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
Friday 23 July 2010
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
Tuesday 13 July 2010
Easier to read, then react...
Dear Reader,
Such a simple concept so well crystallised by Mr. Gross in the previous blog, however, has many routes it can take moving forward. We do not want to give an exhaustive list, but do want to touch lightly on some of the events that can occur considering the current environment to highlight that understanding is not the same as solutions!
Lower cost of debt servicing is reducing the return of countries lending money (those that have large cash reserves), especially since countries like China are generally lending in currencies which are not their own, hence they do not determine the cost of borrowing. The theme of currencies is one that will re appear continuously in the years to come as China becomes more of a core , rather than a periphery, country/economy.
Such a low return on accumulated cash and reduced demand from previous debt driven developed countries will reduce exports. This will be an important driver to force many developing countries to focus more on internal demand to maintain stability, especially since countries like China have experienced huge population migration from rural to urban areas.
There is a possibility that developed countries can reduce their debt burden sufficiently so they can be lean enough to grow satisfactorily in the future. This can occur if debt servicing costs are less than growth rates for a period of time, hence excess earnings can be used to pay down debt. This can be supported by low interest rates. Growth rates could be supported by:-
1.Lower costs (i.e. less wages for you and me, and less jobs in general, as we are seeing)
2.Selling the same product for a higher price. This can be possible when there is a strong competitive advantage in generating that product, or a patent
3.Developing and selling higher value products (i.e. with larger margins)
Points 2 and 3 depend on increasing the export of high quality products. Consequently, this will require other countries to import more in financial terms (unless the currency of the exporting country decreases, hence volumes may increase, but financial volume may be similar in the importing countries currency).
Please note point 1 can be deflationary, and point 2 inflationary. Point 3 is the best option. It simply means we are generating a higher rate of return on invested capital, and therefore, make more profit as we generate a higher return relative to the cost of capital. Point 3 is supported by a weaker currency, which can occur in an inflationary or deflationary environment.
Furthermore, note both points 1 and 2 reduce the quality of life of individuals as they either reduce our wages or increase our cost of living. Wealth is effectively being transferred from the consumer to the corporate in the hope that future profits will be larger. It is therefore vital corporates generate returns on capital greater than their cost of capital moving forward to allow future generations to enjoy that transfer back to the consumer.
Whether this event is probable or not in developed economiems will depend on how countries react. We remain watchful of events.
Yours sincerely,
Alessandro Sajwani
Such a simple concept so well crystallised by Mr. Gross in the previous blog, however, has many routes it can take moving forward. We do not want to give an exhaustive list, but do want to touch lightly on some of the events that can occur considering the current environment to highlight that understanding is not the same as solutions!
Lower cost of debt servicing is reducing the return of countries lending money (those that have large cash reserves), especially since countries like China are generally lending in currencies which are not their own, hence they do not determine the cost of borrowing. The theme of currencies is one that will re appear continuously in the years to come as China becomes more of a core , rather than a periphery, country/economy.
Such a low return on accumulated cash and reduced demand from previous debt driven developed countries will reduce exports. This will be an important driver to force many developing countries to focus more on internal demand to maintain stability, especially since countries like China have experienced huge population migration from rural to urban areas.
There is a possibility that developed countries can reduce their debt burden sufficiently so they can be lean enough to grow satisfactorily in the future. This can occur if debt servicing costs are less than growth rates for a period of time, hence excess earnings can be used to pay down debt. This can be supported by low interest rates. Growth rates could be supported by:-
1.Lower costs (i.e. less wages for you and me, and less jobs in general, as we are seeing)
2.Selling the same product for a higher price. This can be possible when there is a strong competitive advantage in generating that product, or a patent
3.Developing and selling higher value products (i.e. with larger margins)
Points 2 and 3 depend on increasing the export of high quality products. Consequently, this will require other countries to import more in financial terms (unless the currency of the exporting country decreases, hence volumes may increase, but financial volume may be similar in the importing countries currency).
Please note point 1 can be deflationary, and point 2 inflationary. Point 3 is the best option. It simply means we are generating a higher rate of return on invested capital, and therefore, make more profit as we generate a higher return relative to the cost of capital. Point 3 is supported by a weaker currency, which can occur in an inflationary or deflationary environment.
