Saturday, December 29, 2012

UK Government's Share of GDP

Ever wondered what the UK Government share of GDP spending was?

Well here it is.

And it doesn't make pretty reading. The truth is that New Labour managed to orchestrate the double whammy of increasing social tension at the same time as increasing public spending. In addition I would argue that- in many cases- the latter engenders the former.

It is a sad state of affairs when the argument is always framed to the contrary. In other words that there is a natural 'trade-off' between increasing social cohesion by spending more public money and vice versa.

It strikes me that it's time for the Left to start discussing public spending proposals that are not propelled by an ideological conviction that more spending equates to a better society or that it can equalise income disaparity by doing it. No one tried harder- or with a greater sense of moral purpose- than Gordon Brown and look at the result?

It's also time for the Right to stop pretending that we live in a meritocracy and that public spending is some sort of cancer that its more privilieged members can find a way to avoid. All economies need public spending but it isn't to be viewed as a bone to try and placate the masses or as part of some middle class racket.

The result of continuing this nonsense is a disparate society in which a welfare state dependency culture is created alongside a detached uber wealthy enjoying the fruits of their 'meritocratically' earned work.

The greatest case for capitalism is that it creates real opportunities for social mobility and the advancement of civilisation. It's time to remember this.

Tuesday, December 18, 2012

What Investors Can Learn By Playing Poker

I’m a great believer in the idea that much of investing is actually about keeping the right mental approach. That’s partly why I write these articles. It’s always a good idea to crystallize some of your investments and rationale by writing them down. In this way, you can objectively analyze what you are doing. Another way to make sure you are on the right track is to understand an analogy with another popular activity, so you can anchor to some solid truths contained within it. I’d argue that good poker players have much to teach investors, and here is why.

Fold Weak Hands/Don’t Buy Everything You Research

Any decent Texas Hold’em player will tell you that you should probably fold over 90% of your hands at the pre-flop stage. Investors should take the same approach with the stocks that they research. It can be interminably frustrating sitting hour after hour waiting for a decent hand, but sometimes it just works out like that. Don’t play with rubbish, it will only hurt you in the end.

It’s exactly the same with stocks. Let’s put it this way. If Warren Buffett told you only to buy a stock if you were willing to hold for 20 years than this doesn’t imply much turnover does it? It certainly tells you that you should be rejecting nearly everything you look at. Unfortunately many private investors fall in love with much of what they research. In addition, many journalists love ‘making a splash’ by constantly and confidently advocating buying stocks willy nilly. My suggestion would be to look at the disclosure section below the article. I don’t take anyone seriously unless they have skin in the game. That would be like taking earnest poker advice from a guy who only plays for play money on Google+.

Play Strong Hands Early/Balk With Too Much Action Later

This is not gospel, but in general if you are dealt a high pair in Hold’em you should play it aggressively early on. However, if there is too much action later with raising and re-raising later (and your pair hasn’t hit anything) you should strongly consider folding and walking away. In my humble opinion, the mental approach with investing is much like this. A good example can be made when investors find a sector that they find favorable (a high pair) with which they should try to then be overweight. Hit home when you have the advantage.

Now consider what happens when the price of investing gets higher (stock price rises/other players raise); the correct thing to do is to stick to what you think is value. I’ve been very vocal throughout this year on the rationale for a US housing recovery. However, I recently took profits on Beacon Roofing Supply (NASDAQ: BECN) because it hit my target price. I like the company and hit home when I thought it was value but sold when the risk/reward calculation was no longer as favorable for me (Original article on Beacon linked here). Similarly, investors in house builder Lennar Corp (NYSE: LEN) will be entitled to start taking some money off the table after its 80%+ rise this year. Even if you still like the company and sector, any stock that has this rise is likely to be a much larger part of your portfolio and thus increases the risk from any one stock.

Be Greedy When Others Are Fearful and Fearful When Others Are Greedy

Ok, I am going to quit with the Buffett quotes now. I just happen to think it’s a great way to express another key analogy with poker and investing. With poker, when the table goes on ‘tilt’ most good players suggest starting to play tighter and not bluffing because your opponents will be playing all sorts of drawing hands that can bury you in late play. It’s the opposite situation when everyone is being tight on the table. You can afford to bluff a little and play a little looser.

In investing terms, when the market is piling into stocks on high evaluations then it is time to walk away. I have no idea how anyone could rationally argue that Microsoft (NASDAQ: MSFT) was value on 60-80x earnings.

MSFT PE Ratio TTM data by YCharts

Similarly, when Facebook (NASDAQ: FB) went public there were many people who thought it was value even as it valued every Facebook user at over $100 each.  No stone was left unturned in talking about this company, and the ludicrous attempts to link every single global event to Facebook by the media became ever more risible. For example, the idea that the Egyptian revolution was inspired by a Facebook page is promptly dismissed by a cursory look at the facts. According to the International Telecommunications Union (ITU), Egypt’s Internet penetration rate was only 24% in 2009.

Performance Measurement and Money Management

I’m going to conclude with the two most important analogies.

The first is money management. All poker players need to remember is that position sizing is critical because outcomes are uncertain. It is exactly the same thing with investing. A lack of diversification or over-reliance on one stock or sector can be crushing to an investor, and the investment world is littered with ‘one trick ponies’ that shone brightly then collapsed in future years.

Finally, any decent poker player will be able to tell you what he has earned and his strengths and weaknesses. It is a constant effort to calibrate and try to understand what has happened and why.  Investors need to do exactly the same thing. It is no good trying to fool yourself that you had a good year and losses will be made up, etc. Subjectivity has little to do with it. Most serious investors will know exactly what they are making and at what time while positing a reason why.

