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Monthly Archives: August 2013

An Abundant World is asking in a comment what evidence I have for my claim we’re at a peak in the “low risk” behaviour, aka that we are at or just going past Peak Pessimism.

I was tempted to just answer “gut feeling”, and it’s largely that, but digging around I think I have some facts to back it up to some extent. Note though that it’s of course a biased selection in favour of my argument, and it’s not hard to find some counterfactuals. How they balance is where it’s hard to do any better than gut feeling.

The US investors “rotation” (from bonds to equity)

The argument has been made repeatedly and better than I can by the Reformed Broker who has close contact with key constituencies like his clients (high net worth individuals) and industry insiders. This also seems consistent with the general background noise in US-centric media.

Corporate deleveraging is (mostly) over

One great advantage of doing stock picking is that it forces you to be in touch with how businesses are doing on the ground — if through the rose tinted glasses of management reports. My view is somewhat biased because I’m primarily looking at UK-listed corporations. So this is subject to a “London view” bias, even if I select primarily companies with a world or at least European presence. This limitation notwithstanding, I have observed that the sharp change of mood in 2008-2009 from “leverage is good” to “we have too much debt” has essentially run its course. This seems equally true in the relatively few non-UK large caps I look at. The U-turn was sharp and violent — and with everybody doing it at the same time, it’s no surprise there’s been a world recession — but now it seems to me that most companies (which could afford it) have reasonable balance sheets, and more importantly now debt is at reasonable levels (or below reasonable if you’d put it in an a mathematical optimisation framework, for tax reasons if nothing else) management seem to have switched their mindsets from “reduce debt” to “keep it under control”, which is just a notch away from proactive optimism-driven investing.

Bubble virgins

That idea came to me from an article in Handelsblatt about German youth’s (people in their twenties) preferred savings vehicle being the plain bank savings account (which as we all know pays inflation at best, if you chase special deals). This made me realise that there’s a whole generation that has grown up without participating in any sizeable financial craze. The last properly bubbly event on the financial markets was the dot com/tech bubble, which is a good decade ago now. Outside Germany, this younger generation has seen a property bubble in many countries, but mostly as spectators, and it should be easy to sell them that non-property asset classes are different. I think this is a great tail wind for any potential financial asset/sector bubble. It would be a great surprise that this generation doesn’t get to take their turn at the “this time is different” game, like every one previous.

The nominal yield effect

While this is really just an iteration of the money illusion, lot of people are enamoured with the idea that bond (risk free) yields “have to go up”, just because the nominal yields are lower than average they’ve seen during their (investing) lifetime — conveniently, outside Japan you can pick any period and it works to some degree or other whatever backward looking period you choose. This is another push towards “high risk” assets, just to escape the expected “reversal to mean” in “risk free”. This view is based primarily on nominal optics (good luck trying to extract a fact-based narrative from these people) and as such a background force away from anything “risk free”. Being a nominal effect it’s also immune to fundamental changes: it applies regardless of changes in any fact-based scenarios on rates paths.

The 3/5 year rear view mirror effect

Many financial tools, and most forms of historical performance assessment exercises are by convention based on looking at 3 to 5 year time periods, or shorter. This means that the 2009 trough will soon drop from the charts and all people will be seeing is a perennially up trending market, with the odd gentle correction to avoid frightening those who, rightly, would run away from exponential growth.

Troll fatigue

That’s the simple observation that inflationistas, gold bugs and other survivalists are getting increasingly unable to justify why Armageddon is taking so long to happen. Enough defections at the margin, of the less vocal followers, is a great push towards less risk free investing.

Small anecdotal fun “evidence” here: Zero Hedge is going out of fashion apparently.

Structural reforms work slowly

This is perhaps most relevant to the Eurozone: the main problem with structural reforms as a policy tool is that they work very slowly and they often make things worse first. For example on core/peripheral wages convergence we’re probably 2/3 done, but it took 5 years to get there. Export-centric policies are disastrous in the short term when everybody tries concurrently, but once it starts taking effect and there’s a bit of external demand (e.g. US/Japan/Core demand for peripheral Europe) the operational leverage is great. This also relevant to the US where the sequester is essentially a supply side structural reform in its effects.

Conclusion: it’s windy here

Many other things could go wrong, and I’m not clear about what’s happening in China and Emerging Markets, though there as well lot of negative views have limited potential to get much worse. There always can be exogenous disasters, but I think we do have a fair few tail winds pointing to animal spirits going back into positive territory, in the “next several years” kind of time frame — I’m not trying to predict what will happens this Christmas here.

