic contents of a contemporary banks balance sheet. As a result, I have not made a single investment in any until I broke that rule with a single purchase at the start of 2010. I do not expect to make further investments in this field hence have not explored it further. Researching extensively a sector to provide a detailed report on why I would not invest, rather than spending that time in something I could invest, seems more practical
2 Equity financing
1. If equity financing was to be accessible due to the forced appetite for risk as cash rates are so low, corporates are the participant most likely to benefit. Indeed, being the economic participant least leveraged, they are the participant others are looking for help to stimulate economic growth and reduce the burden of current debt in the economy (they indeed would be more helpful for developed economies, in an unproductive way, if they were driven by patriotism rather than profit). This could be stimulating for equities, in theory. However, any growth potential is quite likely to be diluted by an increasing amount of equity. We therefore reiterate past statements that it is quite possible that in 2 to 3 years, equity markets can be pretty close to where they are now. Index investing, unless used as a trading strategy, is likely to generate weak results for the risk of holding equities. This will be incorrect if we find the price/earning multiple starts to expand rather than contract during the above mentioned period (it has been contracting for 10 years. Historically, it contracts for a period of 14 – 17 years, followed by a similar period of multiple expansion). Considering the current perceived economic uncertainty, we find this to be unlikely. Please note your author finds no evidence that price/earning multiples are determined by short term interest rate policy. If forced to answer, it may have more to do with a general underlying emotional trait of human reaction to risk, and the time it takes to discount history (a generation)
2. We note, as many of you have, that different asset classes are trading in strong correlation recently. This may have to do with the perceived macro economic uncertainty. We measure this by the fact almost no two economists agree with what will happen next quarter. Many well respected traders have also mentioned on several occasions how the markets are trading on macro data, and then briefly dominated by earnings data during earning seasons. However, your author strongly believes the more attention the market places on macro issues, the more bottom up investment opportunities there are. And the more your portfolio is focused on deep value, the less the portfolio is affected by macro issues.
3. Corporate spending in likely to be channelled in greater proportion than in the past into emerging markets. It is in those areas that news jobs and wage increases are likely to occur, hence leading to increasing consumer spending: exactly what is required for a number of emerging markets that have become overly dependent on exporting. The wealth of Western nations that developed leading companies will slowly be transferred to emerging countries, in the name of profit. This is the reality of a capitalist society. We cannot ignore this powerful transition of capital movement, however, we must also enter such transactions with open eyes. There are simply no free lunches. Of particular concern for investing in such countries, especially China, are the absurdly large equity offerings that occur year after year, diluting significantly buy and hold investors. It forces one to consider taking a trading position, rather than an investing one in such markets. Indeed, such has been the appetite for emerging market equities that they currently trade at a premium to developed market equities (using trialing price/earning ratio). Though growth dynamics are superior, stable market structures, regulation, limited government intervention, accounting, corruption and quasi free markets certainly do not seem to be. A merited premium on equities? We leave that our readers to decide. As per usual, my thoughts on such matters are resolved by considering case by case studies on the equity exposure I am looking for
4. Though we have explicitly mentioned “lack of credit expansion” above, we were primarily referring to bank credit. Cash receiving historically low deposits has also moved in large volume to debt instruments, hence increasing the debt on government and corporate balance sheets. Indeed, cash has moved to such an extent into this asset class that current bond pricing can be argued to be pricing a significant deflation risk. We remain watchers, and holders of bonds bought during 2008/09, rather than buyers of the majority of such instruments considering current pricing. For the a number of our readers, we would suggest the same
5. The important role of capital markets has been explicitily clear for all to see over the last few years, as bank credit has remained muted whilst capital markets have provided essential funding to large and small companies via either debt or equity instruments. Indeed, this phenomenon is likely to create unique investment opportunities in certain regions of the world, regions of the world that were previousely heavily dependent on bank financing. This is likely to lead to a spate of family and private businesses being IPOed. Indeed, if we take our "equity financing cycle" approach to the limit, in the next 10 years we may see a rash of IPOs from "old industry" companies as family owned businesses rush to list their shares and transform into cash the work of generations to create a respectable business empire. Quite the opposite of the spate of spotty teenage kids selling "new age" company shares during 1995 - 2000. Get ready for 2015 - 2020!
Yours sincerely,
Alessandro Sajwani
Working at a Private Bank I often find that nice stories, rather than nice results, are what are demanded from the industry: words, rather than probabilities and price awareness. Coming from a valuation slant to investing, I would like to break apart the words from my last article to an executable framework of action: which can allow the previously mentioned concepts to be used to generate portfolio results, rather than entertain wealthy friends at a (boring) party.
1 Banking regulation
1. Previously bought senior bonds yielding a greater return than years to maturity should be held. It is the securities that are lower in the capital structure that will be principally affected from Basle III changes
2. Selling perpetuals that are priced greater than a years coupon above par should be replaced with perpetuals trading below par. Ideally, you would want to buy a below par perpetual from the same issuer, hence have the same credit risk. We assume you are happy with the credit risk of the issuer you had previously and mention the strategy only to consider as a result of regulation change
3. There are a small number of preferred shares from RBS that continue to pay dividends, though the majority have been forced to stop by the European Commission due to the bank receiving extensive government funding. One in particular that could be of interest for an aggressive, sophisticated investor would be a certain RBS preferred that continues to pay because it was issued prior to Basle II, hence pays the coupon dependent on whether the bank has distributable reserves, not on, for example, the amount of annual profits. We can use retained earnings as a proxy for distributable reserves. If one looks at the retained earnings on the RBS balance sheet at the end of 2008 (a very terrible year for banks), they have close to 20 billion sterling. By year end 2009 they had almost double that amount. One could say this is an excellent investment prospect. However, in true “Sajwani” speak, I state a personal belief that a good security won’t stay good for long if the underlying company is bad. A company that keeps burning cash from unproductive use, doesn’t make profit for its shareholders, keeps relying on government funding to stay alive, and is majority held by the UK government; I wouldn’t want to bet against the government being upset from preferred shareholders making money from government funding that is keeping the banks doors open. They are likely to eventually restructure the security so payment is cancelled. The choice of investment depends on your thoughts on this issue (time before the government reacts, would they react, opportunity cost… etc). I have made my mind up
4. We state the belief that a large number of rights offerings from banks may be issued in the next 6 – 12 months as insufficiently capitalised financial institutions build up their core tier 1 capital in light of Basle III recommendations. Those banks that will not require further equity are likely to benefit, moving ahead, in stock performance, from those banks that remain over leveraged under new criteria. Though there are a number of banks your author trusts considerably more than its competitors, it is an area I will not divulge further. I admit incompetency in unravelling the exotic contents of a contemporary banks balance sheet. As a result, I have not made a single investment in any until I broke that rule with a single purchase at the start of 2010. I do not expect to make further investments in this field hence have not explored it further. Researching extensively a sector to provide a detailed report on why I would not invest, rather than spending that time in something I could invest, seems more practical
2 Equity financing
1. If equity financing was to be accessible due to the forced appetite for risk as cash rates are so low, corporates are the participant most likely to benefit. Indeed, being the economic participant least leveraged, they are the participant others are looking for help to stimulate economic growth and reduce the burden of current debt in the economy (they indeed would be more helpful for developed economies, in an unproductive way, if they were driven by patriotism rather than profit). This could be stimulating for equities, in theory. However, any growth potential is quite likely to be diluted by an increasing amount of equity. We therefore reiterate past statements that it is quite possible that in 2 to 3 years, equity markets can be pretty close to where they are now. Index investing, unless used as a trading strategy, is likely to generate weak results for the risk of holding equities. This will be incorrect if we find the price/earning multiple starts to expand rather than contract during the above mentioned period (it has been contracting for 10 years. Historically, it contracts for a period of 14 – 17 years, followed by a similar period of multiple expansion). Considering the current perceived economic uncertainty, we find this to be unlikely. Please note your author finds no evidence that price/earning multiples are determined by short term interest rate policy. If forced to answer, it may have more to do with a general underlying emotional trait of human reaction to risk, and the time it takes to discount history (a generation)
2. We note, as many of you have, that different asset classes are trading in strong correlation recently. This may have to do with the perceived macro economic uncertainty. We measure this by the fact almost no two economists agree with what will happen next quarter. Many well respected traders have also mentioned on several occasions how the markets are trading on macro data, and then briefly dominated by earnings data during earning seasons. However, your author strongly believes the more attention the market places on macro issues, the more bottom up investment opportunities there are. And the more your portfolio is focused on deep value, the less the portfolio is affected by macro issues.