And, again, that is part if my point in writing these articles!

Friday, December 14, 2012

Who Told Celebrities They Could Do Science?

One of the most disturbing trends of modern times is the inexorable rise of the tendency for large swathes of the population to substitute proper scientific research in favor of “celebrity science.” Well I apologize, but I prefer to get my medical advice on things like GM foods from the FDA and not from, say, a guest on a chat show or a former swing dancer cum yogic flyer who self publishes books and now thinks he is the world’s authority on the issue.  I’m not sure if my approach is the one taken by the majority anymore.

I’m going to discuss a couple of examples here. It’s time to stand up for the scientists. The real ones, not the idiots.

It’s so much easier for people to listen to a celebrity when they are articulating their expertise on medical matters. Indeed, Time magazine has cited research that claims that 24% of parents place “some trust” in medical information given by celebrities.

The MMR Vaccine and Autism, What the Scientists Said

The most infamous case in modern times is the claim that there was a link between the MMR vaccine (measles, mumps and rubella) and autism. Indeed, anti-MMR litigation was directed at companies that manufacture the vaccine. Current manufactures include GlaxoSmithKline (NYSE: GSK), Sanofi (NYSE: SNY) and Merck (NYSE: MRK). Who speaks up for these companies when they are subject to this sort of nonsense in the media?

The original report on which much of the MMR/Autism claim is made was published in the The Lancet in 1998 by Andrew Wakefield. The report has subsequently been denounced as a fraud by the British Medical Journal and has received widespread condemnation in the scientific community.

In case anyone is in any lingering doubt as to the validity of the claim, the following bodies have found no link between the MMR vaccine and autism.

  • Centers for Disease Control and Prevention
  • The National Health Service in the UK
  • Institute of Medicine (IOM)
  • World Health Organization
  • New Scientist Magazine

In addition the FDA reported on the subject  and discussed the final report of the IOM’s Immunization Safety Review Committee in 2004

“ body of evidence favors rejection of a causal relationship between thimerosal-containing vaccines and autism, and that hypotheses generated to date concerning a biological mechanism for such causality are theoretical only…  …the benefits of vaccination are proven… … widespread rejection of vaccines would lead to increases in incidences of serious infectious diseases”

So this is what the scientists said but they don’t always get listened too, according to a report  until relatively recently “one in four Americans” still thinks that vaccines cause autism.  Why?

What the Celebrities Said

There is no higher profile celebrity expert on autism than Jenny McCarthy and indeed her status on the issue has been raised by appearances on chat shows like Oprah Winfrey and Larry King where she has been on record as believing that vaccines caused her son’s autism. She is not alone as other television and radio presenters have also reiterated these claims.

Indeed media coverage of the Wakefield research caused widespread fear and declining rates of vaccinations with the inevitable disease outbreaks occurring afterwards. Of course the overwhelming scientific evidence (or rather the lack of scientific evidence) is presented to these people, but nothing works. Everything seems to be subservient to homespun anecdotal evidence which is given widespread credibility for no other reason than they saw it on television spoken from the mouth of a celebrity. As another celebrity and great philosopher, Marina & The Diamonds, correctly once wrote “TV taught me how to feel, now real life has no appeal”.

It’s not just celebrities and the media that were at fault here. The Wakefield research was always highly questionable and even after it was widely discredited and evidence came to light that made the Anti-MMR litigation case in the UK untenable, the lawyers still displayed their usual tendency to make money irrespective of the situation. According to an interview with Dr. Michael Fitzpatrick, the lawyers who lead the campaign

“refused to acknowledge openly that the scientific case against the MMR-autism link was overwhelming and advise their clients to conclude the action. Instead, they continued to pursue the case, allowing it to drag on for a small number of families, acting without legal aid funding, for a further three years.”

In addition Fitzpatrick claimed that £8m of the £15m ($23m) in legal aid funding used up in this case went to the solicitors. A further £1.7m went to the barristers and expert witnesses took up £4.3m.



This sad tale of misinformation which was promulgated by self-appointed celebrity experts, fraudsters, self-interested parties and lawyers would be an interesting footnote in history if it was an isolated case. Unfortunately there seems to no end this hogwash. The latest media friendly scare stories-backed up by flimsy “science”- seem to surround genetically modified crops and companies like Monsanto and Syngenta.

I’m certainly not arguing that these companies shouldn’t be subject to scrutiny, but what I am saying is that any criticism of them should be based on the body of scientific evidence rather than listening to chat show ‘experts’, celebrities whose usual response to the overwhelming evidence against their case is simply to find another chat show.

If I want to know about scientific facts I listen to a scientist.

Tuesday, December 4, 2012

Private Investors Outperforming Professionals?

At some point in his/her investing life, every private investor is faced with the same question: Does he actually add value by investing himself or not?  I suspect the most common response is to ignore the question safe in the notion that it’s just a bit of fun on the sideline. Another is to avoid the complication of benchmarking performance and just be happy that the account is positive. However, for full time investors, the issue simply cannot be avoided.

Discerning readers will note that I specifically reference private investors here. The reason is that professional investors are not that as exposed in how they earn money (fees, etc.) to the vagaries of performance. Private investors lose money when performance is negative. Do money managers refund fees?

Why Professionals Aren’t Trying to Outperform

It gets worse: The investment industry has learned a fundamental truth of behavioral finance and constantly applies it. I’m talking about the tendency of investors to psychologically weight a loss double that of a gain.

Asset managers understand this because they realize that investors will overweight a losing performance versus a winning one. In other words, if an asset manager underperforms for a client his downside risk (losing assets under management) is far greater than the upside from outperforming. Now you know why the investment industry produces such ‘samey’ benchmark-hugging performance. It’s in their interests to do so.

