Dear Reader,
This article attempts to identify a connection between several recent buzzwords hanging around newspaper pages that have caught my attention: bond bubble, and mergers and acquisition (M&A) frenzy.
The UK government has been punished harshly by the media and, many perceive, by voters, due to the nationalisation of several large UK financial institutions. The US government has seemingly played a better game.
By providing very cheap money to banks who can then buy government bonds without committing any equity, we have a risk free trade that can allow banks to earn their way out of trouble. Indeed, taking such an argument to its logical conclusion, it is no wonder government bond yields are seen to converge to zero; they may will be converging to the cost of money that banks have to pay. Unless that occurs, money can be made, virtually RISK FREE, with this trade under current regulation.
Can this be an important driver for the large tightening in credit spreads we have seen?
I also emphasis at this point a belief we have presented regularly in this blog; that financing cycles shift from debt to equity to debt continuously over time. After the sudden reduction in bank financing from 2008, equity financing started its cyclical up turn again. However, due to the lowering credit spreads on corporate debt, financing is also becoming abundant from bond issues. We may better call this stage in the financing cycle, “capital market financing”. Indeed, recently, a number of very low leverage, high quality companies such as Johnson & Johnson’s and Microsoft have issued debt at 2 to 3% for maturities at, or greater, than 10 years. This is whilst they both sit on very large cash balances. Such a low cost of capital, which we feel is being fuelled by a loose monetary policy, provides an incentive for companies to accumulate cash, and then, an incentive to do something with this cash. Indeed, newspapers are continuously highlighting the historically high cash balances corporates have relative to market capitalisation. What to do?
With capital market financing only available to corporates, as opposed to consumers, it is unlikely to help the latter increase spending. Hence, is not likely to result in economic growth, as consumer spending is often 70% of the GDP of a developed economy.
So what do corporates do with this cash? Buy a company with the incentive to reduce costs: or buy a company that is trading at the market for less than the cost it takes to replicate its assets (as BHP Billiton did by bidding for Potash).
By reducing costs, they provide the opportunity to increase margins, hence profitability, without relying on growth. If a M&A frenzy was to start, it is likely to be driven by cost cutting rather than expansion. This implies pricing is likely to be disciplined, and may not be the catalyst which will start the price/earning multiple for the market to expand (it has been contracting since 2000). Indeed, few players actually have access to this source of financing. As a result, we feel the stronger may become stronger. This may be a catalyst for the revaluation of dominant, high margin and high return on capital companies that have experienced modest growth over the last decade, but their share prices have done nothing during that same period. It is in this category of companies that our portfolio is heavily positioned.
An interesting question would be, which market structures would be most suitable for such activity? In recent months we have seen most M&A activity in healthcare, technology and commodities (at least at a short glance it seems like that, please correct me if you feel I am wrong, I have no data to back the statement).
I feel healthcare is a wonderful candidate, especially pharmaceuticals. Here we have markets that generally are concentrated with a few dominant players who are experiencing declining growth, and a score of small players with break through products. Usually, when growth was wanted, the big company would buy a small one for the potential of increasing future revenue, and save time and costs on researching for a particular new product. If cost cutting was the aim, would we not see larger companies merge? So cost synergies can really be made? The financing cycle we are in may therefore provide interesting investment opportunities for markets with certain characteristics.
We also note that such transactions are management driven, not investor driven. Hence, if you agree with the above mentioned arguments in concept, you will agree that business dynamics will heavily influence market pricing, not necessarily investor sentiment; at least at the start. Management decisions should be, in a cost cutting environment, more determined by earning yield relative to the cost of financing. In such an environment, value investing will have a role to play in generating good investment results. We strongly feel that value matters, and is the “gravity” that affects the performance of markets in the long run.
Yours sincerely,
Alessandro Sajwani
Wednesday, 6 October 2010
Stick to what your good at, or else...
Dear Reader,
It is a most unfortunate position we are in.
Of the many people I have the pleasure of calling friends who are professional money managers, I find many are currently frightened. I believe this is being driven by many departing from their past approach to investing, which has led them to achieve impressive records, to become the dreaded “macro market timer”, which we have discussed in past articles.
“Value won’t help you in this market, everything is driven by macro”
“Buy and hold is dead, this is a traders market”
“Buy a stock, when you gain 8%, sell it”
“Momentum is where it’s at, markets are more efficient now, value won’t help”
These are some extracts of the kindly advice I have received over the last few weeks. Well, my only piece of advise to the world regarding such matters is the following:-
“The more the market becomes concerned with macro, the more stock opportunities appear, as individual business dynamics become less relevant for buyers”
“The more value you receive for free from an investment purchase, the less dependent you are on profiting from that value on macro issues”
These are basic tenets I hold to be self evident from historic data. When someone has a basic skill, the worst thing they should do is drift away from using it because it is not today’s fad. It is exactly in moments like these that people that stick to what they do best, that I believe, do best.
Yours sincerely,
Alessandro Sajwani
It is a most unfortunate position we are in.
Of the many people I have the pleasure of calling friends who are professional money managers, I find many are currently frightened. I believe this is being driven by many departing from their past approach to investing, which has led them to achieve impressive records, to become the dreaded “macro market timer”, which we have discussed in past articles.
