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%

Sell long term debt for short term debt

Please note below a reply to a clients question on why it may be of interest to reduce exposure to long term debt and increase exposure to short term debt. The reply is not supposed to be a precise statement, but to raise awareness of the characterisitics of short and long term debt.

To place the answer into context let me provide a simple overview of the maturity profile of the bond portfolio in question (note total adds to bond portion of the portfolio. Remainder in cash and equities):-

less than 2 years 0.0%

2 - 5 years 25.2%

> 5 years 32.0%


CLIENT QUESTION: I am not sure I understand the reason for selling bonds which have maturities of more than five years with YTM of over 3.0% and buying shorter dated bonds with YTM of 2.66% and incurring the costs involved. How would I be better off?

You reduce your duration risk. A bond that matures in 2017 (like Anheuser Busch 2017 8.625%) will be considerably more sensitive to perceived future interest rate changes or an increasing inflation rate expectation. The AB 2017 has a YTM of 3.82% at the moment. The GE 2013 offers 2.66%. If you believe that the interest rate could increase more than 1.2% (ie the difference between 3.82% - 2.66%) between the years 2013 and 2017, it makes sense to make the exchange. If you don't, I understand it seems silly to reduce duration risk.

Lets look at some numbers.

Bond Price Aug 2010 Price Mar 2011

Anheuser Busch 2017 8.625% 134 124
GE 3.5% 2013 104 101.5

We can see the volatility is considerably larger for the longer dated bond. This is because its pricing is considerably more sensitive to perceptions in future interest and inflation rates. If you believe interest rates are not likely to increase in the next 6 years the current YTM of 3.82% offered by the AB bond can seem interesting. If you don't believe that. It does not, and I would consider off loading the bond.

Note a bonds return can be reduced to contributions from various risk components. The primary risks are credit and duration risk. I am happy with taking on the credit risk of selected companies (i.e. GE) to generate a yield greater than cash rates or government bond yields. But I am extremely worried about taking on duration risk at the moment.

Note, the benefit of the AB bond is that it has a large coupon. A similar maturity bond with a smaller coupon would be even more sensitive to perceived future changes in interest or inflation rates.

Indeed, we could say the yield of the AB bond is suggesting the base interest rate could be the following over the next 6 years:-

2011 2012 2013 2014 2015 2016 2017

1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 6.0%

However, the value of money reduces over time. Let us discount the money at the rate we believe it will be for that year. The cumulative interest will now not be 27%, but 25.8%. Furthermore, we expect to receive a premium for taking on the credit risk of AB relative to cash rates on a bank account. We would expect a credit risk premium of at least 1% per annum.

Consequently:-

1. If we were to assume the above mentioned rates for the EUR during 2011 to 2017
2. Assume a 1% per annum credit risk for taking on an AB bond relative to keeping cash in the bank
3. Discount the interest received at the rate of interest for that year
4. We would require a yield of 5.7% per annum rather than 3.82%.
5. Hence, you assume interest rates will be lower than what is suggested above, or you are willing to receive no premium to cash for taking on the credit risk of AB

If you do require a 1% premium per annum, I would estimate you are assuming the following EUR rates if you decide you are happy to continue holding the bond with the current YTM it offers:-

2011 2012 2013 2014 2015 2016 2017 Average

1.0% 2.0% 3.0% 3.0% 3.5% 4.0% 4.0% 2.9%

*Please note this exercise has limited accuracy and is produced for the benefit of using it as a thought experiment and to stimulate further discussion*.

(Add 1% per annum to the 2.9% average to add the credit risk. We assume discounting is negliable. It isn't. You are actually assuming slightly lower interest rates)

What is a Value Investor?

Recently we have discovered that a manager we admire has changed his investment strategy. The individual in question initially managed capital looking for well managed companies in the world (with a focus on emerging markets) that were available at a discount relative to peers and in an absolute sense (relative to the historic valuation of the market).

The manager is now focused on using a long – short strategy. Management explains the idea is to reduce market directional effects on the performance of the fund. Unfortunately, the fund has underperformed the general market over the last few years.

We remain a little skeptical. The individual has proven himself to have a fantastic ability to discover hidden companies that are fantastic businesses, but have not yet been discovered by the mass market. Going long such positions with a long term investment philosophy combines well his abilities with the needs of his client base who are looking for such an investment approach (hence the importance of the manager selecting the client base as well as the client selecting the manager).

Attempting to reduce market volatility (i.e. with the aim of generating better short term performance) will therefore only reduce the total return generated from the manager’s key skill of finding undiscovered great businesses, by introducing the cost of going short and the possibility that the short position will go against the fund.