3. Corporate spending in likely to be channelled in greater proportion than in the past into emerging markets. It is in those areas that news jobs and wage increases are likely to occur, hence leading to increasing consumer spending: exactly what is required for a number of emerging markets that have become overly dependent on exporting. The wealth of Western nations that developed leading companies will slowly be transferred to emerging countries, in the name of profit. This is the reality of a capitalist society. We cannot ignore this powerful transition of capital movement, however, we must also enter such transactions with open eyes. There are simply no free lunches. Of particular concern for investing in such countries, especially China, are the absurdly large equity offerings that occur year after year, diluting significantly buy and hold investors. It forces one to consider taking a trading position, rather than an investing one in such markets. Indeed, such has been the appetite for emerging market equities that they currently trade at a premium to developed market equities (using trialing price/earning ratio). Though growth dynamics are superior, stable market structures, regulation, limited government intervention, accounting, corruption and quasi free markets certainly do not seem to be. A merited premium on equities? We leave that our readers to decide. As per usual, my thoughts on such matters are resolved by considering case by case studies on the equity exposure I am looking for
4. Though we have explicitly mentioned “lack of credit expansion” above, we were primarily referring to bank credit. Cash receiving historically low deposits has also moved in large volume to debt instruments, hence increasing the debt on government and corporate balance sheets. Indeed, cash has moved to such an extent into this asset class that current bond pricing can be argued to be pricing a significant deflation risk. We remain watchers, and holders of bonds bought during 2008/09, rather than buyers of the majority of such instruments considering current pricing. For the a number of our readers, we would suggest the same
5. The important role of capital markets has been explicitily clear for all to see over the last few years, as bank credit has remained muted whilst capital markets have provided essential funding to large and small companies via either debt or equity instruments. Indeed, this phenomenon is likely to create unique investment opportunities in certain regions of the world, regions of the world that were previousely heavily dependent on bank financing. This is likely to lead to a spate of family and private businesses being IPOed. Indeed, if we take our "equity financing cycle" approach to the limit, in the next 10 years we may see a rash of IPOs from "old industry" companies as family owned businesses rush to list their shares and transform into cash the work of generations to create a respectable business empire. Quite the opposite of the spate of spotty teenage kids selling "new age" company shares during 1995 - 2000. Get ready for 2015 - 2020!
Yours sincerely,
Alessandro Sajwani
Bank regulation, portfolio insurance and equity financing
Dear Reader,
The resulting news that came from the new Basle III arrangements has over the last two weeks led us to (1) sell perpetuals that trade at more than a years coupon above par and (2) re invest those proceeds into perpetuals that trade below par (which have been rapidly rising to par value due to the volume in this trade of late; case in point is the Prudential 6.5% USD which has risen from mid 80s to mid 90s).
However, the new definitions of core tier 1 capital, which effectively include only retained earnings and equity, are likely to lead banks which do not have sufficient core tier 1 to issue equity. We are wary that a number of rights issues are likely to be announced by a number of banks over the next 6 – 12 months due to this. This is likely to be bad news for the stock prices of these banks (at least temporarily) due to the dilution affect of a rights issue. Though I have not been a holder of bank stocks in my portfolio (I hold only one from early 2010), a number of clients have bought the equity of a number of banks from their home country, due to the strong brand image these enterprises have created in their country of domicile from decades of success and growth. Needless to say, almost all these positions are at a significant loss and I believe there is a strong possibility they will remain so in three years time.
However, this leads us to consider an important point. Your author believes financing cycles switch from being equity to debt based. The 1995 to 2000 asset price increases were fuelled from equity financing. This is most clearly seen by the ever increasing number of IPOs being presented and executed in that period. The asset price increases during 2003 – 2007 was fuelled by debt. We are likely to see the next financing cycle fuelled by equity. This makes good sense when we consider that almost all economic participants are heavily leveraged relative to almost all debt metrics commonly used. I would say the order of highest to lowest leveraged are (1) Financials, (2) Households, (3) Governments, (4) Corporates. So far in the de leveraging process we have seen the most action from financials (examples include the large issuance of bonds, common and preferred shares and the conversion of preferred shares to common shares. The elimination of dividends from common shares and preferred shares and the non calling of similar tier 1 hybrid securities, which were previously assumed to be redeemed on the first call date). It is no accident, they are the most leveraged.
We are likely to see a continuing de leveraging from consumers. This will be most evident from spending decreasing and savings increasing. This is likely to reduce economic growth trends in the next three years compared to what we had prior to the crisis (we have mentioned this point repeatedly over the last 12 months). Consumer credit growth in banks, if the above is true, will also likely be weak. This means an important source of bank income will be weak. Retail banks are therefore likely to generate smaller profits than those generated prior to the crisis. For retail banks, this can only be circumvented if they start lending to consumers in countries where they have lower leverage (i.e. emerging countries. Watch HSBC and Standard Charted).
Government de leveraging is a point currently being discussed with great enthusiasm in the media (i.e. newly described austerity measures). However whether it becomes reality is another issue. Next year we will be in the third year of the US political cycle. Since 1939, this has not been a negative year for equities due to pro election projects that come out of the cupboard. If you believe in history repeating itself...you heard it here first!
This article, however, comes back to a question that often floats around the back of my head: “the economy will not do well until the banks do well”: they are the grease that make the wheels of the economy move. No credit expansion, no economic growth. All indicators I look at do not point to consumer credit increasing: and consumer spending is 70% of the GDP of most developed economies. Wages and asset prices are also not likely to go north (two other pillars your author believes drive consumer spending).
However, one can counter that if financing will be driven by equity, then a lack of credit expansion need not hurt growth. However, equity financing is not generally available to the consumer: it is available to corporates. They may spend in the hope of generating greater profits from increasing market share or investing in developing new products. Equity financing therefore predominantly affects corporate spending. They may affect consumer spending by creating new jobs and increasing wages. However, we are seeing spending increase in emerging markets, where consumers are not leveraged and wages are increasing, as are the number of new middle class consumers. Hence, developed market consumers and workers are not going to be the direct beneficiaries of future corporate spending, should it increase from access to equity financing.
Indeed, should such large corporates remain registered in developed countries, one of the largest beneficiaries will be the government due to growing tax receipts. However, we feel as corporates get larger their power over government increases, and this statement may prove to be frivolous.