“Value won’t help you in this market, everything is driven by macro”
“Buy and hold is dead, this is a traders market”
“Buy a stock, when you gain 8%, sell it”
“Momentum is where it’s at, markets are more efficient now, value won’t help”
These are some extracts of the kindly advice I have received over the last few weeks. Well, my only piece of advise to the world regarding such matters is the following:-
“The more the market becomes concerned with macro, the more stock opportunities appear, as individual business dynamics become less relevant for buyers”
“The more value you receive for free from an investment purchase, the less dependent you are on profiting from that value on macro issues”
These are basic tenets I hold to be self evident from historic data. When someone has a basic skill, the worst thing they should do is drift away from using it because it is not today’s fad. It is exactly in moments like these that people that stick to what they do best, that I believe, do best.
Yours sincerely,
Alessandro Sajwani
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
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
Friday, 1 October 2010
If you want to finish first, first you have to finish...
Dear Reader,
On this article I want to present the personal importance I place to its title by clarifying the role different financial statements place in our security selection.
During a period of slow economic growth and weak credit expansion, corporates that sell their products in that economy are likely to suffer operating margin and revenue growth headwinds.
In such an environment, many leveraged companies that depended heavily on renewing bank debt are likely to suffer from cutting costs significantly to be able to reduce debt or make interest payments (often losing market share as a result) and even potentially falling into bankruptcy. This allows the lower leveraged companies to take their market share. We are seeing this happen already with companies such as Best Buy, who are taking clients that previously went to circuit city, a large competitor that went bust in early 2009.
As a result, we see the leverage in different companies amongst certain market sectors shift in a manner that closely follows the economic cycle. Low leveraged companies become more leveraged as they take on market share from competitors that are down sizing, default or are bought out due to their misallocation of capital in past years, as the rate of return from investing capital in that sector increases. Investing in low leveraged companies that have the balance sheet to survive a crisis and hence reap the rewards of surviving is one investment strategy we are actively pursuing at Long Term Investment Management.
Yours sincerely,
Alessandro Sajwani
On this article I want to present the personal importance I place to its title by clarifying the role different financial statements place in our security selection.
During a period of slow economic growth and weak credit expansion, corporates that sell their products in that economy are likely to suffer operating margin and revenue growth headwinds.
In such an environment, many leveraged companies that depended heavily on renewing bank debt are likely to suffer from cutting costs significantly to be able to reduce debt or make interest payments (often losing market share as a result) and even potentially falling into bankruptcy. This allows the lower leveraged companies to take their market share. We are seeing this happen already with companies such as Best Buy, who are taking clients that previously went to circuit city, a large competitor that went bust in early 2009.
As a result, we see the leverage in different companies amongst certain market sectors shift in a manner that closely follows the economic cycle. Low leveraged companies become more leveraged as they take on market share from competitors that are down sizing, default or are bought out due to their misallocation of capital in past years, as the rate of return from investing capital in that sector increases. Investing in low leveraged companies that have the balance sheet to survive a crisis and hence reap the rewards of surviving is one investment strategy we are actively pursuing at Long Term Investment Management.
Yours sincerely,
Alessandro Sajwani
Tuesday, 28 September 2010
Summary of recent fund managers presentations
Dear Reader,
Today I had the pleasure of meeting a number of fund managers who came to present their investment thesis to our bank.
This blog aims to summarise some of the more interesting points raised:-
1. There was an argument presented that European banks are under capitalised and UK banks are over capitalised (they are short the former and long the latter). The former are likely to be under pressure to raise equity to build core tier 1 over the next 6 - 12 months. This could develop into a competition of who will issue first, leading to a discount to appear for the late comers
2. Lloyds was presented as a UK bank that was over capitalised. When questioned, their principal metric was equity to debt, which had fallen significantly from past rights issues. There was also a belief that writedowns were over estimated to get the damage out of the way last year. There is a belief they will be buying back their shares from the government over the next 2 -3 years due to the fact they hold excess capital
3. Drax was seen as a company with irreplaceable assets in the UK. The cost of making another Drax is higher than the current market cap. We could not agree more. A similar argument has been presented by Potash to explain the reason for the BHP Billiton bid in the directors circular recommending rejection of the offer
4. There is a fear companies like Microsoft will use cash on the balance sheet to purchase another company. Fear arises from the current trend in the market for large IT companies to need to buy a smaller, but faster growth company to make it look sexier. Recently, we have seen Intel and Dell embark in such "red light" activities. Though this is a possibility, for the moment we give management the benefit of the doubt. They refused to overpay for Yahoo, hence seem to possess some discipline in empire building
5. As always, there was positive talk on emerging markets. Debt and equity securities were mentioned. Some mention was made of inflation protection, which was pursued by purchasing the stock of companies with pricing power (i.e. the creators of inflation as we know it)
6. Currency hedging for stock purchases was deemed unnecessary by one fundmanager. His answer to this question is that a currency will benefit a company by increasing its exports if it weakens, and punish you by the opposite if it strengthens. Though on paper, when read quickly, this makes sense, this argument may not be equally valid for industries with different market structures. It is, however, an interesting view
7. Corporates have too much capital on hand. They are likely to spend this in emerging markets (as we emphasised in the last two blogs where we discussed equity financing) or on merger and acquisition activity
8. There seems to be a strong belief that emerging countries will grow considerably faster than developed econmies, which will hardly grow at all in the next few years. Mention was made of a "bubble" in credit markets, and that inflation fears are many years into the future.