Furthermore, note both points 1 and 2 reduce the quality of life of individuals as they either reduce our wages or increase our cost of living. Wealth is effectively being transferred from the consumer to the corporate in the hope that future profits will be larger. It is therefore vital corporates generate returns on capital greater than their cost of capital moving forward to allow future generations to enjoy that transfer back to the consumer.
Whether this event is probable or not in developed economiems will depend on how countries react. We remain watchful of events.
Yours sincerely,
Alessandro Sajwani
What is likely to affect global capital flows over the next decade
Dear Reader and Fellow Investors,
Not one to copy and paste the words of other investment managers, but below please find a wonderful composition by the always insightful William H. Gross.
He writes it better than I can, but past writings on this blog have attempted to present these simple ideas to provide our readers and investors with an appreciation of our asset allocation, which is determined by market valuatons, but also our perception of macro economics and the potential capital flows they will induce. Forget the noise, the below mentioned factors will be the most dominant variables we, as investors, must consider when understanding global capital flows.
"Global financial market returns stand at the threshold of mediocrity. With bonds priced not for recession but near depression, most major global bond indices now yield less than 3%, surely a forerunner of returns to come. Stocks, long the volatile vamp of investor optimism, have not yet adjusted to the New Normal of half-size economic growth induced by deleveraging, reregulation, and deglobalization and have low single digit prospects as well. Yet, what has seemed obvious to those of us collectively at PIMCO for several years now is less than standard fare in the trading rooms of institutional money managers. While the phrase “New Normal” has been welcomed into the lexicon of reporters and commentators alike, the willingness of investors to accept its realities is fog-ridden and whispered, or perhaps softly whistled, much like midnight passersby at a graveyard. Our “New Normal” two-word duality seems to resonate more on the “normal” than the “new” to economists whose last names aren’t Roubini, Reinhart, Rogoff, or Rosenberg. It’s as if “R” has been eliminated from the financial alphabet, and “new” from investors’ dictionaries worldwide.
Perhaps the enigma arises from a multi-generational acceptance of debt as common scrip, available for the asking and seemingly forever productive in boosting living standards – until, that is, liabilities became so large that the interest burden and probability of repayment overwhelmed borrower and lender alike in near unison. To understand why debt may have become a burden instead of a boon it is instructive as Philip Coggan points out in a recent Economist article, to ask why people, companies and countries borrow in the first place.
They do so, he intelligently argues, to boost their standard of living, to bring consumption forward instead of languishing in the present. How could almost any of us have afforded a home without a mortgage? By the time we would have saved enough money we’d have been close to retirement with the kids grown and facing a similar predicament. And so we turned to the wizardry of borrowing on time to be able to purchase and then repay in full. Crucially, since debt is a handshake between at least two parties, the lender had to believe that it would be repaid, and that belief or “credere,” was based on several rather rational expectations when observed on a macro level from 30,000 feet.
First of all, capitalistic innovation fostered productivity, and an increasing standard of living through technology and innovation. Debts could be paid back via profits and higher wages if only because of rising prosperity itself. Secondly, the 20th century, which fathered the debt supercycle, was a time of global population growth despite its interruption by tragic world wars and periodic pandemics. Prior debts could be spread over an ever-increasing number of people, lessening the burden and making it possible to assume even more debt in a seemingly endless cycle which brought consumption forward – anticipating that future generations could do the same.
But while technological innovation – much like Moore’s law – seems to have endless promise, population growth in numerous parts of the developed world is approaching a dead end. Not only will it become more difficult to transfer high existing debt burdens onto the smaller shoulders of future generations, but the overlevered, aging “global boomers” themselves will demand a disproportionate piece of stunted future goods and services – without, it seems, the ability to pay for it. Creditors, sensing the predicament, hold back as they recently have in Greece and other southern European peripherals, or in the U.S. itself, as lenders demand larger down payments on new home mortgages, and other debt extensions.
Aging and population change of course are just part of the nemesis. We could have “saved” for this moment much like squirrels in wintertime but humanity’s free will is infected with greed, avarice and in a majority of instances, hope as opposed to commonsense. We overdid a good thing and now the financial reaper is at the door, scythe and financial bill in one hand, with the other knocking on door after door of previously unsuspecting households and sovereigns to initiate a “standard of living” death sentence.