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A common theme among value or fundamental investors is that stocks should have a “margin of safety”, so as not to lose all their value, go bankrupt or be restructured, when they encounter difficulties. This is solid common sense, yet has no obvious rational reason to be true.

Like any quality, or defect, an investment might have, it’s possible to discount that advantage or defect, and market forces should tend to. In a perfectly efficient market every investment returns the same in risk adjusted terms.

Photo of dice

Expected value? (credit: Toshiyuki IMAI)

In a simple example, which portfolio would one choose between a basket of stocks who have a binary outcome of their value tripling or going to zero, with balanced odds (half fail and half succeed) and a portfolio of stocks where half stay flat, and half grow by 20%; or equivalently are distributed within that range. For a portfolio large enough we get returns (expected value):

  • risky portfolio: 50% (1.5 = 3 * 0.5 + 0 * 0.5)
  • sedate portfolio: 10% (1.1 = 1.2 * 0.5 + 1.0 * 0.5)

Anyone should pick the risky portfolio. Through diversification, we can re-introduce the “margin of safety” to the portfolio as a whole, however risky the individual items. All that matters is the pricing relative to expected value of each investment, as long as the risk is individual (idiosyncratic and not correlated).

Of course in practice it seems to turn out — this is an expression of the low volatility anomaly — that the price of risky investment seems to be higher than the rational expected value. Hence the “margin of safety” rule of thumb being usually a good one to follow.

Good rule, wrong story, I would say. It is very much like folk wisdom often is.

It just captures the low volatility anomaly with an inaccurately simplistic story, which could be detrimental if low volatility became expensive, or when risky investments with little margin of safety are genuinely, if unusually, good value in probabilistic terms.

Obliquity London: Reckitt out, Park Plaza Europe in

In the main Obliquity London portfolio, I’ve finally got rid of Reckitt Benckiser, who have some more dubious practices in their pharmaceutical arm, and have provisioned for fines. The timing was not very good as it was after a rejection by US regulators of their attempt to ban generic suboxone was announced — although the authorities were totally right, the company’s argument about “child protection” was ludicrous.

I’ve replaced it with PPHE Hotels, a middling “affordable luxury” hotel group operating in Europe, that trades at a discount to NAV and seems well run. In addition to give a bit of a value tilt, it passes all the regular portfolio criteria, except for being closely held by the founder and his associates. It’s also listed offshore, hence I guess a greater risk of delisting or mismanagement. The discount seems more than compensating for that,  and even a modest re-rating would make it perform handsomely. During selection I looked at Intercontinental Hotel Group, which seemed so many multiples off, on a thin equity layer, that I ran away at once — maybe I missed something.

Mondi reduced

Mondi, the cardboard packaging manufacturer, which has been plodding along very nicely, was trimmed on hitting weight limits (+50% above reference weight).

Obliquity Stamp Collection: LEDs and Crete

The stamp collection sees a couple of new more racy than usual additions.

Photonstar LED is a (very) small cap with a nice product set: both finished LED lighting products, and core modules for inclusion in others’ products, that seems ripe to grow after years of disappointment. As an investment it has been a disaster for existing shareholders (IPO in 2007…), and the principals are generous with awarding themselves shares and options and diluting shareholders, but by now the exercise price of most of the stock of unexercised options is mostly (well) above the current price, and they seem like people who will want to realise and will need a solid share price once (if) the product takes off.

Besides by now the company is priced for plodding along at the current level of turnover, while I think there’s a fair chance the products catch on, on a larger scale, either alone or perhaps they could be bought out as part of a larger group without capability in this segment. This thus has the potential for a multiple time increase if it does take off. It’s also a story stock which could always see a new wave of speculative buying (from new investors not previously burned, presumably) even if it doesn’t. Or we could get both at the same time (speculative spike on top of real success). Seems worth the risk they may fail trying — breaking the “survival” criteria for a big discount.

Another blue sky punt is Minoan, who have perennially tried to develop a large holiday resort in Crete. As a consequence of the Greek crisis, it seems it could eventually work out as the local authorities are keen to lighten up the bureaucracy and getting things to move. The management seem optimistic, but they probably been ever since and they could always cock it up even in an auspicious environment. But it’s a nice way to have a small exposure to Greek recovery — which is hard to get in listed markets — despite the many chances it goes nowhere. Like Photonstar, it’s priced not much above the value of existing operations (an attached travel agency business which is small compared to the Crete project should it work out) so there’s some padding on the way down.

Both of these positions are small enough that they can go to zero without causing much damage, and I’m happy to give them time to go somewhere, or nowhere, and hopefully they are discounted enough to compensate from the usual blue sky lottery ticket curse.