9. It was refreshing to see a fundmanager recite values I personally abide by: never lose money. Simple mathematics indicates that by dropping 50% in any period of time requires you to gain 100% to be where you started! Couple this with the power of compounding, and it is vital that you miss investments that lead to permenant loss of capital. These can only be avoided by doing your research and sticking to what you understand.
Yours sincerely,
Alessandro Sajwani
Today I had the pleasure of meeting a number of fund managers who came to present their investment thesis to our bank.
This blog aims to summarise some of the more interesting points raised:-
1. There was an argument presented that European banks are under capitalised and UK banks are over capitalised (they are short the former and long the latter). The former are likely to be under pressure to raise equity to build core tier 1 over the next 6 - 12 months. This could develop into a competition of who will issue first, leading to a discount to appear for the late comers
2. Lloyds was presented as a UK bank that was over capitalised. When questioned, their principal metric was equity to debt, which had fallen significantly from past rights issues. There was also a belief that writedowns were over estimated to get the damage out of the way last year. There is a belief they will be buying back their shares from the government over the next 2 -3 years due to the fact they hold excess capital
3. Drax was seen as a company with irreplaceable assets in the UK. The cost of making another Drax is higher than the current market cap. We could not agree more. A similar argument has been presented by Potash to explain the reason for the BHP Billiton bid in the directors circular recommending rejection of the offer
4. There is a fear companies like Microsoft will use cash on the balance sheet to purchase another company. Fear arises from the current trend in the market for large IT companies to need to buy a smaller, but faster growth company to make it look sexier. Recently, we have seen Intel and Dell embark in such "red light" activities. Though this is a possibility, for the moment we give management the benefit of the doubt. They refused to overpay for Yahoo, hence seem to possess some discipline in empire building
5. As always, there was positive talk on emerging markets. Debt and equity securities were mentioned. Some mention was made of inflation protection, which was pursued by purchasing the stock of companies with pricing power (i.e. the creators of inflation as we know it)
6. Currency hedging for stock purchases was deemed unnecessary by one fundmanager. His answer to this question is that a currency will benefit a company by increasing its exports if it weakens, and punish you by the opposite if it strengthens. Though on paper, when read quickly, this makes sense, this argument may not be equally valid for industries with different market structures. It is, however, an interesting view
7. Corporates have too much capital on hand. They are likely to spend this in emerging markets (as we emphasised in the last two blogs where we discussed equity financing) or on merger and acquisition activity
8. There seems to be a strong belief that emerging countries will grow considerably faster than developed econmies, which will hardly grow at all in the next few years. Mention was made of a "bubble" in credit markets, and that inflation fears are many years into the future.
9. It was refreshing to see a fundmanager recite values I personally abide by: never lose money. Simple mathematics indicates that by dropping 50% in any period of time requires you to gain 100% to be where you started! Couple this with the power of compounding, and it is vital that you miss investments that lead to permenant loss of capital. These can only be avoided by doing your research and sticking to what you understand.
Yours sincerely,
Alessandro Sajwani
Monday, 27 September 2010
Turning ideas into investments
I write a small extension to my last article.
Working at a Private Bank I often find that nice stories, rather than nice results, are what are demanded from the industry: words, rather than probabilities and price awareness. Coming from a valuation slant to investing, I would like to break apart the words from my last article to an executable framework of action: which can allow the previously mentioned concepts to be used to generate portfolio results, rather than entertain wealthy friends at a (boring) party.
