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




Monday 28 June 2010

Properties of a great company...great management

Dear Reader and Fellow Investors,

We are not in the habit of talking openly about individual security investments we make, but are more than happy to openly discuss our principles and concepts.

In a client meeting last week, the discussion veered towards the business of the individual, and how he was reacting to his current business environment. The discussion reached a point where the question arose: if half his clientele where to leave the area, would the company be worth half as much due to the immediate drop in revenue?

A range of questions can follow such as was the migration permenant? How can we measure that? Will new people come and take their place? etc etc.

Let us assume, due to the high quality of the area, that the majority of people leaving will return in the future. If this is simply a cyclical adjustment, in the future surely they will make the same earnings, or more, when inflation adjusted? Surely the cyclically adjusted earnings would be a good starting point for valuing the company?

The client very astutely asks, but what if the new clients want different products? I may not have an edge on that product? ahh. That is the question.

However, good management adapts to the different situation. No product is sustainable for ever. What makes a good company great, is its ability to last, and that often means it ability to adapt, and that is often reflected in the quality of its management. Good management understands the market dynamics, places themselves strategically within it to increase barriers to entry for competitors.

Management skill cannot be ignored when looking for an investment strategy based on a long term relationship.


Yours sincerely,

Alessandro Sajwani

A short word about the dollar..

Dear Reader and Fellow Investors,

For those of you who are a regular reader of these articles, I can understand shock in what may seem an opinion on currencies about to appear: something I have become notorious on not providing.

The only thing I would like to say is a recent comment to a client who was querying converting some EUR into USD, having a 100% EUR portfolio. Is the rate good, was the usual question?

The difference between the EUR and USD, in my humble opinion, is the former is an attempted currency, whilst the latter is a concept. Under extreme conditions, one knows what they are likely to get with a USD, much less so with the EUR. As a hedge against such a scenario, the difference between 1.24 and 1.23 may not be very significant.



Your sincerely,

Alessandro Sajwani

Political risk is feeding the natural tendency for deflation to appear

Dear Reader and Fellow Investors,


Having worked in a private banking environment over the last few years, I have often got frustrated with the greater emphasis on asset allocation rather than security selection.

However, since 2007, when I have been in such a working environment, the overweight cash position with risk asset investments that shifted in early 2009 to the 30/30/30 asset allocation with cash, bonds and equities respectively, we have significantly outperformed any major equity index. We hope to continue this positive start we have enjoyed with our clients over the last three years. Though we cannot guarantee this, we do guarantee that your author will be enjoying/suffering the same ride as you, mirroring all investments that are recommended to clients.

It seems that when macroeconomic conditions are in extreme conditions, asset allocation becomes justifiably important. This is similar to our arguments presented in a previous blog where we suggest asset allocation should become more important as risk assets reach valuations closer to the extremes of being over or under valued relative to “intrinsic value”.

The extreme macroeconomic environment we indicate refers primarily to the strong reduction in private credit growth experienced in developed countries since 2008. Its affect has been subtly dampened by huge government intervention. With recent political talk shifting from who can print the most money to who can cut their budget the fastest – this lack of public credit into the economic system will reveal the cracks of significant under investment, weak credit growth and reduced consumer spending from the private sector. Indeed, such a rapid shift in political sentiment will bring to the fore the systems natural tendency to deflate with the current incentives and conditions in place, which it has been yearning to do for several years now, but governments have done such an admiral job in trying to hold it back.

As a result, we are maintaining the principal concept of the asset allocation presented in this blog over the last few months, thereby holding our anxiety to buy more risk assets. Over the last few days we have increased the cash component further at the cost of reducing our senior high quality paper and sub investment grade bond exposure. We fear future credit risk brings more possibility of capital lose than gain moving forward considering the far too tight spreads present in the market at the moment. A portion of such sales have been invested into equities. As a consequence our asset allocation has shifted slightly to:-

Cash 35%
Bonds 22%
Equities 33%
Alternatives 10%


Yours sincerely,

Alessandro Sajwani

Tuesday 15 June 2010

Long Term Investment Management, what is risk?