If there was a difference between what, say, T Rowe Price (NASDAQ: TROW) and Ameriprise Financial (NYSE: AMP) did, surely it would show up in marked differences in share price performance?

AMP data by YCharts

And investors in these companies should understand that they are just making a highly correlated bet on the markets by buying them.

A Waste of Talent

I'm not saying there aren’t a lot of talented people in the investment industry. There are, and in their ‘defense’ I should point out that it is hard to outperform when you are not really trying to do so! While this may be disheartening for the young investment professional anxious to prove himself by generating performance, he is soon overwhelmed by the pressure to conform to the industry game of focusing on getting assets under management (AUM) and not particularly bothering about performance.

Remember folks, given the same performance fee, an asset manager generating 5% with $1 billion AUM earns more than a guy generating 12% with $400 million. Who would you rather be? Also consider that during a down year the whole industry will suffer. As none of the major firms with AUM will deviate from each other’s performance they will all make the same excuses and try and hang onto AUM as best they can.

Some of these clowns even try to sell you their services without a track record. If I want my car window replacement, I go to someone who does it every day and is tried and tested at doing it. Alternatively, if I want my money invested, should I go and give it someone who won’t even tell me how good he is at what I am paying him to do?

Confidence is the Key

Turning back to the challenge for private investors confidence only really resonates with someone if it is accompanied by extensive experience. It is something hard won but easily lost. I’ve outperformed the market for years and across different market conditions. No matter. When I have a couple of months of underperformance, I start to stress. I’m the worst investor ever, this is all a waste of time, I am losing money. My hard earned money.

The usual ‘confidence boosting’ supporting arguments kick in. Historically, you lose money 4/12 months a year so it’s just random that two are next to each other. Look at the long term chart, you had blips before. You outperformed for over 10 years so what is two months in the scheme of things? It’s all good stuff but the truth of it only rings true when you get back to a profitable month. It is a stressful game.

Private Investors Edge

So, when under this stress, why exactly should private investors feel they can outperform? Why should they feel they can add value when all the empirical evidence suggests that fund managers don’t do so?

The answer lies in the fact that private investors are actually trying to outperform rather than mimic a benchmark. They don’t have to diversify away returns by constant adherence to sector weightings in the benchmark indices. In addition they are not obliged to be in the market just because they are trying to generate a buck in management fees. Private investors have far more flexibility.

For example take a stock like General Electric (NYSE: GE), which is going to see its prospects correlated with global GDP growth. Here is how the market priced it in 2000:

GE PE Ratio TTM data by YCharts

The good news is private investors don’t have to pay 50x earnings, while professional investors have to hold it. Another example is Google (NASDAQ: GOOG), of which we can see revenue growth here.

GOOG Revenue Quarterly YoY Growth data by YCharts

It is in a nice uptrend since the recessionary dip, and even with the transition to mobile and tablet Internet usage, Google still has a dominant position in search. However, every fund manager this year was forced to listen to the hoopla and hype surrounding Facebook (NASDAQ: FB) just because one part of the investment industry wanted to sell something to another part of the industry. However, amidst all this, very few people actually pointed out that Facebook had no articulated plan for mobile at the time of the IPO. No matter institutional investors were obliged to pick some up due to benchmark weighting issues. Private investors could avoid it altogether. Meanwhile Google goes on churning out revenue growth.

The Bottom Line

In conclusion, I think there are a whole bunch of reasons why hard working private investors can outperform professionals. It’s a stressful process, but then again it is a whole lot more stressful to look back on 10 years of miserable returns for you and then add up what your investment advisor has made out of this process. Despite the puff that the investment industry churns out, private investors are better placed to generate alpha. The real issue is having the confidence to keep doing it. Hopefully reading and participating in this sort of online forum will help!

Friday, November 30, 2012

Are Rating Agencies Pointless?

The ratings agencies have had their reputations damaged in recent years and I confess I have a certain amount of sympathy for them. They get pilloried and lambasted by the finance industry who has found someone to conveniently blame for their idiotic investment decisions during the sub-prime debacle. On the other hand, they get little credit when their work turns out to be accurate.  Every profitable investment decision is, of course, the sole creation of the investment professional looking at it. Let me be clear, I am not saying they didn’t make mistakes, they did, but they are not responsible for pushing buttons at trading desks.

With that said I thought it would be interesting to look back at what stocks Standard & Poor’s had on positive and negative outlook and see how they performed in terms of stock performance. I know they are analyzing the debt situation so they really should be judged on that basis but, like I said, this is a bit of fun.

The Results are in!

I went back to the start of the year to see what S&P had on positive and negative outlook and then tabulated performance. I’ve tried to be fair and pick a random sample of 16 stocks each and matched them up in terms of sector.

Unfortunately the ‘negative outlook’ stocks have outperformed the ‘positive outlook’ stocks although both underperformed the S&P 500 which is up 13.2% in the comparable period. This doesn’t speak volumes for using S&P ratings to pick stocks!. I happen to think that it is a useful analysis because bond outlooks usually reflect the same factors that equities do.

Now before readers start preparing hate letters to Standard & Poor’s, I want to discuss some of the stocks here and give some opinions as to what is going on.

Negative Outlooks

Frankly I can understand the call on R.R. Donnelley (NASDAQ: RRD). The stock's debt dwarfs the market cap and there is little growth in the business whilst plenty of downside risk. Printing always will be a highly cyclical activity. When the going is good the presses are rolling but when it’s bad the printers are lumbered with underutilized capacity. Moreover there is a huge secular challenge for traditional printers as more and more media moves online. It’s hard to see what it can do about it. The yield is huge but will it be paid?

