when are stocks mispriced?

There are four principal reasons, using our inhouse language, why stocks are mispriced in the market.

1. The accouting causes confusion to investors that won´t dig into the gory details
2. A risk factor is over or under discounted (i.e. fear of government expropriation)
3. Not understanding the business economies, hence the stability in the companies earnings, hence its quality of earnings
4. Growth potential is over or under priced into the stock

Regarding point 2, we look and try to understand the following risk factors for a company:-

Market risk
Real profits
Inflation
Economic cycle
Government
Technology
Regulation
Product substitution
Obsolescence
New competitor
Market structure
Currency
Non recurring affects (i.e. litigation, restructuring, accidents)
Final market demand
Insider actions
EPS relative to analyst expectations
Management record
Capital allocation
Business economics
Fraud
Stigma
Accounting

Classify and categorise risks and portfolio structure

Our database of interesting companies that seem to trade below fair business value is not what we currently spend most time on.

Now that we have defined explicitily the risks we look for in every investment, and keep our eyes open for new ones, we determine what our exposure to different risks are.

Be it government or barriers to entry in a business.

We align this with the asset allocation of the portfolio in terms of exposure to investment strategies and different risks, as well as asset allocation.

Is 100% in cash safe?

I hear many individual say the world is so uncertain at the moment it is best to be 100% in cash.

Two main points.

Uncertainty always exists. Sometimes people pay attention to it, sometimes they don´t.

Often the media is the trigger that determines how much investors are concerned by uncertainty. When the media continuously talks about cancer you may be more fearful about getting cancer, but your probability of catching cancer has not changed by much (it may change a little after your reading if you change your lifestyle, i.e. stop smoking or put sun cream on at the beach). The same is true with investing. There is little you can do to stop uncertainty - hence it is uncertain.

The way we fight uncertainty (the only sensible way uncertainty can be fought in our opinion) is by buying securities with a large margin of safety, i.e. buy cheap. If we don´t pay for growth in a company we think can grow nicely, we don´t get harshly punished if the growth rate the market expected is not achieved due to some unexpected factor!

However, back to cash.

We must remember, as we have discussed in past blogs, we are in a capital destruction environment. Too much capital was created, lots of it was unproductive, it must diseappear to encourage new investment - hence it must be destroyed. The capitalist system allows this to occur.

Depending on the path the capital destruction takes, different asset classes will perform differently.

Debt destruction via haircuts would merit having a large cash position in the portfolio, whilst excessive money printing to keep economies from paying their debt would be a catalyst for equities.

Capital is like water. eventually it will reach its targeted goal. Capital must be destroyed and if governments are against the idea of writing down sovereign debt it will happen via other means including currency devaluation, reduction in wages, reduction in asset values etc.

Note how your cash would perform if:-

The currency was excessively printed?
Your economy was to leave the eurozone?
Inflation kept rising whilst interest rates were kept artifically low?
Your bank went bankrupt?

There are a number of extreme scenarios for normal times that are becoming more common in the capital destruction era we find ourselves in. In this era cash is by no means a risk free investments that allows you to maintain your quality of life. You must be aware of this.

The value contained in being a 100% cash holder is being tapped by the authorities and distributed elsewhere. This is what money printing effectively does. Being 100% in cash is partially equivalent to being 100% invested in the authorities.

Though we are ourselves large holders of cash in a number of currencies (on average 20-25% of portfolios due to our belief that debt writedowns are required in a number of economies) we hold the other 75 - 80% of assets in the securities of companies that are off bank balance sheets.

Note cash can also be held off the bank balance sheet via money market or short term government bond funds (we hold some with an average duration of less than 1 month holding maninly German, Swiss and Dutch debt).

The winners of globalisation

In an economy there are three main economic participants.

Governments
Corporates
Households

One can see by viewing the publically available GDP numbers of an economy how each economic participants is doing. For example, by looking at the income view of GDP data we can see the tax receipts of the government, the wages received by households and the profits generated by corporates are evolving.

However, as we have stated in the past, we see many developments in economies, and hence GDP structure of economies, be significantly affected by the role of globalisation.

Globalisation is a word so commonly used that the majority of the value contained within it has been destroyed. We simply see it as the reduction in barriers to move capital outside your home country to wherever you decide to spend/invest that capital. There are many consequences to this becoming easier and easier.

However corporates are the economic participants that most enjoy the fruits of globalisation.

Governments by definition are local, hence cannot invest capital abroad.

Households are stubborn and don´t move easily to where the best paid jobs are for their particular skill set. Hence in Spain unemployments is over 20% whilst in China wages are increasing by 20% per annum.

Corporates can choose to invest in any region of the world determined only by how profitable the venture is expected to be. Hence they are the winners of globalisation. It is no surprise they are generating record profits with record margins whilst unemployment is at record highs in developed markets and wages are increasing significantly in many emerging markets.

Current asset allocation

Cash

In different currencies to offer diversifiaction and spread the economic risk and "government reaction" risk
We hold EUR, USD, GBP, JPY, HKD, CAD

Bonds

Little exposure to a few investment grade short term positions (<3 years)and a few perpetuals (tier 1, some have a few lower tier 2)

Equity

Most of our capital is allocated here. If currencies weaken (our cash) the equities will rise. If equities fall our cash will be worth more. Mainly non cyclical high quality stock paying dividends at least x3 current cash rate

We also hold the equity of companies involved in the oil and timber business to have indirect exposure to commodities

We classify portfolio by strategies and asset classes

Cash (base currency)
Cash non base currency Currently very popular
Bonds
Cyclical equity
Non cyclical equity
Commodities Currently very popular
Macro strategies

Net nets
Asset plays
Cheap defined free cash flows
High quality
Cheap normalised earning power
Cheap earning power (a reason the company is disliked which is not permenant)
Turnaround
Growth

On a simple cyclical view of the DM economies. This is a time to have at least 50% in equities. People fear debt destruction can cause a deep panic. It will. It will create losses and slow down the economy. The destruction of capital in debt will also destory capital in equity for the economy. You need to make sure it is not your equity that gets destroyed.

Cash/equities we are 40/60

If governments print money this allocation will be enjoyed. If there is a serious of debt destruction events than we will suffer heavily in the short and maybe even the medium term.

But we will have cash in hand to make it work

The basic role of macroeconomics in investing

There are three main macroeconomic variables that really matter to any serious investor (almost irrespective of investment style).

1. The growth of the economy (GDP)
2. The purchasing power of the currency of that economy (inflation)
3. The cost of borrowing/lending money in that currency (interest rates)

Usually economic growth is very cyclical, where the cost of borrowing plays an important role in influencing the growth rate, as does the inflation rate (which often determines the cost of money). We tabulate this simple statement below and create 6 simple stages to a normal cyclical economy:-


We note that currently many developed economies are stuck in stage 5.

It is as if the cycle will not turn anymore.

The high debt burden these economies have accumulated have muted the role of interest rates to stimulate growth. The debt load itself is now the key variable!

This is not a normal cycle. Structural change is required.

This means changes to variables that determine GDP, interest rates and inflation.

1. Such as the structure of economies (i.e. the role of imports and exports)

2. How various economic participants allocate capital (i.e. households save more, governments spend less, corporates invest more in their country of origin if they become more competitive)

3. Floating currency exchange rates to incentivise the flow of capital internationally

4. Increasing productivity by increasing the knowledge of workers to help generate innovative soutions that can be sold internationally

5. Compensating workers for their productivity not their existence


Reactions to the halt of the economic cycle have included massive money printing by DM authorities. However, much of these funds channel their way to regions that experience strong growth and have low debt burdens - emerging markets.

As a result these countries are experiencing strong inflation which may be exported to DM. Hence DM may experience no growth, no change in interest rates but increasing inflation. This reduces the demand to hold the cash and bonds of these economies. Hence we see weakness in currencies such as the USD and GBP. This is positive for the equity markets of these regions.

However such action is increasing the need for CURRENCY DIVERSIFICATION (especially for simple cash holdings) and exposure to REAL ASSETS.

Hence more investors are becoming MACRO ECONOMIC INVESTORS.

It is normal. There are big macroeconomimc problems and they cannot be ignored.

This is made all the more difficult because in DM interest rates are zero. Hence bonds offer very little. It is cash or equities.

Since cash could be diluted by imported inflation and many investors are worried by growth (hence worried by equities)- FX and COMMODITY investments are becoming ever more popular.

I understand.

In the end, by investing in FX and COMMODITY products you are investing in an area where the cyclical properties still seem exist (hence you feel it is more predictable), so feel more comfortable than being somewhere where the cycle seems to have stopped and you don´t know what could happen (the great uncertainty we keep hearing about).

Many also invest in EM because they do not see a structural change there but a simple cyclical one, which again they feel more comfortable with.

However one needs to be very careful with price when buying anything cyclical.

