The words have been so frequently used over the last 18 months that they have lost much of their weight.
A sovereign crisis, for those who need reminding, is a very serious issue indeed.
When a country continuously uses capital it has accumulated from successful ventures in the past in an unproductive manner, the return on that capital is lower than what it once was. This creates a difference between the liquidity expected and the liquidity you have. This creates an incentive to borrow. Often, at this stage of the evolution of an economy, few are aware of where in the cycle this once great economy is at. Historians such as Giovanni Arrighi have discussed such “supercycles” in great detail, describing the evolution of an economy, an evolution that is eerily similar irrespective of the economy or the period we look at.
An economy with a great recent history ensures that borrowed funds are easily accessible, even from those economies that are currently generating higher returns. However, without a change in behavior, attitude, management etc, these funds also generate below average historic returns. This continues whilst lenders/investors belief this is a blip from the continuation of the growth of a great economy. However, at one point, the game changes. Though we are strong believers in mean reversion, understanding the drivers of an economy, market, industry, company, are vital to identify when the dynamics of the game changes. Looking at figures is simply not enough.
At this point there is an understanding that returns on capital are potentially lower for these economies, and may be permanently so without change. This realization in itself makes it harder to fight this tendency. The market will adjust their sentiment by increasing the cost of borrowing for this economy, by reducing the flow of capital towards it. These changes will make it harder with the same resources to generate returns that were achievable in the past. We have feedback loops appearing that are so inherent to market based systems. It is these feedback loops that make the transition from bubble to bust so rapid, and therefore, so dangerous.
So how can this economy grow itself out of trouble?
By using the same capital to generate more return. This can come from 4 prinicipal ways, which are not mutually exclusive:-
1. Reducing costs to generate the same product
2. Being innovative and generating a new product that can offer higher margins
3. Being more organized to develop the same product than your competitors. As a result, you are more efficient
4. Develop the same product at the same cost but have a weaker currency
Unfortunately, points 1 aqnd 4 have been making the headlines recently. The worst solutions.
When investors realise that growth is weak, cost management becomes the focus to try and increase margins. However, this is to the detriment of everyone, as the quality of life will decrease as wages fall and the number of unemployed increase. It is at this moment in time that innovation, a culture to learn, explore and develop must come to the fore to develop new solutions so that capital can flow into these economies again - not because they make the same product cheaper.
Conclusion
The lack of growth from the unproductive usage of capital in developed economies created a heavy debt burden that, for a moment in time, masked the structural growth problems inherent in these economies that resulted from globalisation. Now that debt is a heavy burden which forces the same economies to focus on cost cutting to reduce that burden. This will lead to a transfer of wealth from developed to developing countries.
It is an uncomfortable position to experience, but it must be done. The debt burden must be reduced so new capital can be available to chase new, more productive, projects. Ideally it should be done via creation, by value generation. Having new projects today to invest in. However, inevitably, pain must also be suffered via the reduction in the quality of life for many as consumer spending is replaced by greater savings to pay down debt.
There are some signs, however, that are creating even more fear within me. Negative real interest rates are providing a strong incentive to move from cash to real assets. There is an opinion that this could carry on for an "extended period of time". It is understandable, debt was the straw that broke the camels back, and the authorities do not want to increase the cost of that burden whilst the economy is so fragile. It is this reasoning that led us to believe that rates would stay low in 2009 for many years, as we wrote to our clients back then.
However, it seems there is appearing a 5th option in how to increase the return of an economy, and it has little to do with the real economy, it has to do with the role of asset markets. I fear that asset markets are being used as a transmission channel to inject liquidity into the economy, particularly so in the US, as the financial system has yet to recover from its shock in 2008 (as detailed in many recent blogs).
The distortional rising of asset markets and weakening of a currency are an interesting mix that generate the desired results on paper, in theory. However, in theory there is no difference between theory and practice. In practice there is...