I can understand the negative call on United Technologies (probably due to defense cutbacks) but Abbott Labs is quite puzzling, it’s one of the stronger health care names out there.  Elsewhere, I was surprised to see Walgreen (NYSE: WAG) on negative outlook. Okay nobody liked the Express Scripts deal but its debt is not huge in relation to its cash flow and the business is not going bust anytime soon. Despite believing that it will be tough to get back as many customers as it hopes, I think the stock is cheap and the sector has plenty of upside catalysts.

Positive Outlooks

I don’t get the positive call on Advanced Micro Devices (NYSE: AMD). This is a business with declining earnings and revenues which is a distant second to Intel in many markets. In addition the semiconductor market is cyclical and while most industry commentators were predicting an upturn this year (which didn’t happen) this is not an industry with a huge amount of earnings visibility and AMD is not even a strong player in it.

I like Roper Industries (NYSE: ROP) and think it deserves a positive outlook. The company is acquisitive and in consequence usually has some debt, but it is seeing gross margin expansion in its mix of niche markets. Cash flow generation is very strong and it is a leading player on all of its end markets.  Margins are high and return on equity is usually good so this is not a business that typically has high maintenance capex requirements.

Coca-Cola and United Health Group were good judgments but I think the call on Oracle (NASDAQ: ORCL) was a good one that might not have resonated with many at the time. The company has a significant amount of cash on the balance sheet, but going into the New Year it had given a nasty trading statement and was faced with the obvious need to make acquisitions to buy itself into the cloud space and fight back against SAP. It wasn’t obvious in January that Oracle would have such a good year and S&P deserves some credit.

The Bottom Line

Overall this analysis did not produce a good performance and it suggests that S&P are no better than most at predicting end markets. Don't rely on the ratings agencies to make your investment decisions!

The other point that keeps going through my head is that it is fine to value an asset, but in the end it is the underlying direction in the trend of that asset that truly matters. Investors may think it is all a matter of just buying low valuations and selling high, but actually they need to be aware of the basis on which that valuation lies. For example, Spain and Ireland used to think they had solid debt situations and strong banking sectors thanks to their booming housing markets. Enough said.

Thursday, November 29, 2012

Why the Oil Boom is Over

Long term investors make long term decisions and none should have longer time frames than those in the commodity markets. In this article I want to focus on energy and look at some of the developing trends within the oil market. Essentially, if you are going to buy an oil related company, you are betting on oil prices.

Oil Demand Varies With Pricing

One of the biggest and most pervasive of myths surrounding oil demand is that somehow it is price inelastic. In other words no matter how much the price goes up the demand will remain the same. This idea is simply not true and here is the evidence to prove it.

Note that European oil demand has fallen in recent years and is currently significantly below where it was 17 years ago. The situation is not quite the same in the Americas, but if we break out North America from the number its demand is running pretty close to 2000 levels.

The bulls would have you believe that this is merely a reflection of the ongoing shift in manufacturing production to the Far East, and investors should focus on overall demand. There is some truth in this, but I don’t think it is reflective of the big picture. Nor does it explain the fact that growth has been good in the US and Europe over the last 17 years, and if you add forecast demand in the US and Europe for 2013 it is only 6% above what it was in 1996. This does not suggest that demand is inelastic.

The evidence is that China in particular has seen a rapid escalation in demand in line with its strong economic growth. This fact is even more relevant when we understand how inefficiently China has been using energy.

Here is a graph of the composition of growth in oil demand.

There are some fascinating developments here. First, note how strong Asia/Pacific has been; but as the first chart demonstrated, things are somewhat tailing off. Second, Europe has really managed to reduce oil demand in face of high prices. Third, the Middle East and former Soviet Union have started to be large contributors to demand growth in recent years.

The third point is the key to understanding the dynamics. The growth in demand has been greatest in the regions that subsidize oil prices. Asia/Pacific and the US are also contributors to this trend because, they too, subsidize oil, but few places in the world pay less for gasoline then the Middle East or the former Soviet Union.

The lesson is clear. Demand is not price inelastic, and if you subsidize it more oil will be used.

Road Hogs

There is no more emotive topic in energy usage than that of gasoline. It makes up over 25% of global oil demand and the statistics are simply amazing with regards to who uses what.

You can draw your own conclusions here, but I think the idea that the US necessarily has to use 4.2x as much gasoline as the whole of Western Europe is not a tenable one. As for blaming China gasoline demand for high oil prices, this graph says otherwise.

Where Next With Oil?

I can’t make this anything more than a cursory analysis that tries to highlight the key points.  I haven’t gotten into the supply side or the geopolitics of many of the suppliers (oil is overwhelmingly produced by the Government sector) but increasingly we are seeing developments like shale gas or LNG, which suggests that oil is not that critical an energy demand resource as many previously thought it was. Throw in productivity enhancements (fuel efficient engines, solar powered cars etc.) and demand can be reduced.

If you are going to invest long term in a Chevron (NYSE: CVX) or an Exxon Mobil (NYSE: XOM) you need to appreciate that their evaluations will be based on the long term value in their proven and probable reserves. The price of this depends on the continued willingness of governments to subsidize oil demand (particularly gasoline) and/or to allow for the growth of alternative energy sources. For example the country that is believed to have the largest shale gas reserves in Europe (France) appears to be the most reticent to allow fracking, yet the President claims to be ‘pro-growth.’ Plus ca change?

On the other hand, China is doing anything it can to maintain growth but move away from gasoline usage. This is not great news for a company like Harley Davidson (NYSE: HOG), which would dearly love to make significant inroads into China. Instead I think Harley should look at the second chart and go for growth in the Middle East (the brand is loved there) and other emerging parts of the world.