This is made all the more difficult when commodities do not generate any cash output, it is simple attempting to guess what it is worth tomorrow. Many assume the dilution of cash from money printing and the belief that demand in the future will not be less than today will protect them against a capital loss. A bout of deflation from debt destruction by a number of economies to reduce their debt load would destory that idea and lead to many an unhappy customer. Furthermore, in this scenario demand in the future would then be more likely to be less, not more than today for quite some time.

FX. I don´t know. I just dont have enough knowledge in every economy in the world to make judgements about them.

But, don´t forget that high quality companies in the right market structure with a mis priced valuation and a strong management team also offer a good opportunity for investing - and are more stable in the long term, unlike FX or commoodity investments. Managements can react, a piece of metal can´t.

One more point.

Oil is the key to globalisation.

Items are connected to different regions by transporting them there.

Oil is mainly used to transport physical items.

If you think globalisation will continue, be long OIL in the long run.

Macro, market structure the business: factors that determine returns

Stock prices are primarily determined by

Inflation. Affects costs as well as ccy. Need to ask if ccy looks expensive

Real gdp growth. Which determines ernings growth if sales are in the that country (or the countries they do business in)

Multiple, ie the price you pay

If sell abroad to economies that are growing strongly
Have costs in a weak growth economy where wage growth is slack
And your performance is measured in a weakening ccy
Then you have an interesting combination

This is what GE has!

The above are the macro factors

Then add on the market structure factors particular to a certain industry (i.e. may have a stable structure which gives more visibility on future free cash flow generation)

Add on individual company factors such as management, the price, allocation of capital, the business model, cost management, pricing power, sales force

Comparing potential cash outflow in 5 years to current market cap

I noted in a recent article published by Bestinver that they place importance on comparing the market cap of the company relative to the cash and cash equivalent assets of the company a number of years in the future (2012 in this example).

We like this approach.

If we take a companies net assets and modify their value to current valuations (conservatively), and then add the free cash flow we feel can be achieved over the next 5 years, we can compare this sum to the market cap at the moment.

For example a company that achieves a 20% return on equity consistently that has a conservatively valued balance sheet and can be bought for x2 book would be good value under this approach. If they held hidden assets on their balance sheet it could be an exceptional investment.

Meeting with Carmignac

This week I met with members of the respected investment house Carmignac.

They divided the conversation into three geographic regions: the USA, Europe and Emerging Markets.

Felt the US had little real GDP growth prospects for a number of years
The consumer will continue to de leverage
The US government is reaching a debt ceiling and hence likely to offer less support to GDP growth in the future
Corporations continue to prefer investing abroad than in developed markets in general
Even when country was downgraded their cost of borrowed trended downwards. Their equity took a hit as GDP growth likely to suffer if government will invest less in its economy as can borrow less due to approaching its ceiling
However, still has advantage of the reserve ccy hence many people around the world hold USD and would lend to the government, hence their low rates
Is market suggesting government should take a more aggressive role in supporting its economy by offering the country lower rates

In Europe there was an agreement that only three viable solutions exist: money printing (a temporary solution), fiscal unity or debt restructuring
They are very underweight European equities in general, especially their banks, and are not keen on holding the Euro
Felt Europe was in a similar situation to Japan in the 1990s. There consumer de leveraged but the export machine started working
Now many developed countries need to export so more tension with currencies and trade (not an isolated case anymore)
Euro was more stable than USD because of advantageous interest rate differential
Inflation fears reducing, likely to take Euro down
Europe very dependent on banks for financing (like Japan), whilst USA less so (opposite 75/25 split in bank to capital market funding)

This means whilst banks are unable to lend as they have to re capitalize themselves from poor investing in the past and new regulation, Europe is unlikely to find much new capital in this arena for growth. We may see European companies looking for more capital in the capital markets if they decide to open up, or they will be static

Problem of Japan was it took so long to admit the problem of its banks and start to re capitalize them

Euribor is increasing more than Libor in the US as European banks are not trusting each other as much so cost of borrowing is increasing


Very positive on EM as they become more consumption based and less export based economies. They feel inflation will decrease. Since EM equities now are at a 30% discount to DM equities when compare MS indices, they could be the sweet spot for EM equities: growth, low inflation and cheap initial position. I don’t think I agree as strongly as they do. They are using a relative cheap indictor, when it should be absolute! I don’t think inflation will be easy to control with wages increasing 20% per annum. There will be a benfit from commodity prices decreasing if we see less capital injections from DM central banks and recession in DM, but internal inflation is still a problem resulting from the growth they have which is very high. Interest rates seem to be stabilizing in the EM world – but lets see how the economy reacts.

There portfolio core is on companies helping to make EM consumers have a better quality of life. This is primarily consumer companies, infrastructure and financials

The satellite portion is in more growth opportunities such as technology and raw materials

They like gold miners as feel they are out of synch of the gold price. I note that gold miners sell gold at a certain pre determined price or unhedged. Hence their earnings over the next 10 years will depend on the gold price over that time period rather than just at this moment when there is a lot of fear and when gold attracts the most attention as an investment!

They feel at this moment have to guess what will be the safe havens, i.e. where capital will flow

Worried about EM currencies as they may see lots of capital outflows if DM recession occurs, hence may be an opportunity to buy them soon

EM consumers hard for them to buy foreign basic consumer goods as more expensive (remember their currency is quite weak and costs are higher abroad). For the growing rich they may be attracted to the high quality DM consumer goods, hence the strong business environment for BMW and Louis Vuitton in sales and profits.

EM consumers are therefore buying more local brands and consumer goods, and here there is the potential for many opportunities

Note that many international corporations have lower margins in EM countries, hence their P/S ratio will be lower if all sales where based in these countries

Structural and cyclical trends we observe

When we suggest we are in a structural change as opposed to a cyclical one, we often quote the muted role of interest rates currently observed in DM.

Interest rates are often the dominant variable that determines economic activity in a normal business cycle. However, at one point the debt load becomes so large the DEBT itself becomes the dominant variable that affects economic growth! History suggests this occurs on average every 30 years.

It is not an accident this debt was accumulated by primarily households and governments in DM. The former were borrowing to maintain their quality of life whilst real wages were not increasing due to the birth of a globalised labour force.

Governments were forced to borrow as trade and budget deficits were allowed to continue under the illusion they would eventually sort themselves out.

Eventually the market decided to take action as the politicians were not doing much.

Real GDP growth is not likely until the issue of the debt is resolved. History suggests restructuring is usually required to resolve this problem.

We note the continuous pressure on real wages and the growing % of GDP of profits relative to wages do not seem to be cyclical trends, but fueled by globalisation. This force is so powerful we only see this reduced by protectionism - which of course will create a whole set of new problems with less advantages.

A cyclical trend we have observed over the last decade has been the declining price/earning ratio of DM equities. This occurs every 15 - 20 years on average and is often triggered by a shift in capital to real assets from financial assets. It is therefore no surprise when p/e ratios started to decline in around the year 2000, commodities started to rise and the USD started to decline. We expect this to change over the next 5 years (we feel differently about the USD as we think its role in the future will be different to its role in the past. Another financial asset (ccy) will take more advantage of capital flowing to financial assets as confidence returns to the financial system). This would be extremely positive for equities, especially if they are able to maintain their high level of profitability from being the most flexible participant in the economy, hence the one that can most take advantage of globalisation.

Our biggest fears are increasing tax burdens from debt laden governments, and our obsession with the mean reversion property of profit margins we have observed throughout the last 100 years, which are currently at record highs. Is globalisation allowing this to continue?

What determines GDP

If we were to be simple and crude, my simple understanding of basic economics would suggest that Nominal GDP growth is based on three main drivers:-

1 Population growth and the ratio of young to old workers (i.e. 25 to 50 year olds)

2 Productivity (generally means increasing capital intensity or more innovation from a better educated and better motivated workforce)

3 Inflation: Here we refer to the growth of credit (more savings in an economy more firepower to unleash credit later) and money printing

Hence an economy with large savings, strong productivity increases potential (i..e starting from a relativey low capital intensity and low penetration of highly educated workers) and a steadily growing population with a large proportion of young workers is the ideal combination

We add here a short note on austerity measures. For economies where confidence still remains but has been weakened, austerity can help raise confidence and hence provide access to new capital which can allow new growth to be created. However, generally, in the medium term likely to be problematic, especially if the return of the capital invested is weak.

Austerity in general reduces future deficits, hence reduces the debt level for the future, but does not rsolve the issue of the large debt you currently hold which required the austerity measure to be started.

Large debt burdens are only finally killed by growth, which comes from receiving new capital. Countries where confidence remains need a good plan to attract capital. Those that have no confidence for the market, must eventually restructure debt to attract new capital by offering the potential of large margins (how capitalism works)

The modern value investor needs to be more concerned with Macro issues

Sometimes it does not surprise me that most respected value investors of the last 50 years have been based in the USA.