Conclusions
1. Regulation is affecting the capital structure of banks, which will affect the pricing of securities in the lower part of that capital structure (common stock and hybrid tier 1 capital). The de leveraging of banks is leading this change
2. We fear the de leveraging of the consumer will be negative for consumer spending and retail bank credit growth. Coupled with a weak labour market, this is also negative for the property market. Sufficiently attractive pricing can always help reverse this trend in an open economy. Retail banks with emerging market exposure can increase lending and eventually help reduce their loan loss provisions (if lend wisely there!)
3. The lack of credit demand from consumers and the lack of credit availability as banks build up core tier 1 capital will not be a positive factor for growth. We do, however, see equity financing help provide the necessary investment power for corporates. This money is likely to be channelled in greater quantities to emerging countries rather than developed countries
4. Stability in bank balance sheets will be a big catalyst for a strong multi year run in equities, especially if markets fall below fair value during the wait. As a reference, for the S&P 500, I see fair value as between 930 – 950. History would suggest the next cycle of price/earning multiple expansion could start within 4 – 6 years. We have now been in a multiple contraction period for 10 years
5. We feel for a small cost insurance options should be considered in the portfolio (up to 5% of the portfolio, to protect against extreme situations). For example, (1)buying put options on a relatively low volatily asset as it has been increasing strongly recently and we feel is expensive. An article by Dylan Grice at Soceite Generale recently suggested using Silver. This takes advantage of its perception as being a “cheap gold”; whilst also being heavily affected by the industrial cycle. One can also do as Seth Klarmen has recently done; (2) by cheap “deeply out of the money” long dated put options on government bonds. This can offer significant returns if long term government bond yields increase greater than say 8%, offering a money making security in a quasi hyperinflation environment. Though the probabilities of such events occurring are perceived as low, their consequences are sufficiently damaging for portfolios that they should not be ignored. This is especially true considering the huge amounts of leverage in the economy and the large policy responses we have seen. Deflation protection is most cheaply offered by holding cash in hand.
6. Though a long term problem, one can never ignore that demographics has a huge role to play on the interest rates of an economy. A large aging population may have played a big role in keeping rates low in Japan. Once these investors start drawing from their capital rather than buying new Japanese government bonds, funding costs could rise as dependence on foreign investors increases. Indeed, increasing oil prices in the 1970s can be interpreted as having occured as the USA became a larger oil importer, allowing foreign oil producers to have sufficient power to create a cartel. Previosly, the USAs lack of foreign dependence on oil simply did not make the cartel stable. These two examples of shifting to foreign dependence for an asset (be it oil or money)can play a big role in the evolution of the pricing of that asset. Your author sees debt in the same manner. Once a company issues debt; its existence becomes dependent on foreigners, people outside the company. Partial control of the company is removed from within the company. Initially, this removal is invisible. As debt increases, this transfer of control becomes more apparent. Until, like a virus, the foreign body controls the entire victom until it has sucked all the goodness it has, and it moves to the next victom. Beware of expensive leveraged companies that promise growth!
Sincerely yours,
Alessandro Sajwani
The resulting news that came from the new Basle III arrangements has over the last two weeks led us to (1) sell perpetuals that trade at more than a years coupon above par and (2) re invest those proceeds into perpetuals that trade below par (which have been rapidly rising to par value due to the volume in this trade of late; case in point is the Prudential 6.5% USD which has risen from mid 80s to mid 90s).
However, the new definitions of core tier 1 capital, which effectively include only retained earnings and equity, are likely to lead banks which do not have sufficient core tier 1 to issue equity. We are wary that a number of rights issues are likely to be announced by a number of banks over the next 6 – 12 months due to this. This is likely to be bad news for the stock prices of these banks (at least temporarily) due to the dilution affect of a rights issue. Though I have not been a holder of bank stocks in my portfolio (I hold only one from early 2010), a number of clients have bought the equity of a number of banks from their home country, due to the strong brand image these enterprises have created in their country of domicile from decades of success and growth. Needless to say, almost all these positions are at a significant loss and I believe there is a strong possibility they will remain so in three years time.
However, this leads us to consider an important point. Your author believes financing cycles switch from being equity to debt based. The 1995 to 2000 asset price increases were fuelled from equity financing. This is most clearly seen by the ever increasing number of IPOs being presented and executed in that period. The asset price increases during 2003 – 2007 was fuelled by debt. We are likely to see the next financing cycle fuelled by equity. This makes good sense when we consider that almost all economic participants are heavily leveraged relative to almost all debt metrics commonly used. I would say the order of highest to lowest leveraged are (1) Financials, (2) Households, (3) Governments, (4) Corporates. So far in the de leveraging process we have seen the most action from financials (examples include the large issuance of bonds, common and preferred shares and the conversion of preferred shares to common shares. The elimination of dividends from common shares and preferred shares and the non calling of similar tier 1 hybrid securities, which were previously assumed to be redeemed on the first call date). It is no accident, they are the most leveraged.
We are likely to see a continuing de leveraging from consumers. This will be most evident from spending decreasing and savings increasing. This is likely to reduce economic growth trends in the next three years compared to what we had prior to the crisis (we have mentioned this point repeatedly over the last 12 months). Consumer credit growth in banks, if the above is true, will also likely be weak. This means an important source of bank income will be weak. Retail banks are therefore likely to generate smaller profits than those generated prior to the crisis. For retail banks, this can only be circumvented if they start lending to consumers in countries where they have lower leverage (i.e. emerging countries. Watch HSBC and Standard Charted).
Government de leveraging is a point currently being discussed with great enthusiasm in the media (i.e. newly described austerity measures). However whether it becomes reality is another issue. Next year we will be in the third year of the US political cycle. Since 1939, this has not been a negative year for equities due to pro election projects that come out of the cupboard. If you believe in history repeating itself...you heard it here first!
This article, however, comes back to a question that often floats around the back of my head: “the economy will not do well until the banks do well”: they are the grease that make the wheels of the economy move. No credit expansion, no economic growth. All indicators I look at do not point to consumer credit increasing: and consumer spending is 70% of the GDP of most developed economies. Wages and asset prices are also not likely to go north (two other pillars your author believes drive consumer spending).
However, one can counter that if financing will be driven by equity, then a lack of credit expansion need not hurt growth. However, equity financing is not generally available to the consumer: it is available to corporates. They may spend in the hope of generating greater profits from increasing market share or investing in developing new products. Equity financing therefore predominantly affects corporate spending. They may affect consumer spending by creating new jobs and increasing wages. However, we are seeing spending increase in emerging markets, where consumers are not leveraged and wages are increasing, as are the number of new middle class consumers. Hence, developed market consumers and workers are not going to be the direct beneficiaries of future corporate spending, should it increase from access to equity financing.
Indeed, should such large corporates remain registered in developed countries, one of the largest beneficiaries will be the government due to growing tax receipts. However, we feel as corporates get larger their power over government increases, and this statement may prove to be frivolous.
Conclusions
1. Regulation is affecting the capital structure of banks, which will affect the pricing of securities in the lower part of that capital structure (common stock and hybrid tier 1 capital). The de leveraging of banks is leading this change
2. We fear the de leveraging of the consumer will be negative for consumer spending and retail bank credit growth. Coupled with a weak labour market, this is also negative for the property market. Sufficiently attractive pricing can always help reverse this trend in an open economy. Retail banks with emerging market exposure can increase lending and eventually help reduce their loan loss provisions (if lend wisely there!)