PS. History suggests all great economies die eventually from the unproductive usage of capital; be it for war, lack of innovation or poor spending. Developments in the financial system over the last 300 years has meant once great economies can go a little bit longer by using other peoples money via borrowing. Modern economies therefore often die from being bloated in debt, taking on more than their economy can handle. Once the cost of debt is consistentñly greater than the GDP growth of an economy, it is the beginning of the end. In a market based system, destruction would be swift and fatel.
Monday 15 November 2010
Saturday 6 November 2010
Want to work, forget it, let someone else work for you!
Dear Reader,
Today’s message has no doubt been better transmitted from daily experience than a few words from me.
Globalisation has meant that developed countries have experienced weak wage growth over the last 10 years, as developing countries have offered a considerably cheaper option.
This has not meant that prices for products have fallen. It has meant we had to borrow to keep the same quality of life and that companies have enjoyed larger profit margins.
It is likely that wage declines in developed countries will continue if globalisation continues in its current state.
If we combine the top heavy population structure that many developed economies are experiencing (i.e. larger proportion of population greater than 50 than less), then we are also likely to have an increasing tax burden. This will reduce further the purchasing power of consumers.
--It is for this reason that I often say the principal drivers of an economy are the education of its people (hence its innovation output, new companies generated, greater exports etc) and its demographics. In its purest form, this is macroeconomics . Everything else is mere detail. Good politicians must always be aware of these variables and the affect they have on a country (of course the output may not be measured for years and a particular party may never be recognised for policies that created a positive long term economic environment. Hence, few politicians practice this otherwise logical strategy until disaster happens).--
In such a difficult environment, the incentive to work for a wage will decline relative to what we have experienced during the 80s and 90s. This will no doubt cause political and economic tension, as we have already started to experience.
It is in this respect that investing in the business of high quality corporate seems more fruitful, and offers a nice hedge, against simply earning a wage. Let the corporate do the work for you! Clearly, for this to work, you need to have the capital. Start saving before there won´t be anything left of your wage to save!
Of course, investing is not something you just decide to do one day (you can, but the probability of it being successful are likely to be slim). Furthermore, if you decide to develop a criteria to become a continuously better investor, the returns will not offer the stability of a wage. Furthermore, it is important to note that from the data I receive more people have been burnt from investing than working for a wage....
Yours sincerely,
Alessandro Sajwani
Today’s message has no doubt been better transmitted from daily experience than a few words from me.
Globalisation has meant that developed countries have experienced weak wage growth over the last 10 years, as developing countries have offered a considerably cheaper option.
This has not meant that prices for products have fallen. It has meant we had to borrow to keep the same quality of life and that companies have enjoyed larger profit margins.
It is likely that wage declines in developed countries will continue if globalisation continues in its current state.
If we combine the top heavy population structure that many developed economies are experiencing (i.e. larger proportion of population greater than 50 than less), then we are also likely to have an increasing tax burden. This will reduce further the purchasing power of consumers.
--It is for this reason that I often say the principal drivers of an economy are the education of its people (hence its innovation output, new companies generated, greater exports etc) and its demographics. In its purest form, this is macroeconomics . Everything else is mere detail. Good politicians must always be aware of these variables and the affect they have on a country (of course the output may not be measured for years and a particular party may never be recognised for policies that created a positive long term economic environment. Hence, few politicians practice this otherwise logical strategy until disaster happens).--
In such a difficult environment, the incentive to work for a wage will decline relative to what we have experienced during the 80s and 90s. This will no doubt cause political and economic tension, as we have already started to experience.
It is in this respect that investing in the business of high quality corporate seems more fruitful, and offers a nice hedge, against simply earning a wage. Let the corporate do the work for you! Clearly, for this to work, you need to have the capital. Start saving before there won´t be anything left of your wage to save!
Of course, investing is not something you just decide to do one day (you can, but the probability of it being successful are likely to be slim). Furthermore, if you decide to develop a criteria to become a continuously better investor, the returns will not offer the stability of a wage. Furthermore, it is important to note that from the data I receive more people have been burnt from investing than working for a wage....
