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
Monday 28 November 2011
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.
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.
Saturday 19 November 2011
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).
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).
Friday 18 November 2011
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.
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.
Sunday 13 November 2011
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
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.
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.
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