3. The lack of credit demand from consumers and the lack of credit availability as banks build up core tier 1 capital will not be a positive factor for growth. We do, however, see equity financing help provide the necessary investment power for corporates. This money is likely to be channelled in greater quantities to emerging countries rather than developed countries
4. Stability in bank balance sheets will be a big catalyst for a strong multi year run in equities, especially if markets fall below fair value during the wait. As a reference, for the S&P 500, I see fair value as between 930 – 950. History would suggest the next cycle of price/earning multiple expansion could start within 4 – 6 years. We have now been in a multiple contraction period for 10 years
5. We feel for a small cost insurance options should be considered in the portfolio (up to 5% of the portfolio, to protect against extreme situations). For example, (1)buying put options on a relatively low volatily asset as it has been increasing strongly recently and we feel is expensive. An article by Dylan Grice at Soceite Generale recently suggested using Silver. This takes advantage of its perception as being a “cheap gold”; whilst also being heavily affected by the industrial cycle. One can also do as Seth Klarmen has recently done; (2) by cheap “deeply out of the money” long dated put options on government bonds. This can offer significant returns if long term government bond yields increase greater than say 8%, offering a money making security in a quasi hyperinflation environment. Though the probabilities of such events occurring are perceived as low, their consequences are sufficiently damaging for portfolios that they should not be ignored. This is especially true considering the huge amounts of leverage in the economy and the large policy responses we have seen. Deflation protection is most cheaply offered by holding cash in hand.
6. Though a long term problem, one can never ignore that demographics has a huge role to play on the interest rates of an economy. A large aging population may have played a big role in keeping rates low in Japan. Once these investors start drawing from their capital rather than buying new Japanese government bonds, funding costs could rise as dependence on foreign investors increases. Indeed, increasing oil prices in the 1970s can be interpreted as having occured as the USA became a larger oil importer, allowing foreign oil producers to have sufficient power to create a cartel. Previosly, the USAs lack of foreign dependence on oil simply did not make the cartel stable. These two examples of shifting to foreign dependence for an asset (be it oil or money)can play a big role in the evolution of the pricing of that asset. Your author sees debt in the same manner. Once a company issues debt; its existence becomes dependent on foreigners, people outside the company. Partial control of the company is removed from within the company. Initially, this removal is invisible. As debt increases, this transfer of control becomes more apparent. Until, like a virus, the foreign body controls the entire victom until it has sucked all the goodness it has, and it moves to the next victom. Beware of expensive leveraged companies that promise growth!
Sincerely yours,
Alessandro Sajwani
Monday 23 August 2010
The World is Changing...Remember to Change Your Portfolio With It
If history tells us one thing, it tells us the world never stops changing. As the great French Philosopher/Scientist Blaise Pascal observed "all of human misfortune comes from one thing, which is not knowing how to sit quietly in a room".
Recently law makers and regulators have been getting their hands dirty. No where more so than in the USA. Laws to incentivise whistle blowing, laws to claw back management bonuses, laws on bank reform and health care. The list is a long, and their effects cannot be ignored. Lone investors cannot possibly follow them all and understand fully their consequences. However, one that has particularly caught by attention is the Dodd - Frank "Wall Street" reform.
This caught my attention as we were buyers of General Electric (GE) common stock in mid 2009 at prices around 13.0 - 13.5 USD per share. We hold only one other financial company in our investment portfolio as we remain deeply sceptical of highly leveraged businesses, be it banks or otherwise, and rarely invest in their securities unless we can buy the underlying net assets at very cheap prices (we don’t like paying for growth in leveraged companies).
Digging into this particular Act I realised a number of negative issues could arise for General Electric, as it has a very large finance company within the parent company – General Electric Capital Finance, which is involved in leasing, mortgages and all manner of financial activities. Furthermore, this business in 2008 consisted of 37% of total revenue and 36% of the profit – it is a major part of General Electric, and as a consequence, the company is not merely another industrial company.
Consider that towards the end of August 2010 General Electric was trading with a market cap close to 160 billion USD, whilst GECF had 345 billion financing receivables on its balance sheet. A 5% default rate on that portfolio would wipe out a third of the tangible common equity of the company from 2009 end of year financial statements. Not surprising to hear GE has one of the lowest reserves to loan ratios within the financial sector (comparing to banks) as well as provisions for non performing assets (NPA).
The more astute reader would ask why we are comparing GE to other banks? This is where the Dodd – Frank reform becomes important. GE Capital had been supervised under the Office of Thrift Supervision in the past. This will be merged into the Office of the Comptroller of the Currency. Under the latest reform, GE's financial entities will be expected to comply with more strict Fed requirements, commonly associated with bank holding companies (BHC). Section 113 of the Dodd-Frank bill gives the Fed the authority to regulate nonbank financial firms that "could pose a threat to the financial stability of the United States”. So while most banks and financial firms have been required to increase capital throughout the financial crisis, GE Capital has so far been able to avoid the Federal Deposit Insurance Corporation (FDIC) and its demands for more capital, and hence reducing leverage.
Furthermore, GE Capital itself engages in impermissible BHC activities. One example would be the equity investments made by GE Capital into commercial real estate deals. This is not permitted under Fed BHC rules. Will it be forced to sale? The possibilities of writedowns should this occur would be high. A large portion of their portfolio consists of real estate bought within 2006/07.
We also note that capital shifts between GE Capital and GE could be restricted under Section 23A of the Federal Reserve Act, which governs transaction with affiliates. Is GECC now sufficiently capitalised to cut this connection? If not, would the company would have to be spun off? GE has already stated it would make a 2011 capital contribution of $2 billion to the unit, in addition to the maintenance payments to GE Capital. GE Capital over the last two years has been well protected by the free cash flowing parent company. How would it do without it?
We didn’t stick around to find out. We sold all our positions at prices within 15.16 -15.20 USD per share. We feel there are a number of alternative positions in USD that offer a similar or higher dividend yield, growth potential and are significantly less leveraged and have less possibility of a permanent loss of equity due to regulatory and accounting changes.
Indeed, in the regulator front many changes are being made to help shareholders, be it greater transparency of information or trying to generate better feedback loops to stimulate productive management.
Indeed, economics is also making it better to be a shareholder. Being a resident of Southern Europe I am surrounded by double digit unemployment statistics. Though many highly qualified and bright individuals hope that they can receive a great job offer from a great company with a great wage at their home town, the probabilities are low. Should global growth pick up unemployment is so high that wage increases are unlikely. Should companies invest more to increase production it is more likely it will be done in Asian countries where costs are lower and growth is higher: hence job creation is not likely to be as strong locally. Hence, it is the large companies that would enjoy the fruits of growth, not local residents.
Local residents should consider becoming shareholders of such companies at interesting prices so they can enjoy their profits. It’s never been a better time to be a shareholder to balance your personal job security risk with the potential profits smart management, good products and an established infrastructure to do business can provide.
Recently law makers and regulators have been getting their hands dirty. No where more so than in the USA. Laws to incentivise whistle blowing, laws to claw back management bonuses, laws on bank reform and health care. The list is a long, and their effects cannot be ignored. Lone investors cannot possibly follow them all and understand fully their consequences. However, one that has particularly caught by attention is the Dodd - Frank "Wall Street" reform.
This caught my attention as we were buyers of General Electric (GE) common stock in mid 2009 at prices around 13.0 - 13.5 USD per share. We hold only one other financial company in our investment portfolio as we remain deeply sceptical of highly leveraged businesses, be it banks or otherwise, and rarely invest in their securities unless we can buy the underlying net assets at very cheap prices (we don’t like paying for growth in leveraged companies).