What is harder to understand in this demographic/psychological/sociological explanation of the crisis is why it should morph into a global phenomenon. 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 like PIMCO 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, which only economists with names beginning in R seem to understand (there is no R in PIMCO no matter how much I want to extend the metaphor, and yes, Paul _Rugman fits the description as well!). 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.
Even if your last name doesn’t begin with R, the preceding explanation is all you need to know to explain what is happening to the markets, the global economy, and perhaps your own wobbly-legged standard of living in recent years. 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. Stop whispering (and start shouting) the words “New Normal” or perhaps begin to pronounce your last name with an RRRRRRRRRRRR. Our global economy, our use of debt, and our financial markets have changed – not our alphabet or dictionary.
William H. Gross"
Managing Director
Not one to copy and paste the words of other investment managers, but below please find a wonderful composition by the always insightful William H. Gross.
He writes it better than I can, but past writings on this blog have attempted to present these simple ideas to provide our readers and investors with an appreciation of our asset allocation, which is determined by market valuatons, but also our perception of macro economics and the potential capital flows they will induce. Forget the noise, the below mentioned factors will be the most dominant variables we, as investors, must consider when understanding global capital flows.
"Global financial market returns stand at the threshold of mediocrity. With bonds priced not for recession but near depression, most major global bond indices now yield less than 3%, surely a forerunner of returns to come. Stocks, long the volatile vamp of investor optimism, have not yet adjusted to the New Normal of half-size economic growth induced by deleveraging, reregulation, and deglobalization and have low single digit prospects as well. Yet, what has seemed obvious to those of us collectively at PIMCO for several years now is less than standard fare in the trading rooms of institutional money managers. While the phrase “New Normal” has been welcomed into the lexicon of reporters and commentators alike, the willingness of investors to accept its realities is fog-ridden and whispered, or perhaps softly whistled, much like midnight passersby at a graveyard. Our “New Normal” two-word duality seems to resonate more on the “normal” than the “new” to economists whose last names aren’t Roubini, Reinhart, Rogoff, or Rosenberg. It’s as if “R” has been eliminated from the financial alphabet, and “new” from investors’ dictionaries worldwide.
Perhaps the enigma arises from a multi-generational acceptance of debt as common scrip, available for the asking and seemingly forever productive in boosting living standards – until, that is, liabilities became so large that the interest burden and probability of repayment overwhelmed borrower and lender alike in near unison. To understand why debt may have become a burden instead of a boon it is instructive as Philip Coggan points out in a recent Economist article, to ask why people, companies and countries borrow in the first place.
They do so, he intelligently argues, to boost their standard of living, to bring consumption forward instead of languishing in the present. How could almost any of us have afforded a home without a mortgage? By the time we would have saved enough money we’d have been close to retirement with the kids grown and facing a similar predicament. And so we turned to the wizardry of borrowing on time to be able to purchase and then repay in full. Crucially, since debt is a handshake between at least two parties, the lender had to believe that it would be repaid, and that belief or “credere,” was based on several rather rational expectations when observed on a macro level from 30,000 feet.
First of all, capitalistic innovation fostered productivity, and an increasing standard of living through technology and innovation. Debts could be paid back via profits and higher wages if only because of rising prosperity itself. Secondly, the 20th century, which fathered the debt supercycle, was a time of global population growth despite its interruption by tragic world wars and periodic pandemics. Prior debts could be spread over an ever-increasing number of people, lessening the burden and making it possible to assume even more debt in a seemingly endless cycle which brought consumption forward – anticipating that future generations could do the same.
But while technological innovation – much like Moore’s law – seems to have endless promise, population growth in numerous parts of the developed world is approaching a dead end. Not only will it become more difficult to transfer high existing debt burdens onto the smaller shoulders of future generations, but the overlevered, aging “global boomers” themselves will demand a disproportionate piece of stunted future goods and services – without, it seems, the ability to pay for it. Creditors, sensing the predicament, hold back as they recently have in Greece and other southern European peripherals, or in the U.S. itself, as lenders demand larger down payments on new home mortgages, and other debt extensions.
Aging and population change of course are just part of the nemesis. We could have “saved” for this moment much like squirrels in wintertime but humanity’s free will is infected with greed, avarice and in a majority of instances, hope as opposed to commonsense. We overdid a good thing and now the financial reaper is at the door, scythe and financial bill in one hand, with the other knocking on door after door of previously unsuspecting households and sovereigns to initiate a “standard of living” death sentence.