1 Banking regulation
1. Previously bought senior bonds yielding a greater return than years to maturity should be held. It is the securities that are lower in the capital structure that will be principally affected from Basle III changes
2. Selling perpetuals that are priced greater than a years coupon above par should be replaced with perpetuals trading below par. Ideally, you would want to buy a below par perpetual from the same issuer, hence have the same credit risk. We assume you are happy with the credit risk of the issuer you had previously and mention the strategy only to consider as a result of regulation change
3. There are a small number of preferred shares from RBS that continue to pay dividends, though the majority have been forced to stop by the European Commission due to the bank receiving extensive government funding. One in particular that could be of interest for an aggressive, sophisticated investor would be a certain RBS preferred that continues to pay because it was issued prior to Basle II, hence pays the coupon dependent on whether the bank has distributable reserves, not on, for example, the amount of annual profits. We can use retained earnings as a proxy for distributable reserves. If one looks at the retained earnings on the RBS balance sheet at the end of 2008 (a very terrible year for banks), they have close to 20 billion sterling. By year end 2009 they had almost double that amount. One could say this is an excellent investment prospect. However, in true “Sajwani” speak, I state a personal belief that a good security won’t stay good for long if the underlying company is bad. A company that keeps burning cash from unproductive use, doesn’t make profit for its shareholders, keeps relying on government funding to stay alive, and is majority held by the UK government; I wouldn’t want to bet against the government being upset from preferred shareholders making money from government funding that is keeping the banks doors open. They are likely to eventually restructure the security so payment is cancelled. The choice of investment depends on your thoughts on this issue (time before the government reacts, would they react, opportunity cost… etc). I have made my mind up
4. We state the belief that a large number of rights offerings from banks may be issued in the next 6 – 12 months as insufficiently capitalised financial institutions build up their core tier 1 capital in light of Basle III recommendations. Those banks that will not require further equity are likely to benefit, moving ahead, in stock performance, from those banks that remain over leveraged under new criteria. Though there are a number of banks your author trusts considerably more than its competitors, it is an area I will not divulge further. I admit incompetency in unravelling the exotic contents of a contemporary banks balance sheet. As a result, I have not made a single investment in any until I broke that rule with a single purchase at the start of 2010. I do not expect to make further investments in this field hence have not explored it further. Researching extensively a sector to provide a detailed report on why I would not invest, rather than spending that time in something I could invest, seems more practical
2 Equity financing
1. If equity financing was to be accessible due to the forced appetite for risk as cash rates are so low, corporates are the participant most likely to benefit. Indeed, being the economic participant least leveraged, they are the participant others are looking for help to stimulate economic growth and reduce the burden of current debt in the economy (they indeed would be more helpful for developed economies, in an unproductive way, if they were driven by patriotism rather than profit). This could be stimulating for equities, in theory. However, any growth potential is quite likely to be diluted by an increasing amount of equity. We therefore reiterate past statements that it is quite possible that in 2 to 3 years, equity markets can be pretty close to where they are now. Index investing, unless used as a trading strategy, is likely to generate weak results for the risk of holding equities. This will be incorrect if we find the price/earning multiple starts to expand rather than contract during the above mentioned period (it has been contracting for 10 years. Historically, it contracts for a period of 14 – 17 years, followed by a similar period of multiple expansion). Considering the current perceived economic uncertainty, we find this to be unlikely. Please note your author finds no evidence that price/earning multiples are determined by short term interest rate policy. If forced to answer, it may have more to do with a general underlying emotional trait of human reaction to risk, and the time it takes to discount history (a generation)
2. We note, as many of you have, that different asset classes are trading in strong correlation recently. This may have to do with the perceived macro economic uncertainty. We measure this by the fact almost no two economists agree with what will happen next quarter. Many well respected traders have also mentioned on several occasions how the markets are trading on macro data, and then briefly dominated by earnings data during earning seasons. However, your author strongly believes the more attention the market places on macro issues, the more bottom up investment opportunities there are. And the more your portfolio is focused on deep value, the less the portfolio is affected by macro issues.
3. Corporate spending in likely to be channelled in greater proportion than in the past into emerging markets. It is in those areas that news jobs and wage increases are likely to occur, hence leading to increasing consumer spending: exactly what is required for a number of emerging markets that have become overly dependent on exporting. The wealth of Western nations that developed leading companies will slowly be transferred to emerging countries, in the name of profit. This is the reality of a capitalist society. We cannot ignore this powerful transition of capital movement, however, we must also enter such transactions with open eyes. There are simply no free lunches. Of particular concern for investing in such countries, especially China, are the absurdly large equity offerings that occur year after year, diluting significantly buy and hold investors. It forces one to consider taking a trading position, rather than an investing one in such markets. Indeed, such has been the appetite for emerging market equities that they currently trade at a premium to developed market equities (using trialing price/earning ratio). Though growth dynamics are superior, stable market structures, regulation, limited government intervention, accounting, corruption and quasi free markets certainly do not seem to be. A merited premium on equities? We leave that our readers to decide. As per usual, my thoughts on such matters are resolved by considering case by case studies on the equity exposure I am looking for
4. Though we have explicitly mentioned “lack of credit expansion” above, we were primarily referring to bank credit. Cash receiving historically low deposits has also moved in large volume to debt instruments, hence increasing the debt on government and corporate balance sheets. Indeed, cash has moved to such an extent into this asset class that current bond pricing can be argued to be pricing a significant deflation risk. We remain watchers, and holders of bonds bought during 2008/09, rather than buyers of the majority of such instruments considering current pricing. For the a number of our readers, we would suggest the same
5. The important role of capital markets has been explicitily clear for all to see over the last few years, as bank credit has remained muted whilst capital markets have provided essential funding to large and small companies via either debt or equity instruments. Indeed, this phenomenon is likely to create unique investment opportunities in certain regions of the world, regions of the world that were previousely heavily dependent on bank financing. This is likely to lead to a spate of family and private businesses being IPOed. Indeed, if we take our "equity financing cycle" approach to the limit, in the next 10 years we may see a rash of IPOs from "old industry" companies as family owned businesses rush to list their shares and transform into cash the work of generations to create a respectable business empire. Quite the opposite of the spate of spotty teenage kids selling "new age" company shares during 1995 - 2000. Get ready for 2015 - 2020!