It seems the pressure of generating aesthetically pleasing results (i.e. a gentle continuously upward sloping graph, rather than lumpy returns which in the long term may turn out to be better) can often create such large peer pressure that it forces managers to change their approach if they don´t want to lose client money. Indeed, many exceptional managers have experienced large capital outflows in periods where performance has been poor and management has continued with their approach. Often, capital has flown back once there outperformance returned. It is impossible to outperform everyday, or even, every year. Consistent returns in the long term is as good as it gets. Changing your approach may mean using a method which may never lead to above average market returns, as your skills are not tuned to working in that particular manner - you do it because you have yielded to peer pressure. For many, this path is the beginning of the end...

To continue with the manager we were above discussing. The idea of forcefully selecting companies in the same sector that seem relatively over valued or may suffer from negative news in the short term to go short, in our view, dilutes the high quality research and thinking applied to find the long positions. It seems silly (in my view) to introduce a short position on a relatively low conviction idea to reduce market risk on their best idea.

Value managers look for businesses that they understand, and from that understanding, invest in the securities that seem grossly undervalued relative to their estimation of fair value. Fair value is a subjective concept, hence knowing ones limits and sticking to what you understand, is vital.

When markets fall, value investors, like all other investors, will suffer. When there are fewer opportunities, i.e. markets are expensive, the cash position of a value investors fund is likely to increase. A true value investor will not act on the pressure to forcefully buy anything – no good ideas at good prices – no buying, therefore cash increases if funds are received or positions are sold.

To fear the market may fall, and the consequential affect this may have on short term performance, and to react by changing your management style in a manner that can reduce your total returns by diluting your primary skills, is the greatest sin of the value investor.

Though we appreciate there is an important role for macro economics in the management of a value investors portfolio, we see this reflected in the asset allocation, rather than the idea of developing a long – short portfolio where no gross over valuation is present, but simply the idea to reduce market directional effects on portfolio performance.

Review of recent thoughts: Risk/reward ratio less interesting

Please find below an extract sent to clients summarising thoughts discussed with clients. We summarise thoughts in different sub headings.

You may have noted we have been particularly quiet over the last few months. The words best used to describe this inactivity is fear. Over the last three years we have moved to being aggressive buyers of bonds to cautious buyers of equity. Recently, the current preference has been the steady accumulation of cash (20 - 25% in a portfolios makes us comfortable).

1 Can an economy get out of a crisis born from leverage by issuing more debt?

Many of you have probably just sighed. Here he goes again...talking about over leveraged economies. Doesn't he get it that governments are printing money so that there will be no debt crisis?!

Perhaps this is correct. However, I fear the following: if a country prints money to meet obligations, they risk creating a loss of confidence in that currency. As a result, the cost of attracting foreign capital into that economy will have to increase for debt outstanding. This may exacerbate fears in the value of the currency of that economy, which may increase the cost of capital for that currency, and so forth, creating a positive feedback loop that can cause rapid changes in the value of risk assets and the currency of that economy. Such events are not linear. As Hemingway answered the question, "How did you go bankrupt?: Two ways. Gradually, and then suddenly".

Let us use an example. In Japan, recent discussion has suggested Japan's parliament may target a more aggressive hard inflation target of 2-3%. For the past 10+ years investors in Japan have agreed to receive less than 1.5% in nominal yield. Considering that during this period the country experienced deflation of 1 -3% per year, this provides the buyer with a real yield of between 2.5% - 4.5%. If the Bank of Japan (BoJ) was to target inflation of just 1 - 2%, what rate would investors demand to have a positive real yield?

HERE IS THE PROBLEM, most lucid in the case of Japan. If the BOJ chooses an inflation target, the Japanese central government's cost of capital could increase by more than 200 bps (2%). This would increase their interest expense by more than 20 trillion YEN. Note that approximately every 100bps change in the weighted average cost of capital is roughly equal to 25% of the central governments tax revenue (Source: Haymans). Do you think 1.5% rates are sustainable? I don't. Neither do many market participants...However, while the music keeps playing, lets play the same game...

What we don't know is when the game changes. However, it is important to note the game can change. More points on average (in terms of portfolio return) are given for being aware (and reacting to this) then pretending to time the event precisely. Other developed countries have not quite reached this level of debt outstanding, but are playing the same game, and are developing a similar dependence on extremely low interest rates. My conclusion: debt matters.

Please also note that Japan has the much documented problem of an aging population. As previous Japanese government bond investors start dipping into their capital as they retire, rather than buying more bonds, the country will become more dependent on foreign funding. As most foreign countries are currently experiencing inflation rather than deflation, they will demand a higher nominal yield than those requested from local Japanese investors. Here in lies the problem which can create the above mentioned problem....