Just as oil exploration companies would suffer if there were political changes, so would oil services companies. Therefore any investment in oil services company Halliburton (NYSE: HAL) might not quite see as favorable an outcome as when Dick Cheney was in office.  If you are buying an oil services company you are usually making an investment in a company with a high correlation to spot prices.

Where Next Without Oil?

In my opinion, the next decade for oil prices will not be as favorable as the last. Shale gas has changed the way people think and it’s time for the US and others to gradually wean its populace of gasoline subsidies. Moreover, the Chinese look set to become more energy efficient in the future and may well revolutionize the way the world thinks about electric cars powered by LED based systems.

Not only are the Chinese investing in electric cars but also in high speed railways. It is not often that Warren Buffett is cited as a growth visionary but I think he was right to buy Burlington Northern. Obama has been somewhat thwarted in his pursuit of extensive high speed rail lines, but the free market has been voting for rail. For example, FedEx (NYSE: FDX) was very clear recently that its customers are prefer using slower, cheaper (non express) delivery methods at the moment. This inevitably involves using more railways and fewer airplanes. This is not a disaster for FedEx but it will have to reorganize its investment priorities.

Perhaps it’s time for the US consumer to do something similar and start traveling inter-city by train rather than by car or plane? That is one way to reduce gasoline demand.

Friday, September 14, 2012

Its Time to Buy Blue Chip Stocks

If, like me, your eyes glaze over with boredom every time one of the financial media channels wheels out Jeremy Siegel in order to argue that equities look cheap relative to bonds, you would be entitled to view the following article with great circumspection. Yes, stocks do look inordinately cheap on a relative basis but no, that is not my point. The aim of this article is to demonstrate that stock prices and evaluations really are moved around by sentiment rather than any strict adherence to relative evaluations.

The Equity Risk Premium

I’ll start this tortuous discourse by looking at a long term chart of the equity risk premium as defined by comparing E/P (for the S&P 500) versus long term interest rates (US 10 year treasuries).

A few things are immediately apparent. Equities certainly look relatively cheap right now but then they spent a large part of the 50’s looking even cheaper. Similarly, there is a long period in the 70’s where equities looked cheap. There is also a remarkable period from 1980-2000 where this relationship holds in sync. In fact I am going to contend that it was this period that contributed so much to the structure of the financial crisis.

What happened from 1980 to 2000?

In order to demonstrate this relationship between equity evaluations and interest rates, I am going to perform a regression analysis on the data. Now, hold on, before you run off! It’s not really that complicated.

Essentially, it is just a way of measuring correlation (or rather R^2) between two data series. Simply speaking, the closer the R^2 gets to 1, the closer the two data series move with each other. Here is what happened between 1980 and 2000.

The x-axis is the interest rate and the y-axis is the E/P ratio. Note that the R^2 is remarkably high here.  In addition the best fit equation is suggesting that if long term interest rates are say at 5% the correct E/P ratio should be .9894*5-1.6431=3.3 and the P/E is then likely to be 30.

Granted some of this data is skewed by the nutty period in the late 90’s but nevertheless the relationship is quite accurate over those 20 years.

A graphical depiction of those 20 years here.

This wasn’t just a chart; it was a way of life. A 20 year bull market in which any objector was swept aside in the rush to get long. Not only were they swept aside, but the guys who took on the most risk were the ones rewarded the most. There are a lot of heroes in bull markets.

Unfortunately, this is likely to have caused a concentration of uni-directional ‘punters’ who don’t really understand risk at the higher echelons of the financial services industry. And, boy, did the financial services industry do its best to prove this theory right!

What About From 2000 to Now?

I chose the phrase ‘uni-directional’ carefully, in order to express that this is not just about someone who wants to be long only equities. That game went out of fashion in 2000, as we can see from a chart of the equity risk premium during the period.

Equities start off the decade being expensive, then the crash comes and they are historical cheap from '04-'08. The recent recession definitely wasn’t caused by equity overvaluations, but it was caused by the self same people who had been promoted in the 20 year bull market. They took their ‘skills’ and knowledge of risk and applied them to the next investment fad, in other words housing. The truth is that no one wanted equities post the dot-com crash and everyone wanted commodities, China and housing. Some of that has changed now.

However, the key point for this article is that the relationship between bonds and equities did break down in this period, and it is a fallacy to regard this relationship as something inevitably mean reverting. In addition, the equities that did outperform in this period were small caps rather than large caps.

Where to Next?

Having established that the bonds/equities relationship is nothing set in stone and really a ‘marker’ of investor sentiment and asset class preference, I am now going to argue that good old fashioned blue chip equities could be the way forward!

Purely by way of example here are some current PE ratios and dividend yields for some of the largest cap stocks in the US.

Now if investors can take a long term view then these sorts of stocks look like good value right now. You don’t even have to rely on the equity risk premium to justify these valuations. Wal-Mart $WMT is likely to have its long term growth rate align with the US economy. Coca-Cola $KO arguably has good long term growth prospects within emerging markets and people won’t stop drinking soda anytime soon.  The market may fret over the patent cliff and future reimbursement issues but Pfizer $PFElooks like good value and has a few very exciting drugs in its pipeline.

Another company experiencing short term worries recently is McDonald’s $MCD as the market concerns itself with its European exposure. So what? In the long term the company has a great brand and lifestyle changes (single parent families, trading down etc) are favoring it.  Everyone hates the banks –me included- but as we’ve seen the politicians bend over backwards to keep these guys afloat, perhaps it’s better to look at JPMorgan $JPM and conclude it will get over its short term trading difficulties?