What is harder to understand in this demographic/psychological/sociological explanation of the crisis is why it should morph into a global phenomenon. 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 like PIMCO 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, which only economists with names beginning in R seem to understand (there is no R in PIMCO no matter how much I want to extend the metaphor, and yes, Paul _Rugman fits the description as well!). 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.
Even if your last name doesn’t begin with R, the preceding explanation is all you need to know to explain what is happening to the markets, the global economy, and perhaps your own wobbly-legged standard of living in recent years. 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. Stop whispering (and start shouting) the words “New Normal” or perhaps begin to pronounce your last name with an RRRRRRRRRRRR. Our global economy, our use of debt, and our financial markets have changed – not our alphabet or dictionary.
William H. Gross"
Managing Director
Wednesday 7 July 2010
Long Term Investment Management 2010 Q2 results: -1.44%
Dear Reader and Fellow Investors,
The loss in net worth of the Long Term Investment Management (LTIM) portfolio during the second quarter of 2010 was -1.44% on a bid to bid basis (denominated in EUR).
During the same period of time the Euro stoxx 50, as performed by investing in the ishares Dow Jones Eurostoxx 50 exchange traded fund (ETF), declined by -16.47%. We therefore outperformed our index by 15.03%. We would like to emphasis that we are never pleased with negative results, irrespective of how large an outperformance we achieve. However, we have stated in past quarterly reports that our investment philosophy makes it considerably more probable that we will out perform the market when there is a downfall than when there is an extravagant rise. We feel this attribute is vital to achieve long term investment returns that outperform the market over the entire market cycle.
Our more astute readers would have noticed that for the first time we are denominating our results in Euros rather than American dollars (USD). The reason why we initially presented results in USD was because your author had converted a large amount of his net wealth into USD during 2009. It therefore seemed sensible to measure performance in the most prominent currency used in the portfolio. However, the majority of clients we deal with are EUR based investors. As a result, moving forward we will present results in EUR. Consequently, our benchmark will move from being the Standard & Poor 500 (S&P 500) to being the Euro stoxx 50.
1 Summary
Our outperformance resulted primarily from our asset allocation rather than our security selection. This is not because our security selection was poor on aggregate; it was simply that asset allocation was more important than security selection in the last six months if you wanted to outperform the market. Our currency allocation also worked to our benefit due to the strengthening USD. The portfolio currently has over 40% of assets denominated in USD.
We have consistently mentioned in this blog, and in other writings, that in certain periods of time asset allocation is more dominant that security selection. In a period of weak credit growth and over valued risk assets, you can assure yourself the odds are in your favour that market prices will fall, irrespective of what financial journalists tell you. They have fallen recently, and are more likely to continue to fall rather than rise, in your author’s opinion. As a result, we remain overweight cash.
Though we cannot predict when prices will fall, nor by how much, we continue to use as a reference our estimate of fair value for the market in general, but more importantly, for individual securities. When securities are available at prices that are below our estimate of “fair value” plus a large discount, we start buying the security of that company. As we see more opportunities, we will start accumulating more risk assets, and therefore reducing our current high cash load. On average during quarter two we held 40% of assets under management in the LTIM portfolio in cash.
Our estimate of fair value for the S&P 500 remains at 930, as described over the last number of months in our Long Term Investment Management blog. This index remains stubbornly “over valued” relative to our estimates.
2 Portfolio facts
Our best performer in the portfolio during the second quarter was K-Swiss incorporated. Our worst performer was Monsanto. During the second quarter we executed eight transactions: seven purchases and one sell. We are looking to increase equity positions as prices become more attractive.
We continue to have substantial firepower to invest due to our high cash load, but we find ourselves for the first time in over three years having just over 50% of the principal fund invested in equities. However, the portfolio yield continues to remain low at 1.9%, due to the high cash position that generates virtually zero income.
3 Future progression
We feel it is unnecessary to labour on points mentioned in past reports (please see 2010 quarter one report or 2009 annual report for long term investment management). We continue to believe that economic growth will be weak and that risk assets remain slightly over valued. As a result we are totally against index investing in the current environment. Security selection coupled with a disciplined asset allocation is the approach we continue to take. Our asset allocation will vary with how we see the valuation of the market change and how the debt burden and credit creation process is managed. With regards to the latter point, we continue to remain concerned.