Digging into this particular Act I realised a number of negative issues could arise for General Electric, as it has a very large finance company within the parent company – General Electric Capital Finance, which is involved in leasing, mortgages and all manner of financial activities. Furthermore, this business in 2008 consisted of 37% of total revenue and 36% of the profit – it is a major part of General Electric, and as a consequence, the company is not merely another industrial company.
Consider that towards the end of August 2010 General Electric was trading with a market cap close to 160 billion USD, whilst GECF had 345 billion financing receivables on its balance sheet. A 5% default rate on that portfolio would wipe out a third of the tangible common equity of the company from 2009 end of year financial statements. Not surprising to hear GE has one of the lowest reserves to loan ratios within the financial sector (comparing to banks) as well as provisions for non performing assets (NPA).
The more astute reader would ask why we are comparing GE to other banks? This is where the Dodd – Frank reform becomes important. GE Capital had been supervised under the Office of Thrift Supervision in the past. This will be merged into the Office of the Comptroller of the Currency. Under the latest reform, GE's financial entities will be expected to comply with more strict Fed requirements, commonly associated with bank holding companies (BHC). Section 113 of the Dodd-Frank bill gives the Fed the authority to regulate nonbank financial firms that "could pose a threat to the financial stability of the United States”. So while most banks and financial firms have been required to increase capital throughout the financial crisis, GE Capital has so far been able to avoid the Federal Deposit Insurance Corporation (FDIC) and its demands for more capital, and hence reducing leverage.
Furthermore, GE Capital itself engages in impermissible BHC activities. One example would be the equity investments made by GE Capital into commercial real estate deals. This is not permitted under Fed BHC rules. Will it be forced to sale? The possibilities of writedowns should this occur would be high. A large portion of their portfolio consists of real estate bought within 2006/07.
We also note that capital shifts between GE Capital and GE could be restricted under Section 23A of the Federal Reserve Act, which governs transaction with affiliates. Is GECC now sufficiently capitalised to cut this connection? If not, would the company would have to be spun off? GE has already stated it would make a 2011 capital contribution of $2 billion to the unit, in addition to the maintenance payments to GE Capital. GE Capital over the last two years has been well protected by the free cash flowing parent company. How would it do without it?
We didn’t stick around to find out. We sold all our positions at prices within 15.16 -15.20 USD per share. We feel there are a number of alternative positions in USD that offer a similar or higher dividend yield, growth potential and are significantly less leveraged and have less possibility of a permanent loss of equity due to regulatory and accounting changes.
Indeed, in the regulator front many changes are being made to help shareholders, be it greater transparency of information or trying to generate better feedback loops to stimulate productive management.
Indeed, economics is also making it better to be a shareholder. Being a resident of Southern Europe I am surrounded by double digit unemployment statistics. Though many highly qualified and bright individuals hope that they can receive a great job offer from a great company with a great wage at their home town, the probabilities are low. Should global growth pick up unemployment is so high that wage increases are unlikely. Should companies invest more to increase production it is more likely it will be done in Asian countries where costs are lower and growth is higher: hence job creation is not likely to be as strong locally. Hence, it is the large companies that would enjoy the fruits of growth, not local residents.
Local residents should consider becoming shareholders of such companies at interesting prices so they can enjoy their profits. It’s never been a better time to be a shareholder to balance your personal job security risk with the potential profits smart management, good products and an established infrastructure to do business can provide.
Monday 16 August 2010
Full Steam Ahead...
Dear Readers,
Having lost my frame of reference over the last few weeks due to a wicked cocktail of agonising back pain and prescribed hard drugs, I awoke this morning not to the scream of a thousand different echos, but to a gentle melody that led me to a window with an interesting view....
What great and rapid changes are happening in the world today and how they are affecting the world we live in. The beauty of a free enterprise system is evolving in front of our eyes. We are living it. We are making it. But most importantly, we must appreciate and react to it if you wish to eat its fruits.
Only in the first few seconds of picking up a few newspapers and my head hurts from its pounding footsteps...
Dodd - Frank reform affecting the marked to market valuation of GE capital assets. This needs us to have a clear appreciation and an immediate re valuation of what we feel the company is worth and how the market may react to sudden write downs through its income statement. We were past buyers of this stock in mid 2009 and if the opportunity seems appropriate due to the markets reaction - we will buy more. We must be ready to react appropriately. If we feel the companies current value is fairly priced, we shall sale (the position is currently profitable).
Large Pharma investigation by the Department of Justice. Glaxo could be implicated as are Pfizer, Merck and a range of others. The grounds are based on bribery charges from selling value products to governments (i..e think of any state owned European health institution!). You can imagine the size of this lawsuit if that was true! In reality it is a little dirtier than that and probably will require us to limit the size of pharma exposure in our portfolios until we appreciate the true extent and agenda of this case. At this point in time we are happy with our portfolios approximate 15% exposure to healthcare. We remain intimate shareholders of Sanofi Aventis, Glaxosmithkline and Astellas Pharmaceuticals.
Yours sincerely,
Alessandro Sajwani
Having lost my frame of reference over the last few weeks due to a wicked cocktail of agonising back pain and prescribed hard drugs, I awoke this morning not to the scream of a thousand different echos, but to a gentle melody that led me to a window with an interesting view....
What great and rapid changes are happening in the world today and how they are affecting the world we live in. The beauty of a free enterprise system is evolving in front of our eyes. We are living it. We are making it. But most importantly, we must appreciate and react to it if you wish to eat its fruits.
Only in the first few seconds of picking up a few newspapers and my head hurts from its pounding footsteps...
Dodd - Frank reform affecting the marked to market valuation of GE capital assets. This needs us to have a clear appreciation and an immediate re valuation of what we feel the company is worth and how the market may react to sudden write downs through its income statement. We were past buyers of this stock in mid 2009 and if the opportunity seems appropriate due to the markets reaction - we will buy more. We must be ready to react appropriately. If we feel the companies current value is fairly priced, we shall sale (the position is currently profitable).
Large Pharma investigation by the Department of Justice. Glaxo could be implicated as are Pfizer, Merck and a range of others. The grounds are based on bribery charges from selling value products to governments (i..e think of any state owned European health institution!). You can imagine the size of this lawsuit if that was true! In reality it is a little dirtier than that and probably will require us to limit the size of pharma exposure in our portfolios until we appreciate the true extent and agenda of this case. At this point in time we are happy with our portfolios approximate 15% exposure to healthcare. We remain intimate shareholders of Sanofi Aventis, Glaxosmithkline and Astellas Pharmaceuticals.
Yours sincerely,
Alessandro Sajwani
Friday 23 July 2010
A view on consumer spending
Dear Reader,
At this rate I should call the blog "long term macro forecasting!"
However, I continously receive questions involving macro issues rather than issues such as the ridiculous price Debenhams stock is currently trading at (a topic less interesting for most people).
Though I feel I have more skill in the latter topic than the former, I shall in this particular blog focus on the statement even fellow investment advisors I work with have been saying over the last year: the consumer will push the economy forward soon.
Who am I to say otherwise, but I feel they are more likely to be wrong than right. As far as I am concerned there are three prinicipal factors that allow the consumer to maintain and increase spending. They are:-
1. Increasing wages
2. Increasing availability to credit
3. Increasing asset prices
Who wants to take bets on any of these increasing? I wouldn´t. Consumer spending will not grow strongly. As a result in most developed countries economic growth will be weaker than expected.
Yours sincerely,
Alessandro Sajwani
At this rate I should call the blog "long term macro forecasting!"
However, I continously receive questions involving macro issues rather than issues such as the ridiculous price Debenhams stock is currently trading at (a topic less interesting for most people).