Dear Reader and Fellow Investors,

We define risk as the uncertainty of future cash flows arising from an investment.

The future is simply not known with precision.

So we do not pretend to make our valuations with precision.

We use a margin of safety and make investments that meet certain conditions where we feel we reduce the number of assumptions we have to make, and hence reduce our possibility of error. In this way, we attempt to reduce risk.

Uncertainty is always present. Sometimes the world ignores it, sometimes they focus on it excessively. In the latter condition, we find opportunities to invest where we have above average possibility to make above average returns. It is in those situations we feel most comfortable as investors.

The markets perception of uncertainty between those two above mentioned ranges have a great affect on the valuation of risk assets. In those extremes, sentiment plays a greater than normal role in the markets price. As far as we are concerned, uncertainty varies considerbly less than market volatilty . Hence, more or less investment opportunities can be found depending on how uncertainty is perceived in general by the market.


Yours sincerely,

Alessandro Sajwani

Monday 14 June 2010

Don´t forget the system

Dear Reader and Fellow Investors,

I recently had the pleasure of over hearing a discussion on the merits of free man, free market.

Long term investment management believe in a free market, free person.

Not one for political chattering, however, I would like to portray some points that I believe are important and which we use actively when investing, and indeed, in living.

The system we live in cannot be ignored. We must always try and study it and attempt to understand where it has been, where it is, and where it is going relative to itself and other systems.

Though people make the system, the system eventually makes the people.

When told, free man, free market; I feel obliged to say free market, free man.

Free men have created controlled societies, which made other men controlled, not free.

One cannot separate themselves from their system, they must see it and use it for what it is.

It is the difference in institutions that often make different countries have different systems, and this story is often clearly embedded in history.

People are no different from one place to another. Like in evolution, freak accidents create freak genes that occasionally create a superior species. But we must distinguish the aggregate from the individual. Society is rarely a freak accident in the long run. I have often worried that history takes one path when looking from behind, it may look more rigid than it really is. However, i believe more and more that only the time component is random, the events often have to happen. Much like over valued markets must fall, we simply do not know when, what the random trigger will be.

Let us refer to a previous blog where we hint on our belief that incentives create conditions that make certain events more probable. But what creates the incentives? Often this is painted in history. Whether there was huge immigration, a war, a natural disaster. A system today was made from its history, it only exists because of its history.

Individual events on individual days seem random, but there role in a longer history are predictable when placed into a longer time frame.

As a result, luck favours the prepared mind…

The discussion I overheard also touched on the concept of the law of the land.

Law, in my mind, is the collection of the thoughts of many individuals through history. Law is created to reduce the sound of a single individual. It is fundamental to the working of a society. When a government starts tinkering with the law in unusually large amounts, they are making the sound of one person, of one government, louder than the sound of the majority of a country, or its history. This is a most worrying sign…and the public must decide if they agree or disagree.

As always, yours sincerely,

Alessandro Sajwani


PS.

Management of the system should be focused on stability of the currency (i.e. price stability), clear and fair law and an encouragement of open and free markets where cheaters are punished and good people are rewarded. A sophisticated police force (regulation) to ensure quick money is not being made at the sacrifice of long term gains should exist to stop, for example, poor lending practices or the unjustified usage of securities with assymetric properties. However, good laws would ensure this and good police would ensure it is being practiced. Other variables such as employment should be sorted out by the market. If you give them decent rules to play with, they will give you a good solution.

A good police would also make continuous investigations into the impact of different products coming into the market. There should be less of a gap between academics, investors, government in this area: all there opinions should be valued and participate in final conclusions to law making. Thi ensures less of a conflict of interest towards a particular member of society. Each party, of course, have their own incentives and agenda be it re election, making money quickly or building a reputation.