4 Potential mistakes
We include this section to keep us on our toes. Our biggest mistake by far this quarter was the purchase of Monsanto common stock at a price close to 70 USD per share. I would like to blame this mistake on a partner, but unfortunately I can’t. Though we feel the possibility of permanently losing capital on this investment is improbable, we appreciate that we have paid a little too much for growth, a mistake we strive to limit at LTIM. The gem of this company continues to be the seeds business, but our mistake was the price we paid for the agricultural productivity unit. This is a commodity business that is currently being heavily punished by Asian suppliers that have lower costs, and are flooding a number of markets Monsanto has traditionally been dominant. As a consequence the market has recently re valued this business unit, and quite rightly. As a result, we believe we are likely to hold a marked to market loss for a number of quarters on this security. Not until they issue there new seed products in 2012 do we see a valuation that will start to factor the growth potential of this company. Such experiences lead your author to remember that preaching without the practice didn’t get anyone far. We have tightened our investment procedure even further to ensure we fully scrutinise the price we pay for any security – irrespective of how good the story sounds or how much the stock has fallen.
As always, we invite you to ask any questions or queries you may have with regards to the LTIM portfolio, the advisory client portfolios we manage or anything else you wish to query with regards to investments.
Yours sincerely,
Alessandro Sajwani
The loss in net worth of the Long Term Investment Management (LTIM) portfolio during the second quarter of 2010 was -1.44% on a bid to bid basis (denominated in EUR).
During the same period of time the Euro stoxx 50, as performed by investing in the ishares Dow Jones Eurostoxx 50 exchange traded fund (ETF), declined by -16.47%. We therefore outperformed our index by 15.03%. We would like to emphasis that we are never pleased with negative results, irrespective of how large an outperformance we achieve. However, we have stated in past quarterly reports that our investment philosophy makes it considerably more probable that we will out perform the market when there is a downfall than when there is an extravagant rise. We feel this attribute is vital to achieve long term investment returns that outperform the market over the entire market cycle.
Our more astute readers would have noticed that for the first time we are denominating our results in Euros rather than American dollars (USD). The reason why we initially presented results in USD was because your author had converted a large amount of his net wealth into USD during 2009. It therefore seemed sensible to measure performance in the most prominent currency used in the portfolio. However, the majority of clients we deal with are EUR based investors. As a result, moving forward we will present results in EUR. Consequently, our benchmark will move from being the Standard & Poor 500 (S&P 500) to being the Euro stoxx 50.
1 Summary
Our outperformance resulted primarily from our asset allocation rather than our security selection. This is not because our security selection was poor on aggregate; it was simply that asset allocation was more important than security selection in the last six months if you wanted to outperform the market. Our currency allocation also worked to our benefit due to the strengthening USD. The portfolio currently has over 40% of assets denominated in USD.
We have consistently mentioned in this blog, and in other writings, that in certain periods of time asset allocation is more dominant that security selection. In a period of weak credit growth and over valued risk assets, you can assure yourself the odds are in your favour that market prices will fall, irrespective of what financial journalists tell you. They have fallen recently, and are more likely to continue to fall rather than rise, in your author’s opinion. As a result, we remain overweight cash.
Though we cannot predict when prices will fall, nor by how much, we continue to use as a reference our estimate of fair value for the market in general, but more importantly, for individual securities. When securities are available at prices that are below our estimate of “fair value” plus a large discount, we start buying the security of that company. As we see more opportunities, we will start accumulating more risk assets, and therefore reducing our current high cash load. On average during quarter two we held 40% of assets under management in the LTIM portfolio in cash.
Our estimate of fair value for the S&P 500 remains at 930, as described over the last number of months in our Long Term Investment Management blog. This index remains stubbornly “over valued” relative to our estimates.
2 Portfolio facts
Our best performer in the portfolio during the second quarter was K-Swiss incorporated. Our worst performer was Monsanto. During the second quarter we executed eight transactions: seven purchases and one sell. We are looking to increase equity positions as prices become more attractive.
We continue to have substantial firepower to invest due to our high cash load, but we find ourselves for the first time in over three years having just over 50% of the principal fund invested in equities. However, the portfolio yield continues to remain low at 1.9%, due to the high cash position that generates virtually zero income.