Though I feel I have more skill in the latter topic than the former, I shall in this particular blog focus on the statement even fellow investment advisors I work with have been saying over the last year: the consumer will push the economy forward soon.
Who am I to say otherwise, but I feel they are more likely to be wrong than right. As far as I am concerned there are three prinicipal factors that allow the consumer to maintain and increase spending. They are:-
1. Increasing wages
2. Increasing availability to credit
3. Increasing asset prices
Who wants to take bets on any of these increasing? I wouldn´t. Consumer spending will not grow strongly. As a result in most developed countries economic growth will be weaker than expected.
Yours sincerely,
Alessandro Sajwani
Tuesday 20 July 2010
Another rare macro view
Dear Reader,
Not one for musing on macro issues (the stories sound nice, but they offer a limited ability to select well priced securities with good prospects to make money, with a large possibility of being wrong in your underlying assumptions), but many clients find this arena entertaining and have asked many questions recently. As a result, below please find some of the thoughts that influence my personal macro thinking, and hence the asset allocation we propose.
1 Developed economies issues
As policymakers decide whether we shall suffer inflation or deflation, as fundmanagers decide whether they should be long or short equities and bankers decide whether they should go on holiday in or outside of Europe due to cost cutting, it really is an uncertain world we live in, and market volatility is clearly showing this to us.
Lets start this email with the following observation. When economies are in a low inflation and low interest rate environment, this should be positive for risk assets. Couple that with a loud government voice that seems to be keen to help when too much negative news comes out, we seem to have a strong support that allows risk assets to remain expensive. Indeed, until that government support is muted either by 1. Such action not being found attractive by the public anymore due to its fiscal costs, or 2. Government bond yields shoot up so stimulus becomes harder to fund, it is likely to continue.
However, we may find a second level feedback loop developing. If government funding becomes more difficult, where will capital go? Gold? Equities? A reduction in the markets perception of the quality of government debt is likely to affect the valuation of all risk assets, hence risk assets are also likely to fall in price. Such a scenario could set the conditions for a severe recession to occur unless governments print money to re introduce liquidity into the system, which they probably would. Hence capital would flow to government bonds again, the only creator of money in a system that wants to deflate. Hence government bond yields could stay low for quite some time. Indeed, only until inflation rears its ugly head are government yields likely to rise. Capital is then likely to flow to real assets.
Hence in a low inflation, low interest environment with an embedded government put option, it is a probable scenario that bonds and equities are expensive as yields stay artificially low (hence prices are high). Inflation is likely to be the driver that changes this scenario. Inflation, for the moment, is losing on points to deflation fears due to weak aggregate demand (more on this below).
In such an environment risk assets are likely to stay flat for quite a period of time. They should fall (as we have mentioned in past emails over the last year), but the variables above mentioned offer resistance, and they have little incentive to rise too much because the demand is not there to increase earnings in general for economies (i.e. weak private credit growth). Hence re balancing the portfolio frequently is important to take profits on risk assets as they oscillate up and down, heavily influenced by political and economic news, as well as individual company developments. But, please don't get me wrong, risk assets today are, in general, overvalued. One sector I believe does not seem to be expensive are high quality blue chip companies that have the attributes of low debt, high returns on capital and strong free cash flow generation. This includes companies such as Johnson & Johnson, Wal Mart, Total, Sanofi Aventis etc. The boring companies...
Recent discussion by the authorities to change the game from who can print more money to who can cut their budget the fastest, is, as far as I am concerned, scary. This will reduce the perception of the governments "invisible" put option, which is likely to push risk assets closer to fair value (i.e. they will decline). Furthermore, by shifting the weight of supporting the economy to a weak and credit strapped private sector, one should expect economic growth to be weak, and only a question of time before governments start financing the bill again.
As an aside, it is interesting to note that there is an incrediable statistical data set to show that on the third year of a US presidents reign, equity markets are positive as projects are commenced that are positive for the economy prior to the election. That third year would be next year for Obama's presidency. Such "political muses" may be less relevant than history would suggest due to the large stimulus that has already been launched ove rthe last two years. Nevertheless, an interesting point to keep in the back of our minds.
2 Global market issues
With regards to this issue, I find it worthwhile to quote William H. Gross, who describes this scenario most aptly, and whose view I agree with almost totally.
"What is hard to understand is there are 6.5 billion people in the world and will soon be 1 billion more. Many of them are debt-free and have never used a credit card or assumed a home mortgage. Why can’t lenders lend to them, allowing developing nations to bring their consumption forward, developed nations to supply the goods and services, and the world to resume its “old normal” path toward future profits, prosperity and increasing standard of living? To a certain extent that is what should gradually happen, promoting more rapid growth in the emerging nations and a subdued semblance of it in the G-7 – a “new normal.”
But they – the developing nations – are not growing fast enough, at least internally, to return global growth to its old standards. Their financial systems are immature and reminiscent of a spindly-legged baby giraffe, having lots of upward potential but still striving for balance after a series of missteps, the most recent of which was the Asian crisis over a decade ago. And so they produce for export, not internal consumption, and in the process leave a gaping hole in what is known as global aggregate demand. Developed nation consumers are maxed out because of too much debt, and developing nations don’t trust themselves to stretch their necks for the delicious leaves of domestic consumption just above.
It is this lack of global aggregate demand – resulting from too much debt in parts of the global economy and not enough in others – that is the essence of the problem. If policymakers could act in unison and smoothly transition maxed-out indebted consumer nations into future producers, while simultaneously convincing lightly indebted developing nations to consume more, then our predicament would be manageable. They cannot. G-20 Toronto meetings aside, the world is caught up as it usually is in an “every nation for itself” mentality, with China taking its measured time to consume and the U.S. refusing to acknowledge its necessity to invest in goods for export.
Consumption when brought forward must be financed, and that financing is a two-way bargain between borrower and creditor. When debt levels become too high, lenders balk and even lenders of last resort – the sovereigns, the central banks, the supranational agencies – approach limits beyond which private enterprise’s productivity itself is threatened. We have arrived at a New Normal where, despite the introduction of 3 billion new consumers over the past several decades in “Chindia” and beyond, there is a lack of global aggregate demand or perhaps an inability or unwillingness to finance it. Slow growth in the developed world, insufficiently high levels of consumption in the emerging world, and seemingly inexplicable low total returns on investment portfolios – bonds and stocks – lie ahead. "
We look forward to hear from you if you have any questions or queries.
Yours sincerely,
Alessandro Sajwani
Not one for musing on macro issues (the stories sound nice, but they offer a limited ability to select well priced securities with good prospects to make money, with a large possibility of being wrong in your underlying assumptions), but many clients find this arena entertaining and have asked many questions recently. As a result, below please find some of the thoughts that influence my personal macro thinking, and hence the asset allocation we propose.
1 Developed economies issues
As policymakers decide whether we shall suffer inflation or deflation, as fundmanagers decide whether they should be long or short equities and bankers decide whether they should go on holiday in or outside of Europe due to cost cutting, it really is an uncertain world we live in, and market volatility is clearly showing this to us.
Lets start this email with the following observation. When economies are in a low inflation and low interest rate environment, this should be positive for risk assets. Couple that with a loud government voice that seems to be keen to help when too much negative news comes out, we seem to have a strong support that allows risk assets to remain expensive. Indeed, until that government support is muted either by 1. Such action not being found attractive by the public anymore due to its fiscal costs, or 2. Government bond yields shoot up so stimulus becomes harder to fund, it is likely to continue.
