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




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

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

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

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

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

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

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

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