Over the last decade or so we’ve had an emerging market bond bubble, a gold boom, localized housing booms all over the world, small caps outperforming, a commodities boom, a boom in leverage etc. In other words, investors have wanted anything but large cap equities.

Perhaps it’s time for blue chips to make a comeback in sentiment? And if they do, it will be sentiment rather than anything that Jeremy Siegel and the equity risk premium enthusiasts tell you about it.

Monday, September 10, 2012

How to Diversify Your Portfolio

Very few professional investors would advocate a portfolio of equities without insisting diversification. It is certainly a worthy aim, but what is puzzling is that so few seem to understand it or at least make the effort to think in non-conventional terms about. In my humble opinion the conventional and consensus opinion on the subject is plain wrong and investors with even a rudimentary understanding of the underlying issues can better generate diversified portfolios.

In this article I will briefly focus on two ideas.  The first is the concept of beta (derived from the modern portfolio theory beloved of unintentional index hugging fund managers) and the second relates to mechanical based investment systems. In turn, I’ll share a few thoughts on what investors might do to better achieve diversification.

Beta in Investing

The concept of beta is wonderful in principle. Theoretically all an investor has to do is put together a portfolio of stocks whose average beta works out to one and he/she has a portfolio thaqt approximates market risk.  Bingo he is diversified! Furthermore, when he wants more risk, he just buys more stocks with a beta more than one. When he wants less, he just buys stocks with the opposite property.

Unfortunately, it is not that easy. Beta is- by definition- based on historical data. It tells you what was a high or low beta across previous market conditions. I’m not saying that this isn’t useful. It is. If market conditions are the same going forward then the concept of beta is highly applicable. Alas, markets are not that compliant.

In the last 20 years or so, we have been through a technology boom, a housing market boom, a banking boom, a commodities boom, a banking bust, a housing market bust, a boom in emerging market bonds, boom in Gold, a China housing boom and so it goes on. The fact is that market conditions constantly change and deluding yourself that you can obviate the necessity to think about how macro-conditions are evolving by just relying on some backward looking data like beta, is a recipe for trouble.

Consider, a stock like Intel (NASDAQ: INTC) and then look at Caterpillar (NYSE: CAT). Yes, during the dotcom boom the former was likely to have been a high beta stock as the market priced in every ‘Blade Runner’ technological fantasy whilst Caterpillar would have been a lot less beta. After all, they just provide machinery to the boring housing, mining and construction industries. Fast forward a few years into the dotcom bust/low interest rate era and suddenly housing, mining and anything China are (literally) hot property and no one wants tech. Guess who is high beta now?

This sort of example illustrates that beta changes with market conditions and cannot be relied upon. In a brief aside, I will also note that fans of Soros’ reflexivity would also point out that self reinforcing feedback loops also create investment bubbles (i.e. high beta stocks or sectors) and they can come from origins such as sheer sentiment or regulatory changes. How anyone can think that these factors will be expressed in the historical beta of a stock is beyond me.

Ultimately, if the beta moves around with conditions then structuring a portfolio based on this approach will not lead to diversification because the portfolio will do the same.

Mechanical Based Strategies Lead to Unintentional Style or Sector Biases

Another instrument of self-delusion is the seductive idea that investors can achieve diversification by investing based on a set of mechanical metrics which attempt to capture some sort of attribute or other. Again, I am not completely decrying this idea because I use such metrics to quantify stocks and I think they are useful. What I am saying is that if they are applied without consideration of the macro-conditions or overall portfolio direction they will lead to an unintentional style or sector bias.

In plain English –I can use it in occasion, I promise- if a portfolio is constructed purely using a metric such as , say dividend yield or PE ratio or Price/Assets etc, it will end up manifesting an unintentional market view. To give you an example, consider that in 2008 the highest yielding stocks tended to be banks, insurance companies and house builders. Guess what happened next?  The dividend did not exactly provide a floor to the share price, especially when it had a tendency to disappear as earnings collapsed. Investors can look at the stocks like Citigroup (NYSE: C) as a classic example of this trap.

Another example of a pitfall with this approach can be seen if investors focus on only investing in say an earnings or cash-flow basis. This sort of approach has a tendency to immediately disqualify certain sectors like biotech or oil & gas exploration. No one invests in Vertex Pharmaceuticals (NASDAQ: VRTX) or other such stocks because their growth prospects are all about future cash flows and earnings. If you wait for them, you will be too late to capture the upside.

Putting these two examples together begs a key question. How can a portfolio be truly diversified if it overweights one sector and/or it ignores whole swathes of the market?

An Alternative Approach to Risk Management

I’m going to conclude this article by suggesting another approach. Namely, to try and actively diversify the profit drivers in a portfolio and/or select stocks that have upside drivers which are relatively non-correlated with the macro economy. An example of the former approach would be to say balance an oil services company (which you think is undervalued) with say a company that has a high proportion of its fixed costs in oil or energy. Another example would be to buy a fertilizer company and balance it out with a food producer.

In other words, what you are trying to do is pseudo-hedge away macro risks and create a diversified portfolio that isn’t over exposed to anyone sector of the economy. Of course such an approach requires a lot of forethought into stock selection, but hey, no one said investing is easy!

As for the non-aligned approach, I think special situations investors tend to cross over a lot into this camp. It is all about finding stocks with almost hidden upside potential.  I think an example of this now is Johnson & Johnson (NYSE: JNJ). It isn’t the sexiest stock out there but its growth prospects are mainly about execution. If it sorts out its production difficulties within consumer products, integrates the Synthes acquisition and successfully develops sales of its new drug products then the stock price can appreciate irrespective of the economy.