Such consequences are huge, and many believe the probabilities of them occurring are small. In the past such events have led to collaboration amongst developed economies to create a peace of mind amongst the investment community. However, many of the developed economies are now significantly leveraged.

In any case, we are looking to develop products that can offer a return should such "tail risk" events occur. However, it will only be pursued if the "quasi insurance" is cheap enough. The reason we do this is should the above mentioned event occur, most risk assets are likely to suffer. We are looking for a little flower that can pop out should such extreme events occur. We will update you as such products are developed.

Conclusion: In general, we are not buyers of long term bonds.


2 Europe

We still feel the problems in Europe are being labelled a liquidity crisis rather than a solvency crisis. This denial of the problem makes it difficult to find a solution. We remain concerned.

Conclusion: We are not keen on increasing exposure to the EUR.


3 USD and Oil

Many have expressed fear of the USD weakening relative to the EUR recently. Simultaneously the oil price has been spiking upwards. In my opinion, it is no surprise the USD weakens as oil spikes. The US is the largest user of oil in the world and oil imports make up almost half the trade deficit. As oil goes up, the trade deficit effectively increases and more foreigners hold USD. These foreigners may sell USD as they have too many or may want to diversify, hence reduce the value of the USD relative to other currencies. Remember, oil is traded in USD. If risk aversion was to grip the world, I would continue to want to hold some USD.

Conclusion: We do not feel a dramatic dash to sell USD. If you have no USD, it may be interesting to start holding a position


4 Surely choosing inflation over default is better?

Much is said on the media (the entertainment business) about how inflation is preferred over default, it creates less "damage" to an economy. However, if inflation will be created by increasing liquidity generated via increasing the debt load of the economy (be it via the government, corporates or the household), then at one point once a certain debt load is reached relative to assets and income received, the possibility of default is increased by increasing the flow of credit (i.e. the potential of greater inflation expectations).

Hence, at one point increasing credit does not dilute the problem, but exacerbates it. In the case of Japan provided above, I believe that point has already been past. Money printing is another option. But what is money printing. It is the process of buying back financial securities and placing cash in that bank account in return. However, if that liquidity is used to purchase other financial securities then they will rise in price. If the currency does not fall, you are likely to see less interest by foreign buyers as a consequence. This is not wise for a country that may have trade and budget deficits and requires foreign money to pay their bills. As a result the currency is likely to drop of the cost of borrowing will be forced to increase by market pressure.

Free markets are like water. If one route is blocked, another will be found to reach the destination. Water follows the line of gravity, capital follows the line of the risk/return ratio. These variables can be seriously skewed over short periods of time: I feel both are currently mis priced. Too little return for too much risk. Today, cash can be a good investment and should be a part of the portfolio. Since no one can be sure what will happen (uncertainty always exists) we need to adapt the asset allocation accordingly. A 20 - 25% cash allocation in the current environment seems sensible to me.

Conclusion: Markets are pricing economic recovery too positively. We are not keen on purchasing growth stocks or cyclical companies at current prices. Opportunities do still exist in high quality companies. These are low debt, high return on capital companies that work in slow moving market sectors with few competitors and where the company in question has a dominant position.

As an aside, we have been asked by many clients what could cause an equity market re rating. As we have seen over the last few weeks, the world is uncertain and it could come from anywhere. However, if I was to summarise my answer in one sentence, I would say the following: "A re rerating of risk assets is likely to come from the bond markets rather than the equity markets."

High oil prices could lead to lower margins for capital intensive companies in the next quarterly earning. This may reduce steam in the current equity market rally. However, the re re rating of the S&P 500 going to 1100 or less (current pricing is 1310) is more likely to come from the bond markets - the same source of funding that has effectively allowing the equity market rally to occur.

Vulcan Materials: An interesting asset play in a disliked sector

We at LTIM are attracted by businesses that have large barriers to entry, and therefore, are involved in markets where there are few competitors. When companies have certain positive attributes that create such a market structure, we find few companies that are unable to make exceptional profits.

We are even more excited when we see the pricing of the financial securities of such companies are trading at prices that do not include the potential value generated from having the ability to generate exceptional profits.

The aggregates business is a simple one whereby companies own or lease land where quarries are mined, and the extracted rock is sold. Customers primarily use the material for the development of roads or property (in the majority of cases).

Aggregates are a relatively cheap material (approx. 10 $/ton), but very difficult to transport. As a result, a local quarry will often have a monopoly of the local supply of aggregates.

VULCAN MATERIALS has one of the largest aggregates reserves in the USA. They are very large in the South East, states that have the largest population growth in the country. In these areas they consistently have greater than 40% of the crushed rock quarries under their ownership. This gives them a large market share in the areas they conduct business.