Here is an economy where they have enjoyed a (1) stable political system and (2) currency with (3) continuous access to capital markets for funding. Hence the bet on a cyclical recovery always worked! Buying value therefore generally always paid off!

However, today we are seeing structural changes occur which will change the economic structure and the role of different economic participants in a drastic manner. Here the cyclical bet is more likely to go wrong we feel - as countries are competing with each other as well as companies within a country and outside the country.

This means currency management needs to become a more important part of the valuation equation, forcing the current value investor to be more concerned about MACRO issues.

Currency management coming to the fore

We are seeing the market react as if a default in Greece is likely to happen this week. We always felt this was always going to be the necessary solution to remove the excessive debt load. The market talked about it, but we may see how it really reacts this week.

This would be difficult for the market. It would immediately fear that other European economies could be next, putting great pressure on the EURO and European equities and debt markets as money flows out of the European Union into supposedly safer hands.

It seems the USD has taken this role, no doubt EM debt will also enjoy decreasing spreads.

In our portfolios equities are within 40 - 50%. High quality is approx, twice the amount of cyclicals. We do not want to change this ratio at this stage of developments.

Value investors must be careful as we cannot think of this as a standard business cycle where liquidity is the main issue and a bit more time will help us. We are dealing with structural changes that affect solvency of economies - they are not only liquidity issues. Hence we are looking for companies that can survive and are cheap. Structural changes take time to be resolved. Hence the large cash load in portfolios.

Currency management is becoming more of an issue as large cash holdings must be kept in currencies where its purchasing power can increase. This is likely to be in EM, or countries whose GDP is correlated to these economies. This can include Canada.

We will be studying three different categories of economies to understand their currencies. The first 2 DM, and the third EM.

Important portfolio issues

We have tried to mitigate our exposure to continued weak growth in advanced economies by:-

Buying being very sensitive to price, i.e. not paying for growth

Buying high quality companies whose business is not cyclical and who have strong balance sheets

Diversifying in currencies and not just holding the currency of where we are (which is the EURO)

Buying companies that have revenues that are geographically diversified

As prices become cheaper gaining exposure to cheap physical real assets (often cyclical companies). This strategy helps mitigate risks from excessive money printing by the authorities

We have been keen to gain exposure to emerging economies but are concerned on how to achieve this without increasing the risk/reward ratio. We have attempted to do this via:-

Buying advanced economy companies that have a repectable and growing revenue base in emerging economies

Buying companies that are involved in businesses that deal with real assets. We favour oil and timber. We note the latter commodity is not as easily transportable as the former, hence prices are more locally determined

We have stayed clear of buying foreign currencies such as the AUD, SGD etc as we are not currently comfortable with how to value such variables.

We have also stayed clear from buying industrial or precious metals. Our foray into agriculture ended poorly as we bought an EM company whose corporate governance proved to be most untransparent and anti shareholders.

As a result we are advancing our macro approach to consider new avenues to implement exposure to EM when the prices are more attractive. Our decision to maintain a low exposure has proven to be good so far. We feel it is better to be earning a wage and seeing that increase in those regions, then being a foreign investor in their stock market.

Fears on interest rates, inflation and depreciating currencies

We hold cash versus equities, having little room for bonds at the moment

We hold cash with the aim of deploying in equities when the price is attractive for us

We hold more equities than cash due to the opportunity cost (negative real rate) and fears of continuous money printing eventually increasing inflation in EM and this will be exported to DM, reducing the purchasing power of cash

We fear increasing inflation in EM will lead rates to increase there reducing global growth. We think this will be positive for the USD and lead risk assets to decline. We therefore still hold a substantial holding in cash ready to be deployed when we see more interesting price levels

If the USD does increase, we would be looking to short the currency. Hence LONG US equities and SHORT USD would be a long term trade we would like to continue for a number of years

There are always at least two parties recipient to change. Since I cannot go long EM currencies I can go SHORT the USD. The question is relative to what? We can do a basket of currencies

Whilst alternative currencies are not available to the USD in the transition into a multi polar world, gold is likely to coninue to receive positive capital flows

Balance sheet issues?

Consumers in DM are de leveraging and consumers in EM still can't leverage up to take up the slack. Hence WEAKER GLOBAL AGGREGATE DEMAND IN CONSUMER SPENDING. This is bad for global growth

Currencies increasing in EM will help give consumers in EM a stronger purchasing power. It is also less politically damaging to help reduce inflation then increasing interest rates

Governments in DM are leveraged. De leverage via money printing to reduce the burden of their debt, reduce spending to reduce the deficit (but this reduces future debt but doesn't reolve the problem of past debt - that is often solved by growth which comes from receiving new capital to invest!)

New capital can be attracted by initiatives whilst there is confidence in an economy or debt restructuring when that confidence is gone, or bankruptcies to reduce the number of competitors and hence increase margins

Capital is attracted when their is an opportunity to make a profit!

A global initiative would help develop a plan on how each makor economy should play a certain role to help dilute the large global imbalances that have been developed over the last decade

A single country cannot resove this problem. Whilst capital has become global, labour has not, and neither has politics. This has created a tension on who does what

Corporates are the economic participant that can best maneovre in a globalised world. They are flexible to deploy capital where they want, not fixed like governments or stubborn like households. hence they can optimise their return and better adapt to a changing environment. We see this as corporate profits are increasing as a share of GDP whilst wages and tax returns are decreasing

Growth differential between EM and DM implies that cyclicals should be a better investment in EM and high quality in DM

Commodities have been driven up highly in recent years. Focus on supply constrained commodities such as OIL, PLATINUM and other commodities that are taken from only a few sources that are being restricted or where demand is increasing (but not a cyclical demand)

US needs to change the balance sheet and structure of its economy and be more competitive (via wages and currency and benefits)

Europe needs to have debt sustainability either via writedowns, fiscal transfers or money printing (not a long term solution)

EM need to help the consumer either via increasing currency valuation or easier access to credit or more support so save less

Investment strategies

1 Understand the economy the business is based
Interest rates, inflation, balance of payments, GDP structure

2 Law and government and regulation in the country

3 Market Structure of the industry locally, nationally, internationally

4 Dynamics of the company

Weekend Summary

Though I, and the average reader of this blog, is winding down a pleasant weekend of meeting friends, eating good food, complaining about the weather and the occasional discussion about how banks and politicians ruined the country, the reality is many today are suffering in a way our system has installed in peoples mind is not meant to occur. Too sophisticated is our society to allow suffering to have the basic needs of life– the problem is that with time this list got longer, rather than more necessary.

We shall now stop walking down this well trodden avenue before we enter into an anti consumerism tone and give a well detailed (though skewed) opinion on who is to blame (the answer is of course everybody, though some parties merit a higher coefficient of contribution).

We shall instead focus on our weekly review of movements in the business and financial world:-

Markets continue to rise and fall with large volatility and strong sensitivity to macro news items. Most recently, disappointing unemployment figures made markets drop 2% in the US. This highlights the uncertainty present in many investors’ minds.

Uncertainty is a big problem for many investors as old models/trends/systems are simply not working.

It is not a surprise; past numbers are no guide to the future!

To understand the future, you need to understand the drivers of the current state of affairs. When the economy is in a steady state or in a simple business cycle where interest rates determine economic activity in a dominant manner, than past numbers can be a good guide for the future.

However, one variable they should be looking out for is the debt load of almost all market participants in developed economies. This is simply not another statistic – it is reality! When leverage reaches a certain level it becomes THE statistic, not a statistic. It is the dominant variable that will ascertain the future of many economies. The longer this is ignored, the longer the problem lingers, like an unwanted smell that will not go away. Without the debt load in a country reaches a certain limit that a standard increase in interest rates leads to a large deficit to be continuously maintained to meet the debt load, at one point demand will decrease drastically. This will lead to rates increasing enhancing further the debt problem. Once in this situation there is only one way out – debt forgiveness to reduce the debt load and hence increase the potential return of capital in that country so new capital is attracted into the economy.

There is another way. And that is what is happening in Greece. The market structure is being aggressively changed by large market players been consolidated to ensure companies survive. These companies are becoming quasi monopolies. European competition authority is allowing this to ensure large service based companies survive and it will attract foreign investment because these companies will have stronger attributes to survive. Consolidation will mean job losses – but this will have to be achieved to reduce costs, increase margins and therefore attract new capital. Already in telecom and banking sector. Effectively the competition authority is being bypassed for the benefit of the survival of the economy. Ownership of assets being changed – restructuring of the economy is occurring. Waste will be removed – this means the middle and working class worker will pay as well as the previous owner of the company. Previous stakeholders lose capital or income to attract new capital – this is how it works. But here it is not the debt holder, it is equity capital and employees – the debt holder is being spared, no doubt because they want to tap further funds from the credit market.