Yours sincerely,
Alessandro Sajwani
Working at a Private Bank I often find that nice stories, rather than nice results, are what are demanded from the industry: words, rather than probabilities and price awareness. Coming from a valuation slant to investing, I would like to break apart the words from my last article to an executable framework of action: which can allow the previously mentioned concepts to be used to generate portfolio results, rather than entertain wealthy friends at a (boring) party.
1 Banking regulation
1. Previously bought senior bonds yielding a greater return than years to maturity should be held. It is the securities that are lower in the capital structure that will be principally affected from Basle III changes
2. Selling perpetuals that are priced greater than a years coupon above par should be replaced with perpetuals trading below par. Ideally, you would want to buy a below par perpetual from the same issuer, hence have the same credit risk. We assume you are happy with the credit risk of the issuer you had previously and mention the strategy only to consider as a result of regulation change
3. There are a small number of preferred shares from RBS that continue to pay dividends, though the majority have been forced to stop by the European Commission due to the bank receiving extensive government funding. One in particular that could be of interest for an aggressive, sophisticated investor would be a certain RBS preferred that continues to pay because it was issued prior to Basle II, hence pays the coupon dependent on whether the bank has distributable reserves, not on, for example, the amount of annual profits. We can use retained earnings as a proxy for distributable reserves. If one looks at the retained earnings on the RBS balance sheet at the end of 2008 (a very terrible year for banks), they have close to 20 billion sterling. By year end 2009 they had almost double that amount. One could say this is an excellent investment prospect. However, in true “Sajwani” speak, I state a personal belief that a good security won’t stay good for long if the underlying company is bad. A company that keeps burning cash from unproductive use, doesn’t make profit for its shareholders, keeps relying on government funding to stay alive, and is majority held by the UK government; I wouldn’t want to bet against the government being upset from preferred shareholders making money from government funding that is keeping the banks doors open. They are likely to eventually restructure the security so payment is cancelled. The choice of investment depends on your thoughts on this issue (time before the government reacts, would they react, opportunity cost… etc). I have made my mind up
4. We state the belief that a large number of rights offerings from banks may be issued in the next 6 – 12 months as insufficiently capitalised financial institutions build up their core tier 1 capital in light of Basle III recommendations. Those banks that will not require further equity are likely to benefit, moving ahead, in stock performance, from those banks that remain over leveraged under new criteria. Though there are a number of banks your author trusts considerably more than its competitors, it is an area I will not divulge further. I admit incompetency in unravelling the exotic contents of a contemporary banks balance sheet. As a result, I have not made a single investment in any until I broke that rule with a single purchase at the start of 2010. I do not expect to make further investments in this field hence have not explored it further. Researching extensively a sector to provide a detailed report on why I would not invest, rather than spending that time in something I could invest, seems more practical
2 Equity financing
1. If equity financing was to be accessible due to the forced appetite for risk as cash rates are so low, corporates are the participant most likely to benefit. Indeed, being the economic participant least leveraged, they are the participant others are looking for help to stimulate economic growth and reduce the burden of current debt in the economy (they indeed would be more helpful for developed economies, in an unproductive way, if they were driven by patriotism rather than profit). This could be stimulating for equities, in theory. However, any growth potential is quite likely to be diluted by an increasing amount of equity. We therefore reiterate past statements that it is quite possible that in 2 to 3 years, equity markets can be pretty close to where they are now. Index investing, unless used as a trading strategy, is likely to generate weak results for the risk of holding equities. This will be incorrect if we find the price/earning multiple starts to expand rather than contract during the above mentioned period (it has been contracting for 10 years. Historically, it contracts for a period of 14 – 17 years, followed by a similar period of multiple expansion). Considering the current perceived economic uncertainty, we find this to be unlikely. Please note your author finds no evidence that price/earning multiples are determined by short term interest rate policy. If forced to answer, it may have more to do with a general underlying emotional trait of human reaction to risk, and the time it takes to discount history (a generation)
2. We note, as many of you have, that different asset classes are trading in strong correlation recently. This may have to do with the perceived macro economic uncertainty. We measure this by the fact almost no two economists agree with what will happen next quarter. Many well respected traders have also mentioned on several occasions how the markets are trading on macro data, and then briefly dominated by earnings data during earning seasons. However, your author strongly believes the more attention the market places on macro issues, the more bottom up investment opportunities there are. And the more your portfolio is focused on deep value, the less the portfolio is affected by macro issues.