The common stock has suffered a large decline since 2007. In that period it was trading close to 120 $/share. Now it is trading at approx. 43 $/share.

At this price we believe the stock is an interesting asset play. Indeed, over the last few months we have presented various asset play ideas that derieve from a currently weak US housing sector. Though we do not believe the housing sector in the US will bounce back to 2007 levels next year, we think current pricing has been to aggressive in discounting the value of real hard assets. In this case of aggregates, in past examples like St Joe, physical land.

Many investors are currently focused on the short term earnings of Vulcan materials and how much they can increase volumes or pricing in the next quarter or two.

I am more concerned on how much their aggregate reserves are worth. Here is my simple calculation:-

Reserves = 14 billion tons of proven and probable aggregate reserves at its production facilities in the US and Mexico

Aggregates sell for approx. 10 $/ton

This implies a valuation of 140 bln

However, margin for extracting aggregates is often around 10% (normalised over the business cycle)

Hence we have a valuation of 14 bln

If we remove total liabilities of 4.5 bln

We have a value of 9.5 bln (lets say 9 bln)

The current market cap of the company is 5.5 bln

The company also extracts other materials and has a cement plant in Florida. We assume those assets are worth zero for simplicity and to be conservative. There seems to be a suitable margin of safety if you agree with the above mentioned reasoning.

Risks to consider? Considering current production rates it would take over a 100 years to exhaust their resources. One could express concern that during such a large period the pricing of aggregates may decline significantly. We take shelter in the fact that this material has been used since biblical times in construction, that permits to open new quarries are becoming more difficult to achieve (no one wants a quarry in their back yard!) and that the concentration of the market should allow princing power to be maintained to a satisfactory level. The problem is volume variation as demand is cyclical and costs are primarily fixed (hence a large margin reduction will be felt during a recession. This can be clearly seen from the financial statements as well as the stock price, which is very sensitive to the income statement).

Another cause for concern that must be followed closely is how the cost structure of the company evolves. For example, such capital intensive companies often have relatively large energy costs. It would not surprise me if next quarter earnings will be below expectations due to the strong performance of the oil price. Many mines use diesel power as a source of energy. If these costs can be passed over by higher pricing than the current normalised margin can be used to estimate the future value of their resources (we ignore their earning power. Our only assumption is that over the business cycle they will not burn cash).

Uncertainty always exists...

When young European entrepreneurs are expanding profit making businesses, they pay litte attention to whether a war in Libya will affect the value of their company.

And quite rightly so, in our opinion.

Their principal concern is having access to capital, using that capital to generate a return greater than the cost of the capital, and using the surplus cash flow to meet liabilities and re invest in the company to generate further profits whilst the return on capital is greater than its cost.

It is a shame the financial securities of publically traded companies are not priced in the same way.

Actually, we try and make a business out of this fact: as long as this occurs, the longer we can work. Long live the short term orientated "macro market timer" who wishes to make "easy profits" from trading the market on contemporary news or the current quarters business developments.

We take the approach of viewing a companies financial securities as if we were the owner of the business: How can I grow my business (investment, in our case) so that over the entire business cycle the company can develop in an optimal manner. If we can find good companies with good management who ask this question everyday, and the market structure is positive, we would shy away from obscene portfolio diversification for diversifications sake and simply hold a few companies in our portfolio.

The reality is these companies are hard to find, and indeed, very few exist. This will not stop us, of course, from looking....

This rather long introduction we feel is necessary to cement home our approach to investing (indeed, life in general). It is in times that the world seems more uncertain that you must most remember the above mentioned concepts. Do you really think life was less uncertain yesterday? We don´t think so. You just had the illusion it was. This may be due to media influence or a lack of experience, which allows one to temporarily believe that event is predictable. Just as when you flip three coins in a row and you correctly guess all three outcomes you start to feel you may have a special ability to judge how a coin will drop; on the fourth attempt you are reminded that it was an illusion, you had no special gift.

In life, as in investing, one must continuously remain humble. We feel it helps us make profits: indeed, we feel this is a strong competitive advantage for us. Investing is as much about the stomach as the head, and when one continuously judges risk as being there, as uncertainty existing, one is better able to spot what is cheap or expensive, and hence act decisively when one must.

Understanding a company

To determine if their is a difference between the price and value of a company we believe five moving parts need to be very well understood:-

1 The costs of the company and how they compare to competitors
2 The product and the pricing power on that product
3 Regulation and government influence
4 Macroeconomic influence
5 How different companies interact with each other and suppliers/customers
6 How the market structure has evolved and is influenced by factors 1-5