However, we may find a second level feedback loop developing. If government funding becomes more difficult, where will capital go? Gold? Equities? A reduction in the markets perception of the quality of government debt is likely to affect the valuation of all risk assets, hence risk assets are also likely to fall in price. Such a scenario could set the conditions for a severe recession to occur unless governments print money to re introduce liquidity into the system, which they probably would. Hence capital would flow to government bonds again, the only creator of money in a system that wants to deflate. Hence government bond yields could stay low for quite some time. Indeed, only until inflation rears its ugly head are government yields likely to rise. Capital is then likely to flow to real assets.
Hence in a low inflation, low interest environment with an embedded government put option, it is a probable scenario that bonds and equities are expensive as yields stay artificially low (hence prices are high). Inflation is likely to be the driver that changes this scenario. Inflation, for the moment, is losing on points to deflation fears due to weak aggregate demand (more on this below).
In such an environment risk assets are likely to stay flat for quite a period of time. They should fall (as we have mentioned in past emails over the last year), but the variables above mentioned offer resistance, and they have little incentive to rise too much because the demand is not there to increase earnings in general for economies (i.e. weak private credit growth). Hence re balancing the portfolio frequently is important to take profits on risk assets as they oscillate up and down, heavily influenced by political and economic news, as well as individual company developments. But, please don't get me wrong, risk assets today are, in general, overvalued. One sector I believe does not seem to be expensive are high quality blue chip companies that have the attributes of low debt, high returns on capital and strong free cash flow generation. This includes companies such as Johnson & Johnson, Wal Mart, Total, Sanofi Aventis etc. The boring companies...
Recent discussion by the authorities to change the game from who can print more money to who can cut their budget the fastest, is, as far as I am concerned, scary. This will reduce the perception of the governments "invisible" put option, which is likely to push risk assets closer to fair value (i.e. they will decline). Furthermore, by shifting the weight of supporting the economy to a weak and credit strapped private sector, one should expect economic growth to be weak, and only a question of time before governments start financing the bill again.
As an aside, it is interesting to note that there is an incrediable statistical data set to show that on the third year of a US presidents reign, equity markets are positive as projects are commenced that are positive for the economy prior to the election. That third year would be next year for Obama's presidency. Such "political muses" may be less relevant than history would suggest due to the large stimulus that has already been launched ove rthe last two years. Nevertheless, an interesting point to keep in the back of our minds.
2 Global market issues
With regards to this issue, I find it worthwhile to quote William H. Gross, who describes this scenario most aptly, and whose view I agree with almost totally.
"What is hard to understand is there are 6.5 billion people in the world and will soon be 1 billion more. Many of them are debt-free and have never used a credit card or assumed a home mortgage. Why can’t lenders lend to them, allowing developing nations to bring their consumption forward, developed nations to supply the goods and services, and the world to resume its “old normal” path toward future profits, prosperity and increasing standard of living? To a certain extent that is what should gradually happen, promoting more rapid growth in the emerging nations and a subdued semblance of it in the G-7 – a “new normal.”
But they – the developing nations – are not growing fast enough, at least internally, to return global growth to its old standards. Their financial systems are immature and reminiscent of a spindly-legged baby giraffe, having lots of upward potential but still striving for balance after a series of missteps, the most recent of which was the Asian crisis over a decade ago. And so they produce for export, not internal consumption, and in the process leave a gaping hole in what is known as global aggregate demand. Developed nation consumers are maxed out because of too much debt, and developing nations don’t trust themselves to stretch their necks for the delicious leaves of domestic consumption just above.
It is this lack of global aggregate demand – resulting from too much debt in parts of the global economy and not enough in others – that is the essence of the problem. If policymakers could act in unison and smoothly transition maxed-out indebted consumer nations into future producers, while simultaneously convincing lightly indebted developing nations to consume more, then our predicament would be manageable. They cannot. G-20 Toronto meetings aside, the world is caught up as it usually is in an “every nation for itself” mentality, with China taking its measured time to consume and the U.S. refusing to acknowledge its necessity to invest in goods for export.
Consumption when brought forward must be financed, and that financing is a two-way bargain between borrower and creditor. When debt levels become too high, lenders balk and even lenders of last resort – the sovereigns, the central banks, the supranational agencies – approach limits beyond which private enterprise’s productivity itself is threatened. We have arrived at a New Normal where, despite the introduction of 3 billion new consumers over the past several decades in “Chindia” and beyond, there is a lack of global aggregate demand or perhaps an inability or unwillingness to finance it. Slow growth in the developed world, insufficiently high levels of consumption in the emerging world, and seemingly inexplicable low total returns on investment portfolios – bonds and stocks – lie ahead. "
We look forward to hear from you if you have any questions or queries.
Yours sincerely,
Alessandro Sajwani
Thursday 15 July 2010
The gravity of finance
Gravity is one of the physical forces we most consider when living our daily life in the physical world. We are all aware of our limitations to jump up, and the ease of falling down.
There is an equivalent force in the financial world. It is most commonly perceived as being interest rates. Your author disagrees. Interest rates can be manipulated and changed by mankind as they chose. Gravity does not have that property, and neither does the gravity of finance. That force is valuation.
History suggests market cycles fluctuate significantly over a period of days, months, years, but they are deeply mean reverting when looked over thirty year periods. If a passive investor would initiate investing in risk assets only when they are priced below their average valuation, and start selling when they are priced one standard deviation above their “fair value”, history suggests you are likely to generate returns greater than being continuously invested in the market.
How much mankind will pay for a future flow of cash flows changes over time depending on how “animal spirits” are being fed. However, it changes in the same way, again and again. It as if throughout our history the only constant is the fact we react as humans: emotionally. That emotional component seems to express itself in a constant manner when imprinted on the valuation of risk assets. As we have said in the past, market valuation can be interpreted by how much investors are reacting to uncertainty, whether they are ignoring it when they are very greedy, or obsessing too much on it when very fearful. The reality is that uncertainty is always present. All that changes is our sentiment towards it. Need I have to state that we are strong followers of Mr. Buffett’s philosophy: be fearful when others are greedy, be greedy when others are fearful.
Yours sincerly,
Alessandro Sajwani
There is an equivalent force in the financial world. It is most commonly perceived as being interest rates. Your author disagrees. Interest rates can be manipulated and changed by mankind as they chose. Gravity does not have that property, and neither does the gravity of finance. That force is valuation.
History suggests market cycles fluctuate significantly over a period of days, months, years, but they are deeply mean reverting when looked over thirty year periods. If a passive investor would initiate investing in risk assets only when they are priced below their average valuation, and start selling when they are priced one standard deviation above their “fair value”, history suggests you are likely to generate returns greater than being continuously invested in the market.
How much mankind will pay for a future flow of cash flows changes over time depending on how “animal spirits” are being fed. However, it changes in the same way, again and again. It as if throughout our history the only constant is the fact we react as humans: emotionally. That emotional component seems to express itself in a constant manner when imprinted on the valuation of risk assets. As we have said in the past, market valuation can be interpreted by how much investors are reacting to uncertainty, whether they are ignoring it when they are very greedy, or obsessing too much on it when very fearful. The reality is that uncertainty is always present. All that changes is our sentiment towards it. Need I have to state that we are strong followers of Mr. Buffett’s philosophy: be fearful when others are greedy, be greedy when others are fearful.