Yours sincerely,
Alessandro Sajwani
A Glorious Time to Enjoy Risk Assets...
Dear Reader,
Well, it looks like we passed 1,200 on the S&P 500, the FTSE 100 passed 5,800 and just about every equity market is rallying, presumably because investors have decided that central banks will try and inflate asset prices to help boost "consumer confidence".
Many of you have increased equity exposure to 40%, a suitable exposure to this asset class at the moment. I must admit, personally, I am starting to put on my selling hat. We suggest you consider getting that hat out of the cupboard and dusting it off.
Though recent news is a powerful boost to asset prices, we seriously doubt pumping asset prices with morphine (i.e. increasing the price of a piece of paper), will be the long term solution to slow growth in developed economies. These are structural problems that depend on the cost of labour, the skills of a countries people (i.e. education, attitude etc) and their demographics. The debt burden is of course an important issue. As a consequence, the role of morphine is most uncertain.
Investors are suggesting enjoy the party, don't fight the FED, overload on risk assets. In the short term, this may well prove to be the most lucrative strategy. However, we express a sound of caution. It is a probable event that the drop will be faster than the rise if:-
1. The last drop of morphine is injected and their has been no "perceived positive outcome". Furthermore, It still is not clear to me what the criteria is to deem the project a success
2. Your body has after effects on the morphine....inflation...other central banks react....
3. You become addicted.............Markets drop unless QE keeps continuing...
The environment is being created where speculation is the game, not investment. The best predictor of an investments performance is its entry price relative to its underlying value (clearly a subjective concept). However, I believe that is as good as it gets. Understanding that Mr. Market has mood swings is beneficial to getting the right price, attempting to predict them, is a more dangerous game.
Though it seems likely that within the next 6 months the S&P 500 could reach 1,300, if this occurs, your return will have little to do with company valuation relative to political meddling.
This distortion of asset markets is most worrying. Though with valuations as they are I would be normally making a louder noise to sell risk assets, the continuous intervention by politicians means there could well be room for further distortional rises in pricing. However, I suggest to all that your selling hats should be close to hand and that cyclical or capital intensive companies you have bought over the last 12 – 18 months, you should consider taking at least the profits. Being dependent on your local politician for a quick buck....need I say more....is not a dependent strategy. Only high quality companies, as an equity category, offer a relatively sound valuation at the moment.
Apologies for my bickering, but everyone has become so positive that I feel obliged to remind us that we quite possibily living in an illusionary world.. it may last longer than a honey moon, but buyer beware.......
Yours sincerely,
Alessandro Sajwani
Well, it looks like we passed 1,200 on the S&P 500, the FTSE 100 passed 5,800 and just about every equity market is rallying, presumably because investors have decided that central banks will try and inflate asset prices to help boost "consumer confidence".
Many of you have increased equity exposure to 40%, a suitable exposure to this asset class at the moment. I must admit, personally, I am starting to put on my selling hat. We suggest you consider getting that hat out of the cupboard and dusting it off.
Though recent news is a powerful boost to asset prices, we seriously doubt pumping asset prices with morphine (i.e. increasing the price of a piece of paper), will be the long term solution to slow growth in developed economies. These are structural problems that depend on the cost of labour, the skills of a countries people (i.e. education, attitude etc) and their demographics. The debt burden is of course an important issue. As a consequence, the role of morphine is most uncertain.
Investors are suggesting enjoy the party, don't fight the FED, overload on risk assets. In the short term, this may well prove to be the most lucrative strategy. However, we express a sound of caution. It is a probable event that the drop will be faster than the rise if:-
1. The last drop of morphine is injected and their has been no "perceived positive outcome". Furthermore, It still is not clear to me what the criteria is to deem the project a success
2. Your body has after effects on the morphine....inflation...other central banks react....
3. You become addicted.............Markets drop unless QE keeps continuing...
The environment is being created where speculation is the game, not investment. The best predictor of an investments performance is its entry price relative to its underlying value (clearly a subjective concept). However, I believe that is as good as it gets. Understanding that Mr. Market has mood swings is beneficial to getting the right price, attempting to predict them, is a more dangerous game.