With pasta models not working, investors will have to realize that uncertainty always exists! It is an uncomfortable thought, but it is reality. It is not removed by vast swarms of past data or even a deep understanding of history, though both can help interpret the present to assess what is likely to occur.

However, what is happening now does not happen in your average business cycle. Banks do not loss 90% of their market cap every business cycle, or the central bank prints such large amounts of currency every business cycle, or the housing market loss value for a number of consecutive years. We are in the midst of a large global transition initiated by globalization, and fueled by several components which were unsustainable. Politicians were unable to alter the courses of economies that were expanding in an unsustainable way, so the nature of markets will do the job for them…..

With past models not working, it is no surprise that markets react violently to new news. However, through a simple understanding of the main parameters that will change, one may not know the exact nature of the journey, but will have a good understanding of where we are going. Certain past trends that were strong components of recent economic history, which will not be to the same extent in the future are”-

Developed market middle class living beyond their means through increasing credit and asset prices. This will reduce consumer spending in these economies and lead to an increase in the saving rate

China will not invest so specifically in fixed investments for exports.

The international role of the USD as a reserve currency is likely to decrease over time

Greater political and fiscal union in Europe, or the return of individual currencies

Less welfare support for developed markets, higher retirement ages

Just these few changes, where there is little guess they will occur (only when), will make our future very different from our recent past. These are changes now being forced by the capital markets because politicians were unable to bring them to fruition. If you follow through the natural consequences of these changes, one can have an idea of what our future may look like, and then start asking who would benefit in this environment.

Though we have all heard of these stories, few are accepting them as the new reality. Instead, investors are caught in an “uncertain” world, frightened by the fact that old models don’t work, when it is really quite clear where we are going; only we don’t know how we will get there. One must be willing to forgive the details of the future to appreciate the bigger picture, which has such a powerful force leading it to this destination, that it is hard to think of an obstacle that can stop it.

A point on China not being able to continue with fixed investments to export. Look at the damage they have done on the margins of manufacturing photo voltaic modules. Prices have gone down so strongly that a number of US solar cell companies are going bankrupt every week. The Chinese companies are hardly making profit as they have developed such an overcapacity it would take years to allow demand to meet the supply – typical Chinese investment strategy that leads to a flooding of the market. If they finally end up as the only participants in the market it may be seen as a worthwhile strategy, but instead, it encourages protectionism. This is not clever. It also encourages more innovation in the USA to find new technology to generate solar energy, such as thin films (less labour intensive hence viable in higher cost locations).

We see Repsol and major shareholders getting concerned about Pemex and sacyr partnership. Always be aware of the shareholders of the company and what financial position they are in. Sacyr may want to sell, or get a larger dividend or force Repsol to sell assets so they get an extraordinary dividend as they own business is very weak at the moment. Pemex may want to buy those assets! Caixa worried. Especially as they hold assets like Fenosa where repsol is a large shareholder and they may be forced to sell that position!

Commodities and currencies

With two weeks of negative results in global stock markets that seem to have been triggered by the downgrading of US debt by S&P, our return to the office was focused on looking at opportunities in commodities and currencies.

We are concerned that the USD has a long decline ahead of it as de leveraging from its consumers and government will imply low real GDP growth. They have an incentive to print money as foriegn debt issuance is also in USD. This will encourage the authorities to increase the money supply to dilute the current debt load and encourage a changing economic structure by weakening the currency to help support exports, and put pressure on exporting countries that have currencies pegged to the USD.

We are looking at opportunities versus the MXN and KRW. Chile and Peru are also economies worth studying.

The problem is USD cash. We can hedge by simply investing the USD cash. Fears of weak real economic growth can be partially covered by put options on the stocks we hold.

But why use that cash in put options when can keep the cash and wait for more opportunities?

But then predicting markets? The cash may depreciate, the stock prices may increase, we may be priced out of the market.

Invest in the put option, it can become bigger if markets do fall so can have more to invest later. Whilst we reduce the net long position of the portfolio.

But perhaps can focus on companies and the management of this portfolio, rather then currencies and commodities and other secondary ideas.

Better securities on companies which have more understanding then filling the portfolio with secondary ideas.

If see mis pricings in commodities and currencies they can play a role. but dont be forced to do it. Keep ideas waiting until the price is ready, whether it is real commodities, stocks, bonds or currencies. But we need a broad understanding and have an approximate valuation in which we are willing to buy.

However, currencies are bought because they behave in a certain way in certain environments, or because they have good companies and may want to buy later when their price has dropped but the currency may be expensive. But can also use forward contracts.

Why are real assets outperforming financial assets?

Certain countries have accumulated large cash reserves in foreign currencies over the last decade

There investment decisions has an affect on global asset prices

If there is a global growth slowdown from DM experiencing weaker GDP growth (which they are very likely to experience)

Then countries like China will have smaller trade surpluses

Hence will accumulate less USD

What will they do with the USD they have?

If they see the USA has a policy of weakening their ccy (they have an incentive to do so as foreign countries buy US debt in USD as it is perceived as the global reserve ccy)

Then they will change their investment habit of buying low yielding US treasuries and buy other USD denominated assets such as commodities or equities (real assets)

Hence we see large capital flows into real assets which previously went into financial assets

This will have the affect of reducing the value of a future cash flow of USD, hence the Shiller P/E ratio will come under pressure to decline (equities prices fall if profits do not increase by more than the multiple on profits decline)

Commodities such as gold benefit

This is a typical cyclical behaviour last experienced in the 1970s when equity multiples decreased but commodity prices increased. When financial assets become too expensive from too much credit, real assets become more valuable until financial assets become too cheap and enough debt has been destroyed

History rhymes

Evolution of the European debt crisis

An economy has a excessive debt burden when the cost of servicing the debt is greater than the increase in the GDP

At this point investors become fearful of that economy and capital flight begins, which makes the matter worse as the cost of borrowing increases

INCENTIVES FOR NEW CAPITAL TO BUILD NEW GROWTH OPPORTUNITIES MUST BE CREATED

As were finally done after a decade of economic crisis in Latin America from 1982 until 1990 when the Brady plan was initiated

No new capital will go into an overly debt laden economy until the debt burden is decreased either via debt restructuring, money printing or re distribution. This is a fact

Authorities are focused on austerity at the moment in Europe. As was the case in the start of the Latin America debt crisis in 1982. Later they discovered that under these conditions a country cannot grow out of its debt.

Next year the Europeans will figure this out for the periphery countries as the problem does not diseappear. Why doesn´t it diseappear. Because what started the problem is still there - too much debt.

Since periphery countries cannot print money and the German influence on the ECB does not make it a feasible solution for the moment, there will be either FISCAL UNION (CAPITAL RE DISTRIBUTION FROM RICHER TO POORER COUNTRIES) OR DEBT RESTRUCTURING to resolve the issue.

To get new capital into a country need to suggest growth opportunities not austerity. New capital goes into an economy or company because there is a possibility to make money, often from growth. Capital does not go to an investment for pity, the market is not a moral decision maker.

Pondering how to invest in emerging markets

I often query the EM issue. Higher growth, there currencies are likley to appreciate over the next decade over DM currencies, now all we need is an investment!

Our exposure is via

1 Accumulating REAL ASSETS (consumption will increase if ccy is stronger and will import more)
2 Indirectly via shorting the USD over the long term
3 High quality companies that have increasing sales in these regions

Buying the ccy of these countries and buying their stock is proving to be more difficult. Their ccys are often not freely floating and corruption is rife amongst corporate managers

Macro conclusions

GDP growth will remain weak in developed countries for a number of years, as discussed in more detail in past blogs over the years. Credit growth essentially will be weak as the developed economies are over extended due to excessive credit growth in the recent past. Non leveraged emerging markets do not yet have the financial institutions to take the place of the DM. Hence the world market suffers from a lack of "global aggregate demand". This is de leveraging at work.

Deflation is the natural remedy demanded by over leveraged econmies (i.e. de leveraging. This is the destruction of capital which should not have existed).

Authorities are trying to fight this by applying inflationary policies such as money printing.

Eventually this will lead their currency to drop (seeing this in UK and US where money printing has been most active) and eventually the cost of borrowing in their currency will increase in an attempt to patch up deficits with more foreign capital. In essence, try to attract foreign capital by offering a higher deposit rate or higher bond yield. The latter effect we have not seen yet. We suggested in past blogs that two particular events may trigger this event (European fiscal union or Emerging countries cutting their peg to the USD).