Investing is more of an art than a science and there is no reason for fund managers to try and bamboozle private investors with the idea that they have the secret formula for diversification. They don’t. In truth it is much more about understanding why stocks move in the way they do and trying to balance the overlying risk. There is no reason why private investors can’t do this just as well as institutional investors.

Monday, August 27, 2012

Open Letter To Tsipras and Samaras

To: Alexis Tsipras and Antonis Samaras
Re:  Attempts to de-rail the global economy and humiliate your great nation en route to winning a few miserable votes

Dear Sirs,
Thank you for your concerted efforts at ruining the global economy in order to try and game Northern European taxpayers into bailing out your insolvent country and ultimately shuffling the risk for your profligately accumulated debt onto their taxpayers.

Your plan appears to be working. You see in recent days a slew of companies have been coming out and warning of a drop of in orders and visibility, much of which seems to have accelerated in Europe around the time in between the two Greek elections in May and June.

Companies Are Starting to be Affected by the Uncertainty You Created

Adtran Inc (NASDAQ: ADTN) missed estimates and warned of a tightening spending environment amidst decreasing visibility. Acme Packet (NASDAQ: APKT) has its own issues but it is hard to conclude that orders decreasing in Europe weren’t a big part of their own miss. The same thing applies to Advanced Micro Devices (NYSE: AMD) which talked of weakness in Europe amidst weak PC sales.

To prove that this isn’t just about technology, Nike (NYSE: NKE) warned that its inventory in Europe would be higher than originally planned due to weaker sales. In addition Alcoa’s (NYSE: AA) CEO spent a fair amount of time on the recent conference call explaining how European Purchasing Manager Indices (PMI) were affecting his company. He even produced charts highlighting the increase in correlation between his company’s prospects and the macro-economic environment.

CEO’s are just like the rest of us. If they read newspaper reports talking of another ‘Lehman’ moment inspired by a disorderly Greek exit, they will hold back on investing. They will hold back hiring. They will stop creating wealth. Your plan is working.

Mr Tsipras Goes to Athens

A particular commendation is due for you Mr Tsipras. Your policy of continually reminding the rest of the globe that you might engage in a hard default and therefore possibly trigger off a financial crisis in Europe and ultimately the US was very effective. Indeed, your choice of language belies your intent. Quoting from an interview you gave with the UK’s Channel  4.
“On the other hand, our advantage is that if the funds stop coming in, we will have to stop paying our creditors. That would result in a domino effect in the financial markets all over Europe and create a devastating storm all over Europe.
 Both sides have nuclear weapons in their hands. And the big issue is to try and find a solution so that neither of the two sides pushes the button, because if something like this happens, no-one will benefit”

That’s the way to show them! Threaten Mutually Assured Destruction (MAD) on the other countries in Europe who have been giving you generous aid in order that you reform your economy and get back to a sustainable debt path. Why not reward the ECB for buying your bonds and lending you money by unilaterally defaulting and creating a black hole in their balance sheet? Why not thank the Europeans who voluntarily wrote off a huge part of your debt by threatening to ruin them unless you get what you want?

Turn Greece Into a Bank?

It doesn’t matter a jot that MAD was a doctrine used by mortal enemies in the Cold War. It has morphed into the de rigueur strategy between the best of friends in recent years. However I have a suggestion for how you might tighten your ‘game.’

The banks gamed the taxpayers by pointing out that the global economy would collapse if they weren’t bailed out in order to start merrily creating the conditions for the next crisis. Like Greece, the banks have a small number of people earning an inordinate amount of money and coming up with no end of –dare I say it- Byzantine methods of tax avoidance. The benefits of the arguments of ‘trickle-down’ (even if the reality is a myth) work equally well with banks and Greece’s not tax-paying wealthy. Why not turn Greece into a one big bank and apply for TARP?

Let’s Not Forget Prime Mnister Samaras
For you Mr Samaras the spoils! No I mean literally the spoils. The phrase ‘to the victor the spoils’ refers to an election winner gives government jobs to its voters. Or rather, in this case, promises not to sack any public workers.
This stroke of genius and your election victory, comes after a few years of voting against bailout proposals including the initial May 2010 deal. You even sacked prominent figures from your party when they voted in favor of the bailouts.  You are now holding together a shaky coalition having garnered political support by voting against restructuring measures that the Troika( ECB, IMF and European Commission) have asked Greece to enact in order to get bailout money. Meanwhile the second biggest party - led by the hard left Mr Tsipras- is merrily campaigning and marching against every reform measure.

Well done Sir!  Now precious few believe in you or that your Government will hold or even countenance making measures that might give your creditors a chance of being paid back the money you owe them. 

The good news is it doesn’t matter. You can always use the MAD doctrine to have another pop at blackmailing Germany, Austria, the Netherlands, Finland et al into taking on collective responsibility for your mismanagement, corruption, profligacy and non-tax paying elite. The worse the economy gets, the stronger your MAD bargaining position will be. Right?

Beware the Shark’s Finn

All is going well. You are getting what you want. However be careful, it might not be safe to go back into the waters of debt accumulation. Those pesky Finnish (who contribute more per capita to the bailouts than anyone else) are not happy. They keep raising the issue of collateral. In other words, the pests appear to think that imposing some conditions in order to actually try and get their money back is a good thing. How dare they? They clearly don’t understand how this is supposed to work!

What makes them dangerous is that if they agitate the situation and make noises about leaving the Euro (as they did recently) then the Troika might start crystallizing a choice in their minds. A choice between keeping a contributing nation in or removing a nation that doesn’t appear able or willing to pay any debt back and is threatening to destroy the economies of the rest by taking MAD action.
You never know, the Euro Zone might do something ridiculously silly and decide to throw out the serial debtor and keep the creditor in!