Though it seems likely that within the next 6 months the S&P 500 could reach 1,300, if this occurs, your return will have little to do with company valuation relative to political meddling.
This distortion of asset markets is most worrying. Though with valuations as they are I would be normally making a louder noise to sell risk assets, the continuous intervention by politicians means there could well be room for further distortional rises in pricing. However, I suggest to all that your selling hats should be close to hand and that cyclical or capital intensive companies you have bought over the last 12 – 18 months, you should consider taking at least the profits. Being dependent on your local politician for a quick buck....need I say more....is not a dependent strategy. Only high quality companies, as an equity category, offer a relatively sound valuation at the moment.
Apologies for my bickering, but everyone has become so positive that I feel obliged to remind us that we quite possibily living in an illusionary world.. it may last longer than a honey moon, but buyer beware.......
Yours sincerely,
Alessandro Sajwani
Friday 5 November 2010
The Politicisation of Asset Markets
Dear Reader,
Extract from a private letter issued 29.09.10
We aim to achieve 8% compounded annual growth rate in the long term (5 year measure). However, in a year like 2010, where my expectation was that developed equity markets would be flat, we were aiming to achieve 6%. We are slightly over performing, but as usual, the forecast was wrong (I could argue only slightly, at least for the moment!).
YTD performance of major equity market indices (remember, this is NOT net of fees):-
FTSE 100 + 4.89%
Eurostoxx 50 - 4.02%
S&P 500 + 6.15%
Nikkei 225 - 12.74%
Hang Seng China + 2.49%
Brazil Bovespa + 2.52%
NSE Nifty (India) Index + 15.22%
However, if we assume that you had converted EUR to USD on 31st December 2009 to
invest in the S&P 500 on the same day, your performance would actually be very close to 0.0%!
The aim of this perhaps rather long letter is to inform you, the client, of my deepest fears and highest hopes. Unfortunately, there is rather more of the former than the latter. It is a market that makes no real economic sense, but one which is heavily distorted by political forces. We must appreciate what those drivers are and how they can affect risk asset valuations.
IS THE MARKET CHEAP?
No.
Let us use the Shiller cyclically adjusted price/earnings ratio as a reference for valuation. This takes the index value and divides by the average 10 year earnings of the index. It is a means to remove cyclical factors that affect earnings such as variations in profit margins. The average Shiller price/earning ratio is 16.5. The graph below (no graph included) shows that the S&P 500 is currently trading at a 21.17 price/earnings. This is a 25% premium to fair value. Indeed, the graph below shows that market was only trading at fair value for a period of a few months, mainly from end 2008 to mid 2009. In all other periods during the last 15 years
the market has been over valued using this valuation reference. I tend to agree. Our estimation of fair value for the S&P 500 is between 930 – 950, as we have suggested over the last 12 months. It closed on the 28th October 2010 on 1183.78.
One could conclude that if markets are not cheap, then they should not be bought as
aggressively. This would make sense, and indeed, would agree with our 30 - 35%
weighting on equities for clients, However, I have come to believe that the markets may continue to trend in a non rational manner due to political influence.
Is the US market expensive for EUR based investors if the S&P 500 is trading at 1183 in 6 months time, but the USD has meanwhile dropped 20%?
PROTECTIONISM, A LA SOPHISTIACTED
Much fear has been projected by various economic participants including governments,
investors and consumers on the potential damage protectionism could have on the
global economy. Others are more optimistic by the fact that people are talking about it in a negative way rather than cheering it. Hence, they see it as difficult for it to become a reality. Whatever you think, the reality is protectionism is already here as far as I am concerned, but a la sophisticated.