3 Future progression
We feel it is unnecessary to labour on points mentioned in past reports (please see 2010 quarter one report or 2009 annual report for long term investment management). We continue to believe that economic growth will be weak and that risk assets remain slightly over valued. As a result we are totally against index investing in the current environment. Security selection coupled with a disciplined asset allocation is the approach we continue to take. Our asset allocation will vary with how we see the valuation of the market change and how the debt burden and credit creation process is managed. With regards to the latter point, we continue to remain concerned.
4 Potential mistakes
We include this section to keep us on our toes. Our biggest mistake by far this quarter was the purchase of Monsanto common stock at a price close to 70 USD per share. I would like to blame this mistake on a partner, but unfortunately I can’t. Though we feel the possibility of permanently losing capital on this investment is improbable, we appreciate that we have paid a little too much for growth, a mistake we strive to limit at LTIM. The gem of this company continues to be the seeds business, but our mistake was the price we paid for the agricultural productivity unit. This is a commodity business that is currently being heavily punished by Asian suppliers that have lower costs, and are flooding a number of markets Monsanto has traditionally been dominant. As a consequence the market has recently re valued this business unit, and quite rightly. As a result, we believe we are likely to hold a marked to market loss for a number of quarters on this security. Not until they issue there new seed products in 2012 do we see a valuation that will start to factor the growth potential of this company. Such experiences lead your author to remember that preaching without the practice didn’t get anyone far. We have tightened our investment procedure even further to ensure we fully scrutinise the price we pay for any security – irrespective of how good the story sounds or how much the stock has fallen.
As always, we invite you to ask any questions or queries you may have with regards to the LTIM portfolio, the advisory client portfolios we manage or anything else you wish to query with regards to investments.
Yours sincerely,
Alessandro Sajwani
Thursday 1 July 2010
Can one hedge against inflation and deflation simultaneously?
Dear Reader and Fellow Investors,
Is their an investment that can protect clients against inflation and deflation?
We think we may have found one.
The answer is: trees.
Wood, as a real, finite, asset used for a number of vital functions around the world possesses the properties that can allow its real value to be maintained even though the currency it is being priced with may weaken during an inflationary environment.
However, during a deflation period, so long as the tree is growing more than the deflation rate, should the price of wood fall, you will have more tree, due to its natural tendency to GROW if watered and the weather is suitable. Hence, under such conditions, your tree would still be worth more than it was last year in real terms.
Hence a tree combines properties that can allow an investor to potentially preserve their wealth in a deflationary or inflationary environment.
Our best method of investing in such a strategy is to purchase companies that own forests: NOT companies that have forest concessions.
There are few countries that allow private companies to own forest land. Indeed, we count no more than three or four where we find the countries law offers suitable protection for foreign equity investors.
Over the last few days we have added aggressively to such positions as pricing has become more attractive due to the markets perception of these companies being in the real estate bucket. Though their revenue is strongly affected by the health of the real estate market, the value of their forest is only temporarily impaired in value according to your authors view. Many companies hold these assets on their balance sheet at cost price. Many such transactions have occurred over 50, 60 or even 100 years ago, and hence the balance sheet is extremely under valued. A price to book ratio of 2, for example, would therefore be doing no justice to the real assets the companies possess.
The investment strategy is therefore very much an asset backed one, where we feel we are buying a unit area of forest land at very attractive prices and with the potential of having a quasi hedge against an inflation or deflationary environment.
Yours sincerely,
Alessandro Sajwani
Is their an investment that can protect clients against inflation and deflation?
We think we may have found one.
The answer is: trees.
Wood, as a real, finite, asset used for a number of vital functions around the world possesses the properties that can allow its real value to be maintained even though the currency it is being priced with may weaken during an inflationary environment.
However, during a deflation period, so long as the tree is growing more than the deflation rate, should the price of wood fall, you will have more tree, due to its natural tendency to GROW if watered and the weather is suitable. Hence, under such conditions, your tree would still be worth more than it was last year in real terms.
Hence a tree combines properties that can allow an investor to potentially preserve their wealth in a deflationary or inflationary environment.
Our best method of investing in such a strategy is to purchase companies that own forests: NOT companies that have forest concessions.
There are few countries that allow private companies to own forest land. Indeed, we count no more than three or four where we find the countries law offers suitable protection for foreign equity investors.
