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