In Europe money printing is not an option for individual countries. They will as a result suffer a classic depression. Recent news on Greek bailouts are irrelevant unless their is a chnage in the structure of Europe and new institutions are created. If fiscal union does not occur the cost of borrowing in the US may continue to be held down for a while longer. If fiscal union does not occur, a classic depression will occur within peripheral EU countries to remove the inefficiencies to compete globally and to attract new foreign capial

Regional banks would suffer if US govt rates increase and FED rate does not

“The regional banks rely more on the business of taking in deposits and making loans,” “Right now deposits have little value because rates are so low and the loan demand is very minimal.”

Hence, if market determined US government bond rates were to increase, money would move out of deposits and into money market funds and govt debt. Hence the regional banks would suffer the most from a spread between FED rate and the market interest rate increasing.

Hence, a increasing cost of borrowing for the US government can be negative for banks, especially regional banks.

Less deposits means less money to make loans, hence less credit supply for the American household.

Also banks hold plenty of govt debt, which means more marked to market write downs.

"The Federal Reserve announced last week that it would keep its benchmark interest rate at a record low at least through mid-2013. The persistent low rate is preventing regional banks from turning an increasing deposit base into earnings growth because of flatter yields".

Furthermore, if economic growth is 1 percent or less in the next one to two years, profit estimates for large U.S. lenders including several regional banks may be slashed as much as 30 percent, according to analysts at Deutsche Bank AG.

With lower-than-expected loan growth, regional lenders will continue cutting costs

Total credit-loss provisions among U.S. banks plunged 60 percent in the first quarter this year from the same period in 2010

SOURCE: Bloomberg news.

Currencies do matter

Suppose an American investor was concerned the market was pricing risk assets too agressively relative to his estimate of fair value for the market index. The investor may decide to be 100% in cash and wait for the right moment (when risk assets are priced less than what he believes they are worth).

However, the USD depreciated 20% during the last 2 year. This means his purchasing power globally has declined, though he may say it has not locally (he would be foolish, in America many goods the investor purchases are made abroad, hence his purchasing power has decreased because his costs have increased whilst his capital has generated zero income due to 0% interest rates). Overall, his wealth has decreased by making what seems like a wise decision.

We can say he was wise because he lost less money than if he was invested 100% in the market - at least that seems to be the case for the moment.

However, the reality was he was foolish because he explicitily assumed (without even probably being aware) that the USD was the only currency in the world, hence why he only holds USD.

Making a decision to hold cash may be a good asset allocation decision when compared to bonds or equities and other risk assets - but it might not be the same as having held cash in AUD or SGD during that same time period as the investor was holding USD cash.

Furthermore, often when currencies decrease in value, their assets may increase in value. This typically happens in the US due to the strong faith people have in this currency. Hence when it weakens, many foreign investors buy US assets which seem cheaper relative to foreign currencies. Hence our USD American cash investor is priced out of the market and is forced to continue holding USD cash paying zero income if he keeps his same criteria.

To ignore that financial markets are becoming more globally interconnected and hence one must appreciate the cost of a security and the value of the money the security is priced in, is to be foolish and to ensure certain suffering.

Real assets versus financial assets

We note the ongoing theme of capital flowing to real assets relative to financial assets seems to continue. As a result the USD continues to weaken and the Shiller P/E multiple will continue to decline.

We feel a European alliance on supporting periphery countries can be a critical event in starting the decline of the EUR and the increase of the cost of borrowing for the USD.

The other great event that can start such a large shift is the de pegging of the USD for many emerging countries. This will have the effet of reducing demand for USD and weakening the link between emerging markets (EM) and developed markets (something which is urgently needed due to the inflation this policy is creating in EM).

Support to periphery countries will reduce the spread in the cost of borrowing between such countries and Germany.

We fear the USD can only decline - it is the most important varible (and easiest to change in the current global system) that can reduce the huge imbalances that have built up within the global system.


Main themes

Buy real assets at cheap prices. We prefer timber and oil and are investigating agriculture (we find it hard to invest in this sector at the moment)

Short the USD for the long term

Buy high quality companies

Currency management is becoming more important. The lack of a freely tradable currency in many countries that are accumulating cash makes this difficult and distorts the market (i.e. the need for the Euro and the CHF)

Buy cheap insurance against increasing interest rates (market determined interest rates such as government cost of borrowing or libor rates. The authorities in DM will do all they can to keep interest rates low) in developed markets that have large debt burdens (US, UK, many european countries)

Deep value investments that are considerably less dependent on macro issues. A iliquidity premium may be available here

Direct and indirect exposure to European peripherals is huge!

It is assumed that banks that hold Greek debt will have write downs.

But what if they bought CDS's? Who wrote the CDS will suffer the lose from a restructuring! It is hard to know who wrote the CDS, so libor rates will increase due to the mystery!

Majority of the debt is from retail/commercial loans (75%). Then interbank lending and soveriegn debt.

Insurance companies only really have exposure to the sovereign debt side. Hence are less at risk then the banks - unless they were the ones that wrote the CDS's!

What is a safe haven currency? A country that has favourable macroeconomic features in difficult times. But Switzerland has a banking sector considerably larger than its total GDP. Hence, though Swiss bank exposure to peripherals is small, it is over 100% of GDP to other European sovereign. Do you think German banks would be immune from restructuring of debt in Spain or Italy? There will be blood! And even a 10% haircut for Swiss banks would be huge in absolute terms.

Is the NOK safer? What is there pension fund invested in? How would oil react in such circumstances? The advantage is that there is likely to be slightly less damage to the Norweigian banking system. But there would be little money moving around if oil is not increasing! There are bad, and more bad! Gold would see a chunk of money momve towards it I suppose?

Commodities, bonds and equities

History suggests that commodity prices and the multiple on equities are inversely correlated to each other over many years. There period of evolution also seems to be similar, suggesting one may affect the other directly.

When commodities are going through a decade of increasing prices, history would suggest in that decade the price/earnings ratio for stocks would decline.

There is some sense to this. Many companies have raw material and transportation costs that make up a significant portion of total costs.

However, the operating margin does not follow the commodity cycle! (debt cycle has more influence)

During 2002 - 2007 margins increased whilst commodities also increased in price - no doubt both fueled by the increase in credit in the system. It is the multiple, hence the markets perception of what a future stream of cash flows are worth, that has a strong relation to the price of commodities. Hence it may well be the FEAR of inflation in the future that reduces the multiple on equities. The fear that interest rates will be higher, and a dollar will be worth less.

Debt cycle is longer than the commodity and equity multiple cycle.

Credit is what makes booms and busts according to Ray Dalio. They are what makes GDP growth vary around the increase of productivity. Population growth is the second source of GDP growth. If GDP/capita is constant and the population doubles over time, so will the GDP. Population growth is also what determines the population structure in an economy, i.e. number of 25 to 50 year olds in a society. This will determine the liabilities of a society that has a develope economy, i.e. a welfare system. Productivity needs resources - if it is not funded because capital allocation becomes worse, the GDP growth rate can change?

Credit determines the demand in an economy. Hence can provide purchasing power to companies (support margins) and keep consumers spending. The authorities artifically prop up debt markets, is that why they last longer? Does inflation follow the credit cycle? It seems to. We assume that inflation follows the credit cycle (or is it vice versa).

The margin cycle seems simply to be a function of the business cycle. We note that the 1980 peak was the same as the 1995 peak. The three bottoms between 1980 - 2010 in 86, 01, 09 were all similar. The big difference were the peaks in 06 and 10, which were much larger than any point in the last 30 years. Credit led initially and then cost cutting led? During the first few years of the strong bull market in the 1980s the margin was actually decreasing, reaching its bottom in 1986. Prices were so cheap by that time that multiple expansion was the primary source of equity market returns. Can you imagine the newspapers then, margins are following, beware of stocks! When there is margin pressure you need multiples to be low to make money, when margins are increasing, a high multiple can be mitigated by stronger earnings growth.

So where are we today?

Debt: cost of debt has been falling for 30 years. History suggests it should start increasing. Led by need to attract capital to an economy as short of capital (rather than authorities increasing rates to decrease speed of a recovery in the business cycle. Short of capital as there will be capital destruction and a run for cash, but there is not enough cash). Due to less demand for there currency and their assets because of (1) Lower growth than in the past (paradigm shift in the way the country is perceived. If dollar pegging decreases, less demand for USD. Need to attract it back with a higher interest rate, not with the title of being the reserve currency of the world. FX foreign reserves will decrease in USD etc), or (2) Risk spread increases as fear of default increases? Risk assets will have a headwind as a result, decreasing in price as there yield must increase. Need to buy at low multiples

Equities: Almost 2/3 through a multiple decline process. On a normalised basis (Shiller P/E) equities are trading at an above average multiple. Again, focus on buying low multiples. Very careful with cyclicals whose multiple may look low to very high profits created during a boom time difficult to replicate in the next decade. Opportunities exist in high quality where earnings are more stable and where normalised P/E are relatively attractive: yields are between 7.5 - 10%. We would suggest a buy should have a minimum earnings yield of 2% above equity markets average return: 8.5%. Less, sell - unless you feel very stable and visible earnings.