Over the last few days we have added aggressively to such positions as pricing has become more attractive due to the markets perception of these companies being in the real estate bucket. Though their revenue is strongly affected by the health of the real estate market, the value of their forest is only temporarily impaired in value according to your authors view. Many companies hold these assets on their balance sheet at cost price. Many such transactions have occurred over 50, 60 or even 100 years ago, and hence the balance sheet is extremely under valued. A price to book ratio of 2, for example, would therefore be doing no justice to the real assets the companies possess.
The investment strategy is therefore very much an asset backed one, where we feel we are buying a unit area of forest land at very attractive prices and with the potential of having a quasi hedge against an inflation or deflationary environment.
Yours sincerely,
Alessandro Sajwani
Uncertainty, what uncertainty?
Dear Readers and Fellow Investors,
We have received an interesting number of comments with regards to the uncertainty investors are having with determining whether inflation or deflation will be the biggest problem in the future (see "political risk is feeding the natural tendency for deflation to appear" blog comments).
This is understandable. This decision will be primarily made by politicians. All we know is that debt will have be wiped out, there is simply too much of it. Its burden will have to be reduced before steady growth can resume. The question is, will it be inflated, or will there be defaults? History suggests politicians generally prefer the former option (until afterwards the latter option occurs and finishes the job!).
I have often commented that the valuation of the market can be interpreted by how much the market is discounting uncertainty. Uncertainty is always present. Sometimes the investment community ignores it, in other cases they obsess about it excessively. Today, uncertainty is correctly causing panic amongst investors on whether earnings currently being forecasted will become reality for individual companies, as well as for economies as a whole. Indeed, I believe the market has not discounted enough, yet.
Our principle fear is that debt reduction is generally always followed by a reduction in the quality of life, on aggregate, for a country. In Europe, this is likely to lead to social unrest, as we are starting to witness, and which we hope will remain subdued. However, we fear, this is unlikely to be the case. In such an environment, politicians will be hard pressed to NOT deliver the medicine that is required, which can lead problems to drag on.
Politicians in such a scenario can hope that the problem will be diluted (the same unit of debt reduction will be done over a longer period of time), but eventually, the medicine has to be delivered.
Indeed, this approach often leads to more medicine being necessary in terms of overall resources allocated to the problem. Economic problems arise primarily when capital is poorly allocated (be it in war, excess housing, or too much hope on future corporate profits). John Stuart Mills elegantly said that “panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”. Hence such a dilutive approach may only exacerbate the problem in the medium term.
We feel that all systems that depend on finite resources eventually tend to a pricing equilibrium. Though money is not, in theory, finite (it can be printed at the whim of the central banks/governments wishes), the assets that are priced in its currency are. Hence the two are in reality locked together, and hence money cannot be printed to ad infinitum without severe consequences (i.e. hyperinflation). A tendency to approach equilibrium will occur: whether we like it or not. “Mean reversion” are the two most important words in long term investing.
As a result, we feel there is a natural deflation tendency within the system, due to the large de leveraging process currently occurring. This can only be counter acted by public spending/lending, using money primarily created from thin air. This is not a sustainable solution, as we all know. As long term investors, we will therefore not be investing considering government yields will remain as low as they are now. A unit of accessible debt will be harder to get, and as a consequence, is likely to become more expensive (it has been most apparent to the consumer rather than other economic participants such as corporations and governments. However, without a strong consumer, it is hard to see growth and strength in the corporates or governments happening). This naturally puts pressure on the valuation of all risk assets, as government bond yields are often referred to as the “risk-free asset”. All assets are therefore commonly valued relative to government bonds.
We therefore remain wary of the current valuation using such a “macroeconomic” approach, as well as a more fundamental approach analysing individual companies. We remain overweight cash, for the moment, with a wondering eye for cheap equities.
We would like to conclude with the statement that in a deflationary environment, a unit of cash becomes more valuable. In an inflationary environment, the opposite happens. Many clients find this “relative capital gain” of the value of cash in a deflationary environment difficult to interpret, and are willing to forego it by buying government bonds yielding 2% with 5 year maturities. Though “fixed income” bonds benefit in an environment where that fixed cash flow is worth more, it is highly likely that in a deflationary environment equities would suffer severe declines in value. Hence a wonderful opportunity could arise, which should not be missed. We cannot ignore the risk that the particular bond you have may suffers “a bout of government credit risk”, leading to a capital loss if sold before maturity. With such low yields, we are not willing to take that risk.