3. Corporate spending in likely to be channelled in greater proportion than in the past into emerging markets. It is in those areas that news jobs and wage increases are likely to occur, hence leading to increasing consumer spending: exactly what is required for a number of emerging markets that have become overly dependent on exporting. The wealth of Western nations that developed leading companies will slowly be transferred to emerging countries, in the name of profit. This is the reality of a capitalist society. We cannot ignore this powerful transition of capital movement, however, we must also enter such transactions with open eyes. There are simply no free lunches. Of particular concern for investing in such countries, especially China, are the absurdly large equity offerings that occur year after year, diluting significantly buy and hold investors. It forces one to consider taking a trading position, rather than an investing one in such markets. Indeed, such has been the appetite for emerging market equities that they currently trade at a premium to developed market equities (using trialing price/earning ratio). Though growth dynamics are superior, stable market structures, regulation, limited government intervention, accounting, corruption and quasi free markets certainly do not seem to be. A merited premium on equities? We leave that our readers to decide. As per usual, my thoughts on such matters are resolved by considering case by case studies on the equity exposure I am looking for
4. Though we have explicitly mentioned “lack of credit expansion” above, we were primarily referring to bank credit. Cash receiving historically low deposits has also moved in large volume to debt instruments, hence increasing the debt on government and corporate balance sheets. Indeed, cash has moved to such an extent into this asset class that current bond pricing can be argued to be pricing a significant deflation risk. We remain watchers, and holders of bonds bought during 2008/09, rather than buyers of the majority of such instruments considering current pricing. For the a number of our readers, we would suggest the same
5. The important role of capital markets has been explicitily clear for all to see over the last few years, as bank credit has remained muted whilst capital markets have provided essential funding to large and small companies via either debt or equity instruments. Indeed, this phenomenon is likely to create unique investment opportunities in certain regions of the world, regions of the world that were previousely heavily dependent on bank financing. This is likely to lead to a spate of family and private businesses being IPOed. Indeed, if we take our "equity financing cycle" approach to the limit, in the next 10 years we may see a rash of IPOs from "old industry" companies as family owned businesses rush to list their shares and transform into cash the work of generations to create a respectable business empire. Quite the opposite of the spate of spotty teenage kids selling "new age" company shares during 1995 - 2000. Get ready for 2015 - 2020!
Yours sincerely,
Alessandro Sajwani
Bank regulation, portfolio insurance and equity financing
Dear Reader,
The resulting news that came from the new Basle III arrangements has over the last two weeks led us to (1) sell perpetuals that trade at more than a years coupon above par and (2) re invest those proceeds into perpetuals that trade below par (which have been rapidly rising to par value due to the volume in this trade of late; case in point is the Prudential 6.5% USD which has risen from mid 80s to mid 90s).
However, the new definitions of core tier 1 capital, which effectively include only retained earnings and equity, are likely to lead banks which do not have sufficient core tier 1 to issue equity. We are wary that a number of rights issues are likely to be announced by a number of banks over the next 6 – 12 months due to this. This is likely to be bad news for the stock prices of these banks (at least temporarily) due to the dilution affect of a rights issue. Though I have not been a holder of bank stocks in my portfolio (I hold only one from early 2010), a number of clients have bought the equity of a number of banks from their home country, due to the strong brand image these enterprises have created in their country of domicile from decades of success and growth. Needless to say, almost all these positions are at a significant loss and I believe there is a strong possibility they will remain so in three years time.
However, this leads us to consider an important point. Your author believes financing cycles switch from being equity to debt based. The 1995 to 2000 asset price increases were fuelled from equity financing. This is most clearly seen by the ever increasing number of IPOs being presented and executed in that period. The asset price increases during 2003 – 2007 was fuelled by debt. We are likely to see the next financing cycle fuelled by equity. This makes good sense when we consider that almost all economic participants are heavily leveraged relative to almost all debt metrics commonly used. I would say the order of highest to lowest leveraged are (1) Financials, (2) Households, (3) Governments, (4) Corporates. So far in the de leveraging process we have seen the most action from financials (examples include the large issuance of bonds, common and preferred shares and the conversion of preferred shares to common shares. The elimination of dividends from common shares and preferred shares and the non calling of similar tier 1 hybrid securities, which were previously assumed to be redeemed on the first call date). It is no accident, they are the most leveraged.
We are likely to see a continuing de leveraging from consumers. This will be most evident from spending decreasing and savings increasing. This is likely to reduce economic growth trends in the next three years compared to what we had prior to the crisis (we have mentioned this point repeatedly over the last 12 months). Consumer credit growth in banks, if the above is true, will also likely be weak. This means an important source of bank income will be weak. Retail banks are therefore likely to generate smaller profits than those generated prior to the crisis. For retail banks, this can only be circumvented if they start lending to consumers in countries where they have lower leverage (i.e. emerging countries. Watch HSBC and Standard Charted).
Government de leveraging is a point currently being discussed with great enthusiasm in the media (i.e. newly described austerity measures). However whether it becomes reality is another issue. Next year we will be in the third year of the US political cycle. Since 1939, this has not been a negative year for equities due to pro election projects that come out of the cupboard. If you believe in history repeating itself...you heard it here first!
This article, however, comes back to a question that often floats around the back of my head: “the economy will not do well until the banks do well”: they are the grease that make the wheels of the economy move. No credit expansion, no economic growth. All indicators I look at do not point to consumer credit increasing: and consumer spending is 70% of the GDP of most developed economies. Wages and asset prices are also not likely to go north (two other pillars your author believes drive consumer spending).
However, one can counter that if financing will be driven by equity, then a lack of credit expansion need not hurt growth. However, equity financing is not generally available to the consumer: it is available to corporates. They may spend in the hope of generating greater profits from increasing market share or investing in developing new products. Equity financing therefore predominantly affects corporate spending. They may affect consumer spending by creating new jobs and increasing wages. However, we are seeing spending increase in emerging markets, where consumers are not leveraged and wages are increasing, as are the number of new middle class consumers. Hence, developed market consumers and workers are not going to be the direct beneficiaries of future corporate spending, should it increase from access to equity financing.