Margins: Seem to be too high. Again, as a result, caution on assessing earnings in the last five years when credit growth was strong and recent cost cutting was very swift. Demand a higher yield if buying on potential cash flow. With regards to asset plays, need to consider the potential of weak growth, hence a catalyst is required or the physical assets may decrease in value.

Commodities. Developed market money printing has not increasing lending (but is another solution to dilute the value of the currency and provide more cash for a country that has too many assets and not enough cash generation). No dubt because the lenders have poor balance sheets, but also because they fear that their currency in the future will be worth less, hence may make a real negative return. This money has gone to inflation hedge assets - primariy equities and commodities. Excess liquidty has pushed up commodity prices, which will put pressure on equity multiples. This cash is also going to regions where countries are growing faster. Many of these countries currently have USD pegs - hence extremely loose monetory policy whilst plenty of cash is coming there way and their GDP growth is strong. If this continues, the USD peg will not be sustainable as it will lead to a dangerous inflation (In EM, not in the US! What a strategy to force the Chinese to de peg. But this will reduce further USD demand making potentially the USD weaker. Hence more exports for the US, less imports, reduce trade deficit, help bring the economy back on track, but the USD will fall. As a result households will reduce quality of life as cant import as many goods as before, but they will start getting more manufacturing jobs. BUY US EXPORTERS WHILST SHORTING THE USD WITH A FORWARD CONTRACT. The US stock market can do well, but the household will have less purchasing power. Need to supplement that with investing in their corporations who will be doing well selling and investing in other countries as well as in the USA!

The USD weakening is a central part of the world economy clearing itself up. It is the fountain that will led to change as EM de peg and start losing their export competitiveness - a major source of the imbalance. They will consume more, leading to more imports hence creating more jobs for others! But can China survive this change? The USD policy as the reserve currency is what is holding many imbalances back from being rectified? Reminscent of an old system that now does not exist. There are different engines in the global economy and they need to be set loose, not tied to the USD.

THE PROBLEM IN A SENTENCE IS A LACK OF GLOBAL AGGREGATE DEMAND! THOSE WHO HAD ACCESS TO CREDIT TO CREATE DEMAND ARE TAPPED OUT. THOSE WHO NEED TO TAKE OVER DONT REALLY HAVE ACCESS TO CREDIT AND DONT EVEN HAVE THEIR OWN FREELY FLOATED CURRENCY. HENCE THE OLD SYSTEM NEEDS TO MAKE CHANGE FOR THE NEW WHERE THESE IMBALANCES CAN BE CLEANED UP. Buy developed market banks that can lend to EM, who have experience of those markets and the cutting edge knowledge of having worked in DM for many decades, like standard chartered, HSBC.

A weakening currency in developed countries will not only help them export more hence create jobs and GDP growth, it will reduce the burden of their debts as they are de valued away! This alongside capital destruction will do a good job of clearing up the mess!

I see the problem primarily from the point of view of europe, as I live there. However, it is a global problem. What seems like a lack of change and finding solutions in Europe, is a consequence of also lack of change globally. The old system continues - it needs to be changed. It is slowly being down as we see the USD weaken, the Chinese consume more. But the EUR getting stronger? There is a tension between these currencies as there is a lack of alternatives. The strength of the EURO seems to be a consequence of living in a new world with the old system. The euro is the punching bag due to it having weak political strength. Indeed, history suggests the market likes it when the politicians are weak, because they cannot decide anything! Hence they cannot commit to surprise policies which the market does not like! Such as money printing! How convenient! So the euro strength is a consequence of having poorer options, not because it is the best. There is a consensus that the USD weakening is the most dominant theme in making the world clean up the imbalances we have..

Last thing to do is reduce their rights to the good things which has made us lazy and feel we deserve (have the right) to a good life and most of the basic things to enjoy life. NO! Take away healthy pensions, only enough to survive. Watch how people will work!

Reduce government liabilities by reducing pension benefits, increase the work ethic of the population

Kill the USD reserve currency, float EM currencies openly. Less demand for DM currencies. Then interest rates increase (force default, or govt print money to reduce further value of money)

DM currency decrease from less demand from more alternatives and money printing. This will make them more competitive in exporting. Create jobs and foreigners attracted to their assets. Improve the current account by reducing the trade deficit. BUT TOO WEAK A CURRENCY WILL CREATE A PROBLEM WITH BUYING ENERGY/OIL! HENCE NEED TO BE MORE ENERGY INDEPENDENT BEFORE FOLLOW THIS STRATEGY. IN THE US HAVE FOUND LOTS OF GAS! HENCE CAN FOLLOW THIS IDEA! More of a problem for Europe, hence the greater focus on renewables, energy emissions to force the issue, etc. UNLESS RUSSIA USES THE EURO, THEN CAN BUY ENERGY IN EUROS AND NOT A PROBLEM TO DEVALUE THE CURRENCY TO GENERATE GROWTH!

Weakening DM currency will reduce burden of debt, as many companies will be paid in the newly floated currencies. Build up reserves and debt burdens decrease

If China de pegged - then in theory they would not need to print as much money to keep the currency weak. Hence less money printing for them. Investors that bought gold can buy the YUAN. Hence GOLD COULD FALL IF CHINA DE PEGS. US WOULD ALSO NOT NEED TO PRINT AS MUCH MONEY TO WEAKEN ITS CURRENCY, THERE WILL BE A MORE NATURAL ROUTE! HENCE GOLD IS USED AS THE SAFE HAVEN DURING THE MID WAY POINT - AS WE MAKE THE TRANSITION. BUT WHEN WILL THE TRANSITION BE MADE!? UNTIL THEN HOLD GOLD? THE CHINESE WANT GOLD TO BACK THEIR CURRENCY UP AS WELL?

The reason the EUR is strong is a similar reason to why gold is strong. Gold has a historic reference as a store of value due to its physical properties and historical use, and the fact that GOVERNMENTS CANNOT PRINT IT! THE EUR HAS THE SIMILAR PERCEIVED STABILITY, AT THE MOMENT, AS ITS POLITICIANS ARE SO WEAK TOGETHER THEY CANNOT AGREE ABOUT ANYTHING. IT IS THEREFORE PERCEIVED IT IS UNLIKELY THEY WILL PRINT MONEY! HENCE THE EUR MAINTAINS ITS VALUE VERSUS THE USD. LIKELY VERSUS GOLD IT HAS NOT DONE MUCH AT ALL! AND ALSO WEAKENED VERSUS THE CHF

(To understand why incentive for authorities to print money - need to appreciate the difference between CREDIT & MONEY. The debt burden that has been created is phenomenal, and unprecendented. When people want access to money by liquidating assets - need to appreciate in the US there is 2 trillion in cash, and 50 trillion in financial assets. There is simply not enough cash for everyone without printing money or having defaults/write downs etc). Credit appears, and can as easily diseappear...! If it is backed by future promised earnings that cannot be met (ie buying expensive assets with debt) then write downs must be made. This reduces the stock of capital (assets) in the world - this is exactly what is required as too much money should simply not have been created! Leading to spreads for returns becoming too small. This needs to expand so new capital can come in and start the cycle anew. Capital destruction is required - or money printing. The latter is viewed as being more politically savvy in gaining votes)

THE CHF TAKES THE ROLE OF THE DEUTSCHEMARK FOR MANY EUROPEANS, as that currency is deeply hidden within the Euro. It is seen as safe haven, but will a strong enough currency erode its economy to self correct those self haven characteristics it has, ie less exports, more imports, hence trade deficit etc. SHORT CHF at what level?

If you want to gain the most by doing the least, you should move to Singapore over the next 50 years.

It is considerably harder to know what will happen tomorrow, which depends on sentiment, then what happens in 10 years, which depends on reason.

(why do cycles exist? Part of human nature, the system. Also, when something exists, it is hard to get rid of. It becomes part of us, how we perceive the world. It is an unconscious reference that affects the behaviour of all of us)

Quality, price, patience, diversification and the financial position of the client

When one invests as an outside, passive, minority investor there are two prinicipal considerations the investor must make:-

1 The quality of the investment
2 The price of the investment relative to your estimate of intrinsic value

The further out you are of the company, the more concerned you are with quality.

The closer you are to the company, e.g. an inside investor or an activist investor, the more important price becomes to the equation. This is because you have more detailed or timely knowledge, or you can act as a catalyst to unravel the value that exists in that company.

Another factor, is of course, the financial position of the client. For example, this can affect how long you can wait for the investment to work out.

The emphasis must always be in using public information and clever investigation that any well respected analyst can do, but doing superior anaysis and knowing when we are out of our circle of competence. This will generally limit us to a few sectors where we build deep understanding and so we can more easily spot opportunities by analysing more companies per unit of time.