Cheer Leaders on the Sidelines?

On the sideline sit a multitude of investors who are pointing out that, according to BIS figures, Greece’s total debt held in foreign institutions is less than Ireland owes the UK. These investors think that if Greece is removed, then the uncertainty will be too.

These people think that markets hate uncertainty and so do CEOs. When it is removed then firms will invest again. Markets will move strongly higher and pent up corporate investment spending will be released. Be careful. These people are not afraid of your empty threats and they are sitting and waiting for your exit in order to get back in to the business of not rewarding blackmailers and investing, creating wealth, employment and good will.

Look out for them. They might get what they want soon.

Kind Regards,
N. Machiavelli

Monday, August 13, 2012

Soup Kitchens, the Homeless and Hedge Fund Managers

I stumbled upon this article recently about soup kitchens and the homeless. I must confess that is one of the most delusionally hilarious things I have ever read. Before I witter on here is the link for yourselves to read.

Do Soup Kitchens Help the Homeless?

It is not so much the subject matter but the logic contained in it that is so inherently ridiculous.

For example (my italics) let me quote this

"A government drive to reduce homelessness has helped bring down the numbers sleeping rough by around two thirds, but recent bad economic news - notably the slide in house prices - has rung alarm bells. The homeless charity Crisis, whose Christmas centres open this weekend, warns that homelessness can affect anyone. It warns that even if you have a good job, things can go wrong quickly. A recent survey showed one in five people said it would only take a month for an unexpected drop in income to have a knock-on effect on their housing. "

Now at what point in this whole process is the author or anyone else in the UK going to dare to utter the truth that dare not bear its shame. When is someone going to point out that a good reason why there are so many homeless people is precisely because house prices are too high. Somehow the logic is twisted into this sick idea that high house prices are good for the economy and therefore good for the homeless.

Perhaps the reasoning is that if bankers and real estate speculators are celebrating their new found wealth by moving on from cream of mushroom and are now tasting the delights of lobster bisque, the trickle down effect will kick in and the homeless will now be enjoying more conventionally acceptable fungi in their soup?

But the nonsense doesn't stop there. My italics again.

Former rough sleeper Mark Johnson says it really can happen to any one of us: "We're all prone to that - you know all of us - a breakdown in a relationship, or some sort of trauma or a death or a tragic event - we're all there, much closer than we care to realise." He remembers hearing a very similar view from a city hedge fund manager: "He said in a very quiet conversation we had: 'Do you know what, I know that I'm only ever a couple of bad decisions away from being on the street myself,' and I thought that was a really good insight into being in this world because everyone is."

At which point Mark Johnson (name sounds a bit too generic so my bullshit radar is bleeping already) was entitled to respond to this sterling 'insight' with the comment 'Ok then let me pop in your office and do a couple of futures trades and with a bit of luck I too could be earning huge sums of money and be set for a life of privilege just for convincing someone at an asset management firm that I know what I am doing'.  

Now given that hedge fund managers do make bad decisions. More than a couple of them. All the time. It should be somewhat surprising to the author of that article that not more soup kitchens had little corners in them where the community of recently homeless hedge fund managers might get together and plan their latest arbitrage situation.

No matter, there is in fact a deep insight in this article. It's not in the content of it but rather the underlying assumptions that she makes safe in the knowledge that they exist within the unchallenged and pervading social concensus within London.

In other words, high house prices are good for everyone at all times, including those who can't afford their own home. We do live in a meritocracy where outcomes are distributed based on ability and all that bailing out of the bankers after they made hundreds of bad decisions was really just a way of reducing the numbers of the homeless. Now I get it!

Saturday, March 24, 2012

Spanish Housing Market

Spain Housing Market in Crisis

Some economic statistics on Spain displayed here, which suggest that it is still in crisis. Worrying times ahead, but great if you want to buy a property in Spain.

Spain Housing Market Statistics

The funny thing about Spain (and Ireland) was that before the 2008 recession their deficit situation was quite good. Of course, this was the consequence of a housing boom which boosted GDP growth and finances, yet, stored up a whole load of problems now. As ever, it’s worth reminding ourselves that irrespective of the efforts of the Government to capitalize the banks, if their underlying assets are falling in value then more capital will be needed.

The key is the Spanish housing market and, things don’t look good.

Spain House Price Index

Firstly, the latest quarterly numbers (general index) for the Spanish house price index is out from the Instituto Nacional de Estadistica

Q1 2010
Q2 2010
Q3 2010
Q4 2010
Q1 2010
Q2 2010
Q3 2010
Q4 2010
New Housing
Existing Housing
General Index

These are annualized numbers which suggest that Spain’s housing market is getting worse.

Furthermore, despite the fall in bond yields since the ECB’s LTRO operations, the banks in Spain are tightening lending conditions.

Spanish Bank Lending

Here is a summary of the Banco de Espana Bank Lending Survey

Q1 2011
Q2 2011
Q3 2011
Q4 2011

This number is just the share of banks tightening vs. easing. It’s a similar type of survey to the one that the Federal Reserve does for Bank Lending.

And, nor is it likely to get better any time soon! 

Spanish Bank Bad Debts

Let’s go back to the Banco de Espana for a breakdown of lending and deposits of credit institutions and, then compare this with how many are classified as doubtful

Eur (bn)
Q2 08
Q3 08
Q4 08
Q1 09
Q2 09
Q3 09
Q4 09
Q1 10
Q2 10
Q3 10
Q4 10
Q1 11
Q2 11
Q3 11
Q4 11

The rise in the doubtful rate is worrying.

The crisis isn’t over for Spain.


House Price Index
Banco de Espana Bank Lending Survey
Banco de Espana Credit Data