Yours sincerly,
Alessandro Sajwani
Wednesday 14 July 2010
Stock selection criteria
Dear Reader,
We have often mentioned in past articles on this site that our investments are primarily based on companies that are relatively easy to understand, with clear, basic and sustainable competitive strengths, favourable and stable market structures and a cheap price for the security of interest. We add to this criteria companies that have little debt relative to equity and generate a consistent positive free cash flow. In difficult times such companies are less likely to diseappear due to oweing more than they own, and less likely to find themselves in a desperate situation with limited liquidity; and therefore forced to borrow from banks or the capital markets at absurdly high rates . We truly live by our mantra: focus on the downside risk and the upside return will take care of itself. This approach allows us to try and reduce the number of assumptions we must make to decide on going ahead with an investment idea. The more assumptions we make, the higher the chance of error, and therefore a potential loss in invested capital.
We take this opportunity to summarise a recent position we have started to accumulate in our portfolios: Cintas (CTAS, NASDAQ).
Its primary business is designing, manufacturing and servicing employee uniforms. Over time it has expanded it´s product line to include linens, fire extinguishers and janitorial supplies. It also has a document-management business.
The key to Cintas’ business is the route density around centralized laundry and warehouse facilities. The more clients serviced within the radius of the facility, the higher the incremental margin earned on each additional client. Drivers are much more than just delivery people, they are customer-service contacts and are at least partly responsible for cross-selling additional services.
The Cintas growth story was built around successfully driving the consolidation of a very fragmented industry. As the market leader in a business with significant scale economies, they’ve been able to translate their size into higher margins than their competitors, and have also made it difficult to compete with them on price. This is the competitive edge of Cintas.
As the business matured, the City/Wall Street has consistently marked down Cintas’s valuation (low growth companies without large media attention are often punished by investment banks). The share-price damage only accelerated as the economy became worse in 2008/09. The company has responded by quickly reducing headcount and capital spending, but earnings have still been hit.
However, we are happy with the sustainability of the competitive edge of this company, which generates an earning power that can currently be bought for an attractive price.
We do not assume this company will grow more than in the mid to low single-digits on the top line. Yet, even with such an assumption, the valuation available in the market is likely to offer the possibility of generating a modest return over the next 5- 7 years (the next business cycle).
That may seem rather mundane, one does not look to double their money in the next year with this investment. Indeed, the reality is it is highly improbable in many investments. The search for quick money in stock markets often lead to quick losses. What is more probable with the average investment is potentially losing money, and this is what we feel we are not likely to incur with the purchase of the common stock of this company if bought at less than 25 USD/share. Yet, we will enjoy the benefit of:-
1. Growing with this company
2. Enjoying the market re valuation of its sustainable earning power
Over the next business cycle we feel we are likely to generate 50 – 80% return (including dividends) from this investment, with little possibility of making a permanent capital loss. This is likely to be substantially higher than the cumulative return on cash deposit rates during that period. We like to hold investments of these characteristics in our portfolio to help the portfolio generate consistent, low risk (risk as defined as the probability of permanent capital loss) returns.
However, we cannot leave this article with simply stating this is the perfect "no risk" stock. There are various business risks we are following that can either temporarily, or permenantly damage the valuation of the company (we are more concerned with the latter, and see opportunity with the former).
The health of the business is closely tied to employment, so continued rising unemployment would likely not be a positive for the share price. That could be partly offset – or exacerbated – by the direction of fuel prices, which are a big cost component. A more structural risk is that attempts to unionize the Cintas workforce gain steam with the advent of new labor laws and regulations proposed by the current administration. The company today has 34,000 employees, of which under 400 are unionized, so any significant shift toward a more unionized employee base could have a highly negative impact on margins. They’ve been successful in avoiding unionization so far, but it’s clearly an issue we have to continuously monitor. We like the approach management is tackling this issue as is displayed on its web site and corporate documentation.
Yours sincerely,
Alessandro Sajwani
We have often mentioned in past articles on this site that our investments are primarily based on companies that are relatively easy to understand, with clear, basic and sustainable competitive strengths, favourable and stable market structures and a cheap price for the security of interest. We add to this criteria companies that have little debt relative to equity and generate a consistent positive free cash flow. In difficult times such companies are less likely to diseappear due to oweing more than they own, and less likely to find themselves in a desperate situation with limited liquidity; and therefore forced to borrow from banks or the capital markets at absurdly high rates . We truly live by our mantra: focus on the downside risk and the upside return will take care of itself. This approach allows us to try and reduce the number of assumptions we must make to decide on going ahead with an investment idea. The more assumptions we make, the higher the chance of error, and therefore a potential loss in invested capital.
We take this opportunity to summarise a recent position we have started to accumulate in our portfolios: Cintas (CTAS, NASDAQ).
Its primary business is designing, manufacturing and servicing employee uniforms. Over time it has expanded it´s product line to include linens, fire extinguishers and janitorial supplies. It also has a document-management business.
The key to Cintas’ business is the route density around centralized laundry and warehouse facilities. The more clients serviced within the radius of the facility, the higher the incremental margin earned on each additional client. Drivers are much more than just delivery people, they are customer-service contacts and are at least partly responsible for cross-selling additional services.
The Cintas growth story was built around successfully driving the consolidation of a very fragmented industry. As the market leader in a business with significant scale economies, they’ve been able to translate their size into higher margins than their competitors, and have also made it difficult to compete with them on price. This is the competitive edge of Cintas.
As the business matured, the City/Wall Street has consistently marked down Cintas’s valuation (low growth companies without large media attention are often punished by investment banks). The share-price damage only accelerated as the economy became worse in 2008/09. The company has responded by quickly reducing headcount and capital spending, but earnings have still been hit.
However, we are happy with the sustainability of the competitive edge of this company, which generates an earning power that can currently be bought for an attractive price.
We do not assume this company will grow more than in the mid to low single-digits on the top line. Yet, even with such an assumption, the valuation available in the market is likely to offer the possibility of generating a modest return over the next 5- 7 years (the next business cycle).
That may seem rather mundane, one does not look to double their money in the next year with this investment. Indeed, the reality is it is highly improbable in many investments. The search for quick money in stock markets often lead to quick losses. What is more probable with the average investment is potentially losing money, and this is what we feel we are not likely to incur with the purchase of the common stock of this company if bought at less than 25 USD/share. Yet, we will enjoy the benefit of:-
1. Growing with this company
2. Enjoying the market re valuation of its sustainable earning power
Over the next business cycle we feel we are likely to generate 50 – 80% return (including dividends) from this investment, with little possibility of making a permanent capital loss. This is likely to be substantially higher than the cumulative return on cash deposit rates during that period. We like to hold investments of these characteristics in our portfolio to help the portfolio generate consistent, low risk (risk as defined as the probability of permanent capital loss) returns.
However, we cannot leave this article with simply stating this is the perfect "no risk" stock. There are various business risks we are following that can either temporarily, or permenantly damage the valuation of the company (we are more concerned with the latter, and see opportunity with the former).
The health of the business is closely tied to employment, so continued rising unemployment would likely not be a positive for the share price. That could be partly offset – or exacerbated – by the direction of fuel prices, which are a big cost component. A more structural risk is that attempts to unionize the Cintas workforce gain steam with the advent of new labor laws and regulations proposed by the current administration. The company today has 34,000 employees, of which under 400 are unionized, so any significant shift toward a more unionized employee base could have a highly negative impact on margins. They’ve been successful in avoiding unionization so far, but it’s clearly an issue we have to continuously monitor. We like the approach management is tackling this issue as is displayed on its web site and corporate documentation.
Yours sincerely,
Alessandro Sajwani
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