When the asset markets in the US go up as they have, providing the perception that
investors and consumers are richer, whilst your currency becomes weaker, it becomes
more difficult to spend that “perceived wealth” abroad. Hence you are effectively being told to buy American!
What a clever and tacit way of achieving your objective of increasing consumer
confidence in the hope that 70% of the US economy can be steered back to life. However, there is a catch. If every economy plays the same trick it is a total waste of money! This is because it becomes harder to reduce your currency value by “creating money” to dilute its purchasing power, because everyone else is doing it as well!
QUANTITATIVE EASING (QE), WHY DO IT?
As a result, the much discussed QE2 has led the USD to weaken, but risk assets to go up. Why is the latter happening?
When the government buys bonds, they are not buying it from me and you, they are
buying them from large financial institutions. Hence these institutions will have large lumps of cash in their hands. They will not use this cash to buy shoes (i.e. to consume) they will invest it in risk assets. We have seen over the last 18 to 24 months yields on bonds effectively converge to zero as a result, and money being moved into other risk assets with the same consequence, reducing their yield.
Remember, as we have written in past letters, consumer spending is 70% of developed
economies GDP, and, in my opinion, supported by three important pillars:-
1. Wages; with unemployment so high they are unlikely to go up on average
2. Credit expansion; de leveraging is so prominent amongst banks that credit
growth is likely to remain weak for years to come
3. Asset prices; with risk assets relatively expensive considering weak GDP growth
for developed economies and the potential for inflation, this should not to go up
drastically
If you were the FED, which one of these variables is the easiest to manipulate in the hope of increasing consumer spending, the bed rock of developed economies?
They tried to increase credit expansion by capitalising the banks, no luck.
They tried to create jobs by proposing to create new projects, no luck so far.
This leaves us with asset prices. If they could create enough liquidity that would get into asset markets, we could increase their value in USD terms and give the perception that consumers are richer then they really are, hopefully boosting consumer confidence (does this sound familiar? It should do, we have been living off this model since the 90s). However, if the USD weakens, in global purchasing power, you are no richer.
QE therefore has the consequence of weakening the USD and increasing the price of risk assets. And it will have the same affect on any other country that applies the same strategy. However, if everyone done it, no one is getting richer, we are just wasting money, hence reducing its value, hence reducing the purchasing power of a unit of currency.
WHO WINS?
In such an environment, there is one economic participant, I believe, that can gain over others.
These are the participants that use the capital markets to receive money. i.e.
CORPORATES. If Pfizer, Microsoft and Johnson and Johnson’s can issue 10 year bonds and pay 2% for that money, we are effectively transferring wealth from consumers (who need the income, especially retirees) to corporates.
Furthermore, this advantage can be exacerbated if:-
1. They have low leverage to start, hence they can borrow to buy their leveraged
competitors and buy them at attractive prices as they suffer paying large interest
payments from bonds issued with much higher rates
2. They have pricing power, so can partially protect their operating margin if
inflation becomes an issue
3. Have low capital expenditures relative to revenues. If there is inflation, then
capex costs will increase. If you have little capex (i.e. are not a capital intensive
business) then you are less affected by inflation via input costs, but if you have
pricing power, can enjoy increasing your selling price.
4. Stable market share and high and stable returns on capital
The points above mentioned are what I subjectively call HIGH QUALITY COMPANIES.
I strongly believe this classification of companies have the cheapest equity in town, and are the companies that can do best in a difficult economic environment. It is for this reason we have been buying throughout the year these companies.
Below I include a table (no table included) to summarise some of our larger holdings of companies I classify in this category, and whose price is close to the past buying price. If you don’t hold them, I suggest you consider them as an investment solution. I can assure you I hold the vast majority myself.
