I was snow white, until I drifted

Dear Reader,

You will have noticed from our writings since this blog began in early 2010, various traits that define our view to investing:-

1. Understand the underlying business and the business model of the securities of the company you wish to buy. Without this, valuation is useless
2. Understand the market structure and its influence on the business model
3. We let valuation guide our investment approach. As a result, we are extremely price sensitive when purchasing, and will not buy an asset without a significant margin of safety attached
4. We believe in mean reversion (inflation adjusted)
5. Various cycles become dominant in influencing the pricing of risk assets at various moments in time. This includes the economic, business, market and financing cycle
6. If the underlying does not generate a cash flow, be wary of pricing

Well, Mae West said she was snow white, until she drifted; today we will drift a little too from our core competencies due to a clients request.

I have the pleasure of dealing with a client who has locked up a number of bonds that offer yields to maturity over 6%, were bought under par and mature within 3 to 4 years: my current concern, they were all in Australian Dollars (AUD). Since purchase this currency has appreciated significantly relative to the currency they were exchanged for. However, as believers of point 2 mentioned above, please note the following chart depicting the evolution of AUD versus the US dollar (USD).





Though you may have realised we are not currency players, we do become nervous when we see such large shifts occurring in such a short period of time, and such a powerful trend over such a long period of time (10 years, like gold). Many would say the current strengthening of the AUD simply takes it to where it was in 2008, a sign that the “China” story is still intact (as far as the market is concerned), not damaged by the economic slowdown suffered in developed economies from being over leveraged, and hence putting pressure on their consumers from spending.

I do not have a precise counter argument for the above mentioned statement to suggest it is wrong. A currency is a sign of the strength of its underlying economy. There can be no doubt that data over the last couple of years suggest the Australian economy is doing better than most developed economies, seemingly from its exposure to emerging market development, and hence their demand for Australian raw materials. As a result, it should not be a surprise that its currency has performed better than the USA, UK, Euroland and Japanese currencies, which are also widely traded. However, it does matter what the starting point of each currency exchange was when considering any period of time. It should also be noted that the AUD has the highest interest rates amongst developed economies.

However, I fear the AUD has become too closely intertwined with the “China” story. Not being fed solely by the above mentioned reasoning, but also because China does not have a freely accessible floating currency for foreign investors. Capital flows to the AUD have therefore, I believe, potentially gone out of hand, leading to the AUD to pass by a significant margin its average value over the last 10 years to other developed country currencies. Though I must repeat my confidence in such statements are not anywhere as close as my confidence in investments of company securities; the strengthening of the AUD is a fact shown in the above graph, which cannot be ignored.

For those who believe the future really will be different from the past, they may be willing to believe that trends such as the strength of the AUD will continue. We find it hard to fight the historical role of mean reversion, especially with assets such as currencies and commodities.

I therefore advise clients that do not have expenses in AUD or are not based in that country, and who have a greater than 10% exposure to this currency in their portfolios, that they consider hedging their AUD exposure relative to their base currency. For the client above mentioned, AUD/USD would be advised.


Yours sincerely,

Alessandro Sajwani