If one has a long term investment horizon, companies that dont have an immediate catalyst but are very cheap and slightly lower qualitym may be considered by the outside, minority, passive investor. However, only if plenty of data is available for many years and physical data measurements can be made in terms of volume, production capacity etc to verify the accounts, and this data can be verified by independent parties.

If one has limited time or knowledge to analysis in great depth the companies under investigation, then diversification can compensate for a lack of knowledge. Buying deep out of the money put options when interestingly priced is another means.

However, for one with deep knowledge of a company, and who by concentrating their portfolio may achieve control to the extent they can form their own catalyst, it makes sense to have a more concentrated portfolio. This investor generally has strong know-how and know-who, and large financial resources. For example, it makes more sense for the founder of a company to have a large portion of their wealth in their company, then a builder who notices the company on the pink sheets. The founder has considerably more knowledge on the company and the sector, hence is better able to make a good decision. They also have timely knowledge on competitors.

One must always examine odds, and consequences.

A word about confidence....Greece

Greece has a budget and trade deficit. This means the government and the people of the country, in general, must borrow to maintain their quality of life, as they spend more then they earn. This means the country is dependent on foreign parties supplying capital to maintain their quality of life. This was expected to continue unless the Greeks (1) spend less, (2) sell more, (3) both. When one depends on foreign funds to live your daily life, in my opinion, you do not control your future anymore. In recent months we have all been made aware that the supply of capital from external parties to Greece is drying up. Hence the country is forced to aggressively apply one, or all, of the above mentioned points.

Cutting costs (reduce spending) is an evident way of showing the people in a country that their quality of life is being reduced. Hence, it is often meet with social unrest. The deeper the cuts, the larger the backlash. Rather then phasing budget cuts slowly over a number of years to responsibly manage the economy when capital was available in the market for Greece, bail out funds have been received from European governments that want to see the money returned quickly, so that they do not receive public backlash at home for their actions. The budget cuts are therefore deeper and must be orchestrated over a considerably shorter period of time. This means shock treatment for the Greeks, which is always extremely uncomfortable. Since EU country governments are voted into power by the national population, they are more likely to follow policies that are for the national interest, not Europe’s. Hence Greece received several billions in Q2 2010 to meet conditions that they must affectively reduce 10% of its GDP in two years. Of course it will not be achieved without a near civil war. However, at that time markets rallied and the Euro strengthened. We believe that leveraged companies or countries don’t get out of trouble by cutting costs only. They must invest in new initiatives that can generate future income to meet obligations and generate future prosperity. This is an incentive for people to work, and gives confidence to foreign investors so more capital becomes available if projects are developing positively. This is only achieved by receiving fresh capital injections and seeing that capital deployed productively. In the past this was achieved in Greece by devaluing its currency. With the country now using the common currency that is the euro, it cannot apply this strategy anymore.

Selling more means more work in the same unit of time (increased productivity) or simply working more hours. This also reduces quality of life as it generally means working harder and for longer. However, if done well, financial compensation need not be reduced and unemployment rates may not have to increase harshly. However, the question is what do the Greeks sell? Since they primarily deal with agricultural goods and low to medium quality industrial goods, they compete very heavily on price. Since they sell primarily to countries that use the same currency, they must either become more productive or wages must fall to become more competitive and generate higher returns on capital, which can attract fresh capital into the country. As mentioned above, in the past this was achieved by devaluing the currency, a more socially accepted practice to make the country competitive.

When a country is dramatically cutting costs (the public and private sector), all economic participants spend/invest less due to increased uncertainty and unemployment rates, and no new money is coming into the country, there is effectively less wealth in the country as assets prices are declining and the incoming cash flow is being reduced. This means the government is also receiving less tax income, reducing further its creditability and strength. Countries within the EU have also forsaken the ability to print their own currency, a privilege now held only by the ECB. Governments can only ask to borrow more money in the market. When a country reaches the stage Greece is in, this door becomes firmly closed.

As a result the Government of Greece received a bail out package from the European Union countries and the IMF under some very extreme conditions in Q2 of 2010. Furthermore, the Greek banks can only receive funding from the ECB as no other party accepts Greek bonds as collateral for loans.

Because of the extreme cuts required to receive the bailout package, unemployment will rise in Greece. This will encourage less spending, hence the government receives less tax as less business is being conducted. This forces the country to need to borrow more. Hence cutting costs whilst not receiving the benefits from these savings (i.e. used to pay interest payments), or new capital from abroad to invest in the country, will lead to a reduction in GDP. This will lead to more Greeks defaulting on bank loans. This forces the banks to need to raise capital. But the market is not welling to inject new equity into Greek banks at the moment due to the lack of clarity in what will happen. Hence the only funding avenue for Greek banks is the ECB. A lack of confidence in a country is a vicious circle.

So European countries should inject more money into Greece? But the voters in the European countries ask why should they help a country that overspent and did not work hard enough to overcome their problems when they were manageable? Other European countries are also suffering various degrees of discomfort due to a weak economic environment in developing countries in general.

So let the country suffer and pick itself up alone? Why should a single country affect the sustainability of a currency for several economies much larger then Greece’s?

This is a good question. The answer is the financial market in Europe is considerably more advanced in being “Europeanised” then a common European labour market, fiscal policy or language. French banks hold Greek bonds and German banks hold Portuguese debt etc etc. If Greece was to say they could not redeem their debt because they don’t have the cash, then banks around Europe will have to make write downs of several tens of billions of Euros. This would require a number of banks to raise capital, likely creating pressure in European equity markets. Furthermore, Euribor rates would most likely increase as interbank lending costs increase due to a lack of trust amongst banks on who held Greek debt and who would have to make the highest write down and how it could affect their solvency. Europe contains many leveraged economies and increasing the cost of a loan would likely boost default rates if they stayed high for too long.

But again, Greece is such a small economy relative to the EU, the European banking sector could absorb the write downs – only a few aggressive hedge funds would go bust.

However, the real fright comes when you look into the details. The ECB cannot fund the Greek banks if the government defaults on the debt. If Greek business people see their government default on Greek debt: they know the biggest holders are Greek banks and that these financial institutions now have no sources of funding: Greek money will be pouring out of Greek banks into German bank accounts in a last dash attempt to preserve their wealth before their banks collapse. However, governemtns are well trained in such affairs. Capital will be refused to leave the country, as was most recently done in another European country, Iceland. When external capital is not available for banks, deposits are there only source of funding and governments will try to keep them there at whatever cost.

The question is, how will other “weak European economy business people” react if they see that happen in Greece? Will we see large cash movements out from Spanish and Portuguese banks to German banks? Of course we will! Hence, suddenly, there really isn’t a single Europe! Capital cannot move freely around Europe! There is only Germany and a few select others. The market will make that happen. If the politicians don’t throw out the weaker economies by letting one default, the market will probably do that job for them very quickly…

The weak European countries will become like sieves: capital will not be retained in them – what goes in will come out as a result of a total loss of confidence.

Now that is what we envision happen if Greece does not redeem their bonds by taking that decision themselves. There has been discussion of having a voluntary roll over of debt so that a technical default does not occur and hence the Greek banks can continue to receive ECB funding and the Greek government do not need to meet their immediate financial liabilities. But how does this solve their problems? They still have no new capital coming into the country to help rebuild the economy! Hence it is simply being kept afloat! They must create liquidity from the assets they have. This means forced privatizations. But with the economy so weak, these assets would be sold at below normal market condition prices. But this is the price Greece will have to pay. There must be wealth destruction. It can come from a number of ways including defaulting on debt, selling their assets at a cheap price or wages falling (as it cannot come from a devaluing currency anymore). Funds from these savings can be used to reduce their debt load. When this is reduced, new capital from the markets may start coming in.

Wealth destruction is the procedure of removing the money that should have never existed, because it was poorly invested in the recent past. The mis allocation of capital always leads to an eventual reduction of the total capital in the world, as it has not been wisely deployed to increase its size. This would reduce the wealth of the country and hence the quality of life of its inhabitants. How will Europeans react to this? This is a question we do not know how to answer.

But what about the Euro?

If several weaker European countries are made to become “economic sieves”, this would scare foreign investors and likely lead to a sharp reduction in the valuation of the Euro. However, this is only likely to happen in the unlikely event that Greece decides not to pay its debt.

What if the rollover happens, how would the other “weaker countries react?”

“Same as usual.” “Just keep on going and wait for something to change?”
Probably.

An external catalyst seems to be required to start the wealth destruction process. In a capitalist system, this is the most efficient way to allow unsustainable countries, or companies, to start again in less onerous terms.