CONCLUSIONS
I summarise below the asset allocation, on average, for portfolios during 2010:-
START 2010 CURRENTLY DIFFERENCE
CASH 30% 25% -5%
BONDS 30% 25% -5%
EQUITIES 30% 35% +5%
ALTERNATIVES 10% 15% +5%
Throughout the year we have:-
1. Continued using cash to buy the equity of high quality companies
2. Started selling bonds and buying Phoenix notes (we have discussed these
structured products in past letters. If you need further information please let us
know)
3. Bought exposure to emerging market debt via the Templeton Global Bond Fund.
However, we have not continued with this in the second half of the year
Due to my fears of continuous government intervention I would suggest reducing the
cash further. Hence cash should edge closer to 20%, and equities closer to 40%. This could also be supplemented by using cash to buying Phoenix notes. We do not suggest holding more than 15 – 20% of the portfolio in such securities.
We also like the idea of buying commodity exposure via oil and gas and tree growing
companies. However, the vast majority are now too expensive. To the above list we would be happy buyers of EXXON MOBIL at 65 USD or less.
There is no doubt that markets will eventually correct themselves. They are simply
becoming too expensive. However, it becomes harder and harder to ignore the loud
signals Mr. Bernanke is making: TAKE MY PUT OPTION. We slowly heed his statement but
refuse to have more than 40% equity exposure at current market pricing.
May I end with a point on many investors minds: currencies. My own personal portfolio
has a Q3 performance of approx. -5.0%. Stock picking contributed +2.5%, but currency
losses where -7.5% on a marked to market basis during that period. Currencies do matter!
As you may have guessed, 60% of this account is denominated in USD, which has been
destroyed during the Jul – Sep period. However, if I was to make one bet today as a
prediction for 2011, it would be that the EURO would weaken relative to the USD, edging closer to the 1.20 rate from its current 1.40 level. Though quantitative easing in the US will not disappear, I honestly do not believe that this is the main point, because everyone is doing it, or will do it, directly or indirectly.
What is important is to have a certain degree of currency diversification. We have
suggested to pure EURO investors that they should consider holding at least 20 - 25% in USD. The same would be true of other pure currency portfolios. Personally, I have an equal split amongst Euros and USD, as well as a range of other currencies such as CAD,HKD and GBP.
Furthermore, many of the high quality companies we have mentioned above are also
generating profits outside of their home country. As a result, they also offer a partial currency hedge. It is also worth noting that if a countries currency weakens, the exporters of that country enjoy a competitive advantage over a similar manufacturer whose home currency is increasing. It is for this reason that Siemens, Europe’s largest exporter, has a stock price that enjoys appreciation as the EURO weakens.
We thank you for your continued support in us, and look forward to discuss the above
mentioned ideas, or others you may have.
Yours sincerely,
Alessandro Sajwani
Extract from a private letter issued 29.09.10
We aim to achieve 8% compounded annual growth rate in the long term (5 year measure). However, in a year like 2010, where my expectation was that developed equity markets would be flat, we were aiming to achieve 6%. We are slightly over performing, but as usual, the forecast was wrong (I could argue only slightly, at least for the moment!).
YTD performance of major equity market indices (remember, this is NOT net of fees):-
FTSE 100 + 4.89%
Eurostoxx 50 - 4.02%
S&P 500 + 6.15%
Nikkei 225 - 12.74%
Hang Seng China + 2.49%
Brazil Bovespa + 2.52%
NSE Nifty (India) Index + 15.22%
However, if we assume that you had converted EUR to USD on 31st December 2009 to
invest in the S&P 500 on the same day, your performance would actually be very close to 0.0%!
The aim of this perhaps rather long letter is to inform you, the client, of my deepest fears and highest hopes. Unfortunately, there is rather more of the former than the latter. It is a market that makes no real economic sense, but one which is heavily distorted by political forces. We must appreciate what those drivers are and how they can affect risk asset valuations.
IS THE MARKET CHEAP?
No.