The reality seems to be that any system is unstable, different systems can simply seem to be sustainable for longer. Humans seem to have tendency for self destruction, often driven by personal greed and feed on by herd behaviour. All things human are flawed, they are therefore ephemeral. They will be changed, and often, those who want change to those who do not, will have a conflict. We fight for different flawed ideas. this is life. we all need to identify ourselves to something to feel we exist..

Categorisation of being a monetarist or Keynesian is best left to bureaucrats.

Saturday 12 June 2010

Asset allocation versus security selection

Dear Reader and Fellow Investors,

For us, security selection is always important.

However, the importance of asset allocation varies over the economic, business and market cycle.

The factor that most effects the role of asset allocation for us is valuation.

When the market is trading at x 0.5 our estimate of fair value, we don´t care if the world is blowing up, we are increasing our equity position overall in the portfolio. The only variable that will matter to us in that moment will be the flow of increase into equities per unit of time.

Likewise, if the market is trading x 2 our estimate of fair value (as it did in the late 90s), we don´t care how many opportunities we are finding, we will be underweight equities. In our portfolios equities can take 20 - 75% of asset allocation.

As a note for our readers, the barrier where asset allocation starts to become more dominant in portfolio construction PURELY on a valuation basis can be seen on the below diagram. We use the S&P 500 as an example.





Yours sincerely,

Alessandro Sajwani

Incentives, conditions and events

Dear Reader and Fellow Investors,

I recently read an article that, as many articles do these days, focused on how Greece became so indebted and hence got itself into such a precarious state of affairs.

It put forward an opinion I had not heard yet, which suggested that to understand the current Greece predicament we have to go back more than a decade, to when Greece applied to hold the Olympics. This event forced the country to take on more debt.

Interesting.

I am of the opinion that single events in history, or in life, rarely mean anything.

What is more important are the incentives the system has created (willingly or unwillingly) that generate conditions that allow certain events to happen. If Greece could not borrow, it could not build an Olympic stadium. End of story.

Identifying the incentives that allow you to appreciate the conditions we are in and hence the probable turn of events that are likely to occur is what our macroeconomic overlay attempts to enforce on our security selection discipline when constructing our portfolios.

This macro overlay, macro because it compares regions and often focuses on country aggregated data, is more closely related to profits than may first seem. Indeed, earnings per share on aggregate seem statistically to follow nominal GDP growth quite satisfactory (we refer to the fantastic work by Crestmont research). Indeed, one could even keep on assuming and say currencies simply move over the long term to the rythme of capital flows where one gets more profit per unit of currency....

Lets leave it there for now.


Yours sincerely,

Alessandro Sajwani

History suggests earnings will weaken, markets likely to remain burdened for a couple of years

Dear Reader and Fellow Investors,

Today will be a brief blog that will focus on the very simple concept that stock prices are determined by their ability to generate profits/free cash flow.

Fair value by Graham and Dodd was determined by using the 10 year average earnings, to ensure one was not over paying for unsustainable growth. A suitable multiple is then applied to this figure.

We have mentioned in past discussions that using such an approach we feel fair value for the S&P 500 lies between 900 - 950.

Below we include a graph that shows clearly in the late 90s how the price of the S&P500 went away from the 10 year average earnings per share (EPS) of the S&P 500 index. This is not sustainable. Indeed, we know what happened next.

We can see in more recent times that the 10 year average EPS have run away from the market price. You may apply the converse that we have said, and say it is a unique buying opportunity. We beg to differ.

Rather than having a pricing bubble, in recent years, I believe we experienced an earning bubble that led to operating margins to expand considerably above average (operating margins are a strong mean reverting variable). This was fueled by strong expanding credit, as wage growth remained weak during this period for developed countries.

Though margins have started to fall over the last 18 months, pricing is not in line, in your authors opinion, with the bursting of this earning bubble. We are likely to remain in a weakly priced stock market for a couple of years.





Yours sincerely,

Alessandro Sajwani