Another alternative is that the ECB starts printing more money to fund the weaker economies. This is "a la USA", hence would probably lead the Euro to display a pricing behaviour we have seen recently for the USD. However, Germany is very much against this solution and the ECB has so far positioned itself with a similar stance, even if it has bought many billions of government bonds already....

Indeed, one could day that the bailouts are a way of making it easier to have political, fiscal and economic union. Creditors will become the "equity" owners of these countries....

St Joe Review

Description
St Joe is the largest private landowner in North West Florida, owning over 550,000 acres in this region. The company operates in four segments: Residential Real Estate, Commercial Real Estate, Rural Land Sales, and Forestry.

Current situation
The company has had a lackluster record in making the transition from a paper mill manufacturer to real estate developer. This has attracted the interest of many short sellers who feel the company needs to write down projects they have on their balance sheet. Though we do not disagree with the ideas presented, we feel assets bought many decades ago are more heavily undervalued on the balance sheet then recent projects are overvalued.

The strong reduction in bank lending over the last few years has had a powerful effect on real estate prices, which have fallen strongly in the region where St Joe conduct business. As a result, sales have reduced significantly and profits have been negative for three consecutive years. We note that free cash flow is, however, positive during that period.

The need to maintain properties built and pay employees to (attempt) to sell assets imply the income statement is likely to continue bleeding until the real estate market improves. This situation could continue for a number of years.

However, we believe the large cash load and the strength of the St Joe balance sheet allow the company to survive a very turbulent number of years (net debt is negative).

The survivability of St Joe and the price being paid to purchase their land considering the current price of their stock on the equity market ($21/share) makes it an interesting ASSET PLAY proposition.

Attributes of the investment
A fear of inflation and a weakening USD can lead to more foreigners purchasing US land. St Joe is a pure, debt free, land play in the USA. As a result, in the above mentioned scenario it is likely to attract more attention than it does now. We are also comfortable holding cheap land in a strong inflationary environment relative to cash.

We are also attracted by positive moves with changes in the members of the board of directors (and changes in the executive team) and the consequential focus on reducing non core costs, as well as building relationships with skilled partners in developing new projects on their lands. They seem happier to outsource business that they are not skilled in executing. We are happy by the first developments and the recent candor presented in ST Joe´s Q1 2011 report.


What can go wrong
The company is currently bleeding due to having fixed costs and no sales. This situation can be maintained for some time by the company due to the low debt, high cash position of the company. However, if the company does not invest wisely to ensure buyers/tourists are attracted to the region, land values may not increase strongly or quickly enough before the company is forced to sell more land at undeveloped prices to meet fixed costs paid to ensure the land can be developed wisely.

This investment therefore requires confidence in managements ability to achieve this objective. For the moment we are confident with the changes we are seeing with regards to capital allocation and operating decisions for the company. We follow developments closely.

Catalysts
New management and their initiatives. Improving US economy and real estate markets. New joint venture/ partnerships with skilled and experienced partners to develop new projects on their lands. Increasing traffic at new international airport.

Why is St Joe mispriced (in our opinion)
Large fear in real estate markets at the moment (especially in Florida. We have other investments in this region related to real estate due to the current pricing available). Large short sell position in the stock from recognised hedge fund managers. Poor execution record with regards to sales relative to built capacity.

The difference between risk and uncertainty

Here is an example that illustrates our view of the difference between risk and uncertainty.

Suppose an individual was in front of a table. On that table is a glass filled with water.

If Wall Street was involved in analying the process of the individual drinking the water they would focus on whether the individual was going to use their right or left hand to pick up the glass, whether they would drink it on one go or in several sips, what temperature the water is, etc.

However, we believe these things are uncertain. With the information we have it is hard to acertain whether the inddividual in question is left or right handed.

We can look at a large sample of data and from that determine a probabilty the individual is left or right handed. However, for us, uncertainty does not frighten us. It always exists.

In this example, what is important to us is that the individual has arms. If he does, we can be pretty certain he will drink the water when the individual is thirsty. We don´t pretend to know when that will be. This is how we invest. If we can see the principal scenario clearly, we go ahead. We do not pretend we can predict with precision every small detail, a practice that leads Wall Street to focus on the short term. We focus on the main points and hence focus on what is likely to happen over many years.

Risk and uncertainty

Low risk and high uncertainty has the potential of being a great investment. Wall street hates uncertainty and punishes it like it was high risk. There are a range of possible events and we dont know which one will occur with a clear probability.

Uncertainty is not necessarily we dont know what can happen. It is which of the events that could happen that will happen with a confident probability.

But if have good management, they are better than there competitors and work in a team such that the sum is better than the individuals, chances are in battle things can go there way.

Low risk because execution is likely to work? Little capital?

Time is a friend of the value investor, and of the great business.

When do equities do well?

In past articles we have written on the strong mean reverting properties of equity returns.

We have shown that equity markets historically experience large periods of time where the multiple on future earnings contracts or increases. These "market" cycles often last 15 - 17 years. We are currently 11 years into a declining multiple market cycle.

During such a period we find that equity markets are particularly sensitive to macro news. Indeed, in a period of a declining price/earning ratio, the market is extremely senstive to a macro economic indicator such as the PMI. This is because in such a period fundementals are not as important in investing as awareness of how the macro environment is evolving. As a result, during this period of the market cycle, buy and hold is not as an effective investment strategy. One needs to re balance the portfolio with greater frequency.

The best environment for the stock market would be if there was low inflation and increasing earnings overall(economic growth).

If there is an anticipation of strong future inflation, then each dollar of future profit will be worth less, as each dollar will buy less. As a result investors will pay less for future profits, hence the price-earning ratio will decrease. The fear of inflation (a macroeconomic feature) can therefore lead to price/earning ratios decreasing. During such periods of time it is therefore no surprise that the equity markets are very sensitive to the PMI index. We can see below this was the case during the 1970s, when inflation was a problem for the US economy. A similar trend is now occuring.


Furthermore, when bond yields start becoming much larger than the dividend yield, it is another indication the market is anticipating inflation.

Deflation would also be bad for equity markets. However, this would not affect the multiple. Future dollars of profits would in fact be worth more and the multiple in theory could even increase. The problem is that earnings for the economy in general will suffer. Hence the same multiple on a lower earning leads to a lower stock price.

The fear of inflation and the extreme valuation reached in 2000 have been vital contributors to the declining price-earning ratio the equity markets have suffered during the last 11 years. What is a surprise is how well bonds have performed during this period, as yields have continued to compress due to government distortions in this market - which is probably the largest contributor to the markets inflationary fears.

Globalisation & Oil

If oil was to reach a price of 300 USD per barrel, would globalisation continue?

Would the movement of goods between countries across seas and lands be profitable? For many companies that import goods from abroad, the answer would be no. Hence external trade would fall drastically if oil prices kept going up.

A high oil price is the ultimate lucky break for pro protectionist followers. A high oil price would increase the trade deficit initially for countries that import oil or import goods from abroad, but eventually it will force economies to adapt.

Countries would be forced to become more self sufficient. Advanced countries would invest more in energy efficient technology and alternative energy supplies.

A high oil price is the rebellious child of globalisation.

Wages: the dominant variable behind sticky inflation?

Does the price/earning ratio increase when earnings increase greater than wages? The two competing variables that make up GDP when viewing the economy in terms of income?

During the 1970s real GDP was growing faster than it was during the 80s or 90s, yet the stock market did nothing during that decade.

Of course during the 1970s inflation was a big concern - a major component being wage inflation. Since employment costs are a large percentage of total business costs for many industries, when wages grow strongly, it bites into profits. Since stock market returns are eventually determined by profits, increasing wage costs can affect stock market valuations via reduced margins, and therefore, earnings.

Since wages are currently frozen in developed markets (indeed have grown very weakly over the last decade) due to the easier movement of capital internationally and the lower labour costs in developing countries, can we see this as a sign inflation fears are being overdone?

Commodity price spikes perhaps could be viewed as transitions that come and go, determined primarily by supply and demand, hence are self correcting relatively quickly (especially in agriculture). Yet commodity market returns often grow strongly for large periods of time (generally when real GDP numbers are above average. This could be implied to mean they are primarily driven by increasing demand more than a lack of supply?)

Labour markets are not so efficient at self correcting - as wages are often "sticky" due to the difficulty in reducing wages. Nevertheless, in countries like Spain this stickness is being shattered due to the terrible condition of the national economy in terms of growth and new employment opportunities.

Is this wage stickiness a precursor for inflation? Since free floating currencies should be primarily determined by supply and demand, any inflationary pressure from international capital movements should be self correcting (unless there is strong government intervention)in the medium term. This could leave wages as the dominant factor that determines stickly inflationary pressure in an economy.

Furthermore, note in an inflationary environment it becomes harder politically to reduce wages. As a result, inflation is likely to be constrained only by creating a recession. This was achieved in the early 1980s by increasing interest rates to nearly 20%