Indeed, should such large corporates remain registered in developed countries, one of the largest beneficiaries will be the government due to growing tax receipts. However, we feel as corporates get larger their power over government increases, and this statement may prove to be frivolous.
Conclusions
1. Regulation is affecting the capital structure of banks, which will affect the pricing of securities in the lower part of that capital structure (common stock and hybrid tier 1 capital). The de leveraging of banks is leading this change
2. We fear the de leveraging of the consumer will be negative for consumer spending and retail bank credit growth. Coupled with a weak labour market, this is also negative for the property market. Sufficiently attractive pricing can always help reverse this trend in an open economy. Retail banks with emerging market exposure can increase lending and eventually help reduce their loan loss provisions (if lend wisely there!)
3. The lack of credit demand from consumers and the lack of credit availability as banks build up core tier 1 capital will not be a positive factor for growth. We do, however, see equity financing help provide the necessary investment power for corporates. This money is likely to be channelled in greater quantities to emerging countries rather than developed countries
4. Stability in bank balance sheets will be a big catalyst for a strong multi year run in equities, especially if markets fall below fair value during the wait. As a reference, for the S&P 500, I see fair value as between 930 – 950. History would suggest the next cycle of price/earning multiple expansion could start within 4 – 6 years. We have now been in a multiple contraction period for 10 years
5. We feel for a small cost insurance options should be considered in the portfolio (up to 5% of the portfolio, to protect against extreme situations). For example, (1)buying put options on a relatively low volatily asset as it has been increasing strongly recently and we feel is expensive. An article by Dylan Grice at Soceite Generale recently suggested using Silver. This takes advantage of its perception as being a “cheap gold”; whilst also being heavily affected by the industrial cycle. One can also do as Seth Klarmen has recently done; (2) by cheap “deeply out of the money” long dated put options on government bonds. This can offer significant returns if long term government bond yields increase greater than say 8%, offering a money making security in a quasi hyperinflation environment. Though the probabilities of such events occurring are perceived as low, their consequences are sufficiently damaging for portfolios that they should not be ignored. This is especially true considering the huge amounts of leverage in the economy and the large policy responses we have seen. Deflation protection is most cheaply offered by holding cash in hand.
6. Though a long term problem, one can never ignore that demographics has a huge role to play on the interest rates of an economy. A large aging population may have played a big role in keeping rates low in Japan. Once these investors start drawing from their capital rather than buying new Japanese government bonds, funding costs could rise as dependence on foreign investors increases. Indeed, increasing oil prices in the 1970s can be interpreted as having occured as the USA became a larger oil importer, allowing foreign oil producers to have sufficient power to create a cartel. Previosly, the USAs lack of foreign dependence on oil simply did not make the cartel stable. These two examples of shifting to foreign dependence for an asset (be it oil or money)can play a big role in the evolution of the pricing of that asset. Your author sees debt in the same manner. Once a company issues debt; its existence becomes dependent on foreigners, people outside the company. Partial control of the company is removed from within the company. Initially, this removal is invisible. As debt increases, this transfer of control becomes more apparent. Until, like a virus, the foreign body controls the entire victom until it has sucked all the goodness it has, and it moves to the next victom. Beware of expensive leveraged companies that promise growth!
Sincerely yours,
Alessandro Sajwani
The resulting news that came from the new Basle III arrangements has over the last two weeks led us to (1) sell perpetuals that trade at more than a years coupon above par and (2) re invest those proceeds into perpetuals that trade below par (which have been rapidly rising to par value due to the volume in this trade of late; case in point is the Prudential 6.5% USD which has risen from mid 80s to mid 90s).
However, the new definitions of core tier 1 capital, which effectively include only retained earnings and equity, are likely to lead banks which do not have sufficient core tier 1 to issue equity. We are wary that a number of rights issues are likely to be announced by a number of banks over the next 6 – 12 months due to this. This is likely to be bad news for the stock prices of these banks (at least temporarily) due to the dilution affect of a rights issue. Though I have not been a holder of bank stocks in my portfolio (I hold only one from early 2010), a number of clients have bought the equity of a number of banks from their home country, due to the strong brand image these enterprises have created in their country of domicile from decades of success and growth. Needless to say, almost all these positions are at a significant loss and I believe there is a strong possibility they will remain so in three years time.
However, this leads us to consider an important point. Your author believes financing cycles switch from being equity to debt based. The 1995 to 2000 asset price increases were fuelled from equity financing. This is most clearly seen by the ever increasing number of IPOs being presented and executed in that period. The asset price increases during 2003 – 2007 was fuelled by debt. We are likely to see the next financing cycle fuelled by equity. This makes good sense when we consider that almost all economic participants are heavily leveraged relative to almost all debt metrics commonly used. I would say the order of highest to lowest leveraged are (1) Financials, (2) Households, (3) Governments, (4) Corporates. So far in the de leveraging process we have seen the most action from financials (examples include the large issuance of bonds, common and preferred shares and the conversion of preferred shares to common shares. The elimination of dividends from common shares and preferred shares and the non calling of similar tier 1 hybrid securities, which were previously assumed to be redeemed on the first call date). It is no accident, they are the most leveraged.