I am often asked what will be the trigger for a real change to the current “range bound” market we have been in recently. The answer is usually always the same: the bond market.
As always, we look forward to hear your thoughts and comments.
Yours sincerely,
Alessandro Sajwani
We have received an interesting number of comments with regards to the uncertainty investors are having with determining whether inflation or deflation will be the biggest problem in the future (see "political risk is feeding the natural tendency for deflation to appear" blog comments).
This is understandable. This decision will be primarily made by politicians. All we know is that debt will have be wiped out, there is simply too much of it. Its burden will have to be reduced before steady growth can resume. The question is, will it be inflated, or will there be defaults? History suggests politicians generally prefer the former option (until afterwards the latter option occurs and finishes the job!).
I have often commented that the valuation of the market can be interpreted by how much the market is discounting uncertainty. Uncertainty is always present. Sometimes the investment community ignores it, in other cases they obsess about it excessively. Today, uncertainty is correctly causing panic amongst investors on whether earnings currently being forecasted will become reality for individual companies, as well as for economies as a whole. Indeed, I believe the market has not discounted enough, yet.
Our principle fear is that debt reduction is generally always followed by a reduction in the quality of life, on aggregate, for a country. In Europe, this is likely to lead to social unrest, as we are starting to witness, and which we hope will remain subdued. However, we fear, this is unlikely to be the case. In such an environment, politicians will be hard pressed to NOT deliver the medicine that is required, which can lead problems to drag on.
Politicians in such a scenario can hope that the problem will be diluted (the same unit of debt reduction will be done over a longer period of time), but eventually, the medicine has to be delivered.
Indeed, this approach often leads to more medicine being necessary in terms of overall resources allocated to the problem. Economic problems arise primarily when capital is poorly allocated (be it in war, excess housing, or too much hope on future corporate profits). John Stuart Mills elegantly said that “panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”. Hence such a dilutive approach may only exacerbate the problem in the medium term.
We feel that all systems that depend on finite resources eventually tend to a pricing equilibrium. Though money is not, in theory, finite (it can be printed at the whim of the central banks/governments wishes), the assets that are priced in its currency are. Hence the two are in reality locked together, and hence money cannot be printed to ad infinitum without severe consequences (i.e. hyperinflation). A tendency to approach equilibrium will occur: whether we like it or not. “Mean reversion” are the two most important words in long term investing.
As a result, we feel there is a natural deflation tendency within the system, due to the large de leveraging process currently occurring. This can only be counter acted by public spending/lending, using money primarily created from thin air. This is not a sustainable solution, as we all know. As long term investors, we will therefore not be investing considering government yields will remain as low as they are now. A unit of accessible debt will be harder to get, and as a consequence, is likely to become more expensive (it has been most apparent to the consumer rather than other economic participants such as corporations and governments. However, without a strong consumer, it is hard to see growth and strength in the corporates or governments happening). This naturally puts pressure on the valuation of all risk assets, as government bond yields are often referred to as the “risk-free asset”. All assets are therefore commonly valued relative to government bonds.
We therefore remain wary of the current valuation using such a “macroeconomic” approach, as well as a more fundamental approach analysing individual companies. We remain overweight cash, for the moment, with a wondering eye for cheap equities.
We would like to conclude with the statement that in a deflationary environment, a unit of cash becomes more valuable. In an inflationary environment, the opposite happens. Many clients find this “relative capital gain” of the value of cash in a deflationary environment difficult to interpret, and are willing to forego it by buying government bonds yielding 2% with 5 year maturities. Though “fixed income” bonds benefit in an environment where that fixed cash flow is worth more, it is highly likely that in a deflationary environment equities would suffer severe declines in value. Hence a wonderful opportunity could arise, which should not be missed. We cannot ignore the risk that the particular bond you have may suffers “a bout of government credit risk”, leading to a capital loss if sold before maturity. With such low yields, we are not willing to take that risk.
I am often asked what will be the trigger for a real change to the current “range bound” market we have been in recently. The answer is usually always the same: the bond market.
As always, we look forward to hear your thoughts and comments.
Yours sincerely,
Alessandro Sajwani
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