Let us use the Shiller cyclically adjusted price/earnings ratio as a reference for valuation. This takes the index value and divides by the average 10 year earnings of the index. It is a means to remove cyclical factors that affect earnings such as variations in profit margins. The average Shiller price/earning ratio is 16.5. The graph below (no graph included) shows that the S&P 500 is currently trading at a 21.17 price/earnings. This is a 25% premium to fair value. Indeed, the graph below shows that market was only trading at fair value for a period of a few months, mainly from end 2008 to mid 2009. In all other periods during the last 15 years
the market has been over valued using this valuation reference. I tend to agree. Our estimation of fair value for the S&P 500 is between 930 – 950, as we have suggested over the last 12 months. It closed on the 28th October 2010 on 1183.78.
One could conclude that if markets are not cheap, then they should not be bought as
aggressively. This would make sense, and indeed, would agree with our 30 - 35%
weighting on equities for clients, However, I have come to believe that the markets may continue to trend in a non rational manner due to political influence.
Is the US market expensive for EUR based investors if the S&P 500 is trading at 1183 in 6 months time, but the USD has meanwhile dropped 20%?
PROTECTIONISM, A LA SOPHISTIACTED
Much fear has been projected by various economic participants including governments,
investors and consumers on the potential damage protectionism could have on the
global economy. Others are more optimistic by the fact that people are talking about it in a negative way rather than cheering it. Hence, they see it as difficult for it to become a reality. Whatever you think, the reality is protectionism is already here as far as I am concerned, but a la sophisticated.
When the asset markets in the US go up as they have, providing the perception that
investors and consumers are richer, whilst your currency becomes weaker, it becomes
more difficult to spend that “perceived wealth” abroad. Hence you are effectively being told to buy American!
What a clever and tacit way of achieving your objective of increasing consumer
confidence in the hope that 70% of the US economy can be steered back to life. However, there is a catch. If every economy plays the same trick it is a total waste of money! This is because it becomes harder to reduce your currency value by “creating money” to dilute its purchasing power, because everyone else is doing it as well!
QUANTITATIVE EASING (QE), WHY DO IT?
As a result, the much discussed QE2 has led the USD to weaken, but risk assets to go up. Why is the latter happening?
When the government buys bonds, they are not buying it from me and you, they are
buying them from large financial institutions. Hence these institutions will have large lumps of cash in their hands. They will not use this cash to buy shoes (i.e. to consume) they will invest it in risk assets. We have seen over the last 18 to 24 months yields on bonds effectively converge to zero as a result, and money being moved into other risk assets with the same consequence, reducing their yield.
Remember, as we have written in past letters, consumer spending is 70% of developed
economies GDP, and, in my opinion, supported by three important pillars:-
1. Wages; with unemployment so high they are unlikely to go up on average
2. Credit expansion; de leveraging is so prominent amongst banks that credit
growth is likely to remain weak for years to come
3. Asset prices; with risk assets relatively expensive considering weak GDP growth
for developed economies and the potential for inflation, this should not to go up
drastically
If you were the FED, which one of these variables is the easiest to manipulate in the hope of increasing consumer spending, the bed rock of developed economies?
They tried to increase credit expansion by capitalising the banks, no luck.
They tried to create jobs by proposing to create new projects, no luck so far.
This leaves us with asset prices. If they could create enough liquidity that would get into asset markets, we could increase their value in USD terms and give the perception that consumers are richer then they really are, hopefully boosting consumer confidence (does this sound familiar? It should do, we have been living off this model since the 90s). However, if the USD weakens, in global purchasing power, you are no richer.
QE therefore has the consequence of weakening the USD and increasing the price of risk assets. And it will have the same affect on any other country that applies the same strategy. However, if everyone done it, no one is getting richer, we are just wasting money, hence reducing its value, hence reducing the purchasing power of a unit of currency.
WHO WINS?
In such an environment, there is one economic participant, I believe, that can gain over others.
These are the participants that use the capital markets to receive money. i.e.
CORPORATES. If Pfizer, Microsoft and Johnson and Johnson’s can issue 10 year bonds and pay 2% for that money, we are effectively transferring wealth from consumers (who need the income, especially retirees) to corporates.