We are likely to see a continuing de leveraging from consumers. This will be most evident from spending decreasing and savings increasing. This is likely to reduce economic growth trends in the next three years compared to what we had prior to the crisis (we have mentioned this point repeatedly over the last 12 months). Consumer credit growth in banks, if the above is true, will also likely be weak. This means an important source of bank income will be weak. Retail banks are therefore likely to generate smaller profits than those generated prior to the crisis. For retail banks, this can only be circumvented if they start lending to consumers in countries where they have lower leverage (i.e. emerging countries. Watch HSBC and Standard Charted).
Government de leveraging is a point currently being discussed with great enthusiasm in the media (i.e. newly described austerity measures). However whether it becomes reality is another issue. Next year we will be in the third year of the US political cycle. Since 1939, this has not been a negative year for equities due to pro election projects that come out of the cupboard. If you believe in history repeating itself...you heard it here first!
This article, however, comes back to a question that often floats around the back of my head: “the economy will not do well until the banks do well”: they are the grease that make the wheels of the economy move. No credit expansion, no economic growth. All indicators I look at do not point to consumer credit increasing: and consumer spending is 70% of the GDP of most developed economies. Wages and asset prices are also not likely to go north (two other pillars your author believes drive consumer spending).
However, one can counter that if financing will be driven by equity, then a lack of credit expansion need not hurt growth. However, equity financing is not generally available to the consumer: it is available to corporates. They may spend in the hope of generating greater profits from increasing market share or investing in developing new products. Equity financing therefore predominantly affects corporate spending. They may affect consumer spending by creating new jobs and increasing wages. However, we are seeing spending increase in emerging markets, where consumers are not leveraged and wages are increasing, as are the number of new middle class consumers. Hence, developed market consumers and workers are not going to be the direct beneficiaries of future corporate spending, should it increase from access to equity financing.
Indeed, should such large corporates remain registered in developed countries, one of the largest beneficiaries will be the government due to growing tax receipts. However, we feel as corporates get larger their power over government increases, and this statement may prove to be frivolous.
Conclusions
1. Regulation is affecting the capital structure of banks, which will affect the pricing of securities in the lower part of that capital structure (common stock and hybrid tier 1 capital). The de leveraging of banks is leading this change
2. We fear the de leveraging of the consumer will be negative for consumer spending and retail bank credit growth. Coupled with a weak labour market, this is also negative for the property market. Sufficiently attractive pricing can always help reverse this trend in an open economy. Retail banks with emerging market exposure can increase lending and eventually help reduce their loan loss provisions (if lend wisely there!)
3. The lack of credit demand from consumers and the lack of credit availability as banks build up core tier 1 capital will not be a positive factor for growth. We do, however, see equity financing help provide the necessary investment power for corporates. This money is likely to be channelled in greater quantities to emerging countries rather than developed countries
4. Stability in bank balance sheets will be a big catalyst for a strong multi year run in equities, especially if markets fall below fair value during the wait. As a reference, for the S&P 500, I see fair value as between 930 – 950. History would suggest the next cycle of price/earning multiple expansion could start within 4 – 6 years. We have now been in a multiple contraction period for 10 years
5. We feel for a small cost insurance options should be considered in the portfolio (up to 5% of the portfolio, to protect against extreme situations). For example, (1)buying put options on a relatively low volatily asset as it has been increasing strongly recently and we feel is expensive. An article by Dylan Grice at Soceite Generale recently suggested using Silver. This takes advantage of its perception as being a “cheap gold”; whilst also being heavily affected by the industrial cycle. One can also do as Seth Klarmen has recently done; (2) by cheap “deeply out of the money” long dated put options on government bonds. This can offer significant returns if long term government bond yields increase greater than say 8%, offering a money making security in a quasi hyperinflation environment. Though the probabilities of such events occurring are perceived as low, their consequences are sufficiently damaging for portfolios that they should not be ignored. This is especially true considering the huge amounts of leverage in the economy and the large policy responses we have seen. Deflation protection is most cheaply offered by holding cash in hand.
6. Though a long term problem, one can never ignore that demographics has a huge role to play on the interest rates of an economy. A large aging population may have played a big role in keeping rates low in Japan. Once these investors start drawing from their capital rather than buying new Japanese government bonds, funding costs could rise as dependence on foreign investors increases. Indeed, increasing oil prices in the 1970s can be interpreted as having occured as the USA became a larger oil importer, allowing foreign oil producers to have sufficient power to create a cartel. Previosly, the USAs lack of foreign dependence on oil simply did not make the cartel stable. These two examples of shifting to foreign dependence for an asset (be it oil or money)can play a big role in the evolution of the pricing of that asset. Your author sees debt in the same manner. Once a company issues debt; its existence becomes dependent on foreigners, people outside the company. Partial control of the company is removed from within the company. Initially, this removal is invisible. As debt increases, this transfer of control becomes more apparent. Until, like a virus, the foreign body controls the entire victom until it has sucked all the goodness it has, and it moves to the next victom. Beware of expensive leveraged companies that promise growth!
Sincerely yours,
Alessandro Sajwani
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