Furthermore, this advantage can be exacerbated if:-
1. They have low leverage to start, hence they can borrow to buy their leveraged
competitors and buy them at attractive prices as they suffer paying large interest
payments from bonds issued with much higher rates
2. They have pricing power, so can partially protect their operating margin if
inflation becomes an issue
3. Have low capital expenditures relative to revenues. If there is inflation, then
capex costs will increase. If you have little capex (i.e. are not a capital intensive
business) then you are less affected by inflation via input costs, but if you have
pricing power, can enjoy increasing your selling price.
4. Stable market share and high and stable returns on capital
The points above mentioned are what I subjectively call HIGH QUALITY COMPANIES.
I strongly believe this classification of companies have the cheapest equity in town, and are the companies that can do best in a difficult economic environment. It is for this reason we have been buying throughout the year these companies.
Below I include a table (no table included) to summarise some of our larger holdings of companies I classify in this category, and whose price is close to the past buying price. If you don’t hold them, I suggest you consider them as an investment solution. I can assure you I hold the vast majority myself.
CONCLUSIONS
I summarise below the asset allocation, on average, for portfolios during 2010:-
START 2010 CURRENTLY DIFFERENCE
CASH 30% 25% -5%
BONDS 30% 25% -5%
EQUITIES 30% 35% +5%
ALTERNATIVES 10% 15% +5%
Throughout the year we have:-
1. Continued using cash to buy the equity of high quality companies
2. Started selling bonds and buying Phoenix notes (we have discussed these
structured products in past letters. If you need further information please let us
know)
3. Bought exposure to emerging market debt via the Templeton Global Bond Fund.
However, we have not continued with this in the second half of the year
Due to my fears of continuous government intervention I would suggest reducing the
cash further. Hence cash should edge closer to 20%, and equities closer to 40%. This could also be supplemented by using cash to buying Phoenix notes. We do not suggest holding more than 15 – 20% of the portfolio in such securities.
We also like the idea of buying commodity exposure via oil and gas and tree growing
companies. However, the vast majority are now too expensive. To the above list we would be happy buyers of EXXON MOBIL at 65 USD or less.
There is no doubt that markets will eventually correct themselves. They are simply
becoming too expensive. However, it becomes harder and harder to ignore the loud
signals Mr. Bernanke is making: TAKE MY PUT OPTION. We slowly heed his statement but
refuse to have more than 40% equity exposure at current market pricing.
May I end with a point on many investors minds: currencies. My own personal portfolio
has a Q3 performance of approx. -5.0%. Stock picking contributed +2.5%, but currency
losses where -7.5% on a marked to market basis during that period. Currencies do matter!
As you may have guessed, 60% of this account is denominated in USD, which has been
destroyed during the Jul – Sep period. However, if I was to make one bet today as a
prediction for 2011, it would be that the EURO would weaken relative to the USD, edging closer to the 1.20 rate from its current 1.40 level. Though quantitative easing in the US will not disappear, I honestly do not believe that this is the main point, because everyone is doing it, or will do it, directly or indirectly.
What is important is to have a certain degree of currency diversification. We have
suggested to pure EURO investors that they should consider holding at least 20 - 25% in USD. The same would be true of other pure currency portfolios. Personally, I have an equal split amongst Euros and USD, as well as a range of other currencies such as CAD,HKD and GBP.
Furthermore, many of the high quality companies we have mentioned above are also
generating profits outside of their home country. As a result, they also offer a partial currency hedge. It is also worth noting that if a countries currency weakens, the exporters of that country enjoy a competitive advantage over a similar manufacturer whose home currency is increasing. It is for this reason that Siemens, Europe’s largest exporter, has a stock price that enjoys appreciation as the EURO weakens.
We thank you for your continued support in us, and look forward to discuss the above
mentioned ideas, or others you may have.
Yours sincerely,
Alessandro Sajwani
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