COVID-19 and Portfolio Thoughts

Well, that was a fun! *sarcasm alert*

Our Man isn’t a doctor and, unlike far too many in finance and politics, he doesn’t even want to play one on TV! It says far too much about today’s world that the most sensible thing about COVID-19 from a non-expert came from the manager of Liverpool FC!

Thus OM isn’t going to opine on the spread of COVID-19, how you should deal with it, and what the various estimates of the virus’s potential R0, incubation period and case fatality rate are or what they might mean.  If, like OM, you work at a smaller company he will point you in the direction of Elad Gil’s primer and if you want to start thinking about the broader economic effects of a pandemic then Professor Wren-Lewis has you covered.   The three things OM will note is that so far we’ve learned:

1. Strict containment works in limiting COVID-19’s spread (see Singapore)
2. Aggressive and broad testing helps identify early who to isolate in order to prevent the virus' spread (see South Korea).
3. Western countries have, so far, been slow to do both of these things.

Instead OM is going to talk about is the market and some forward looking thoughts, as well as what it might mean for the portfolio. 

While COVID-19 originated in China, it was largely ignored by Western markets until the end of February, which coincided with (was caused by?) a sharp rise in cases in the West. The subsequent correction has been swift, sharp and brutal.   The largest factor in COVID-19’s market impact is the uncertainty – how far will it spread, how bad or deadly is it, and how much impact will it have on the economy and life. In the absence of high quality data, and limited trust in leadership and institutions (WHO, Chinese Government, CDC, etc.), the range of outcomes is wide and it’s often the loudest, not the best placed, voice that holds court. After not affecting the markets for ~6 weeks, this uncertainty quickly became doubt and fear.  In such times, investors go where they feel safest and to what has worked previously – especially government bonds. In the US equity markets, that has been Software and especially Software-as-a-Service, which ended February +7% for the year.

Since COVID-19 started in China, OM will be watching to see the resumption of normality there first.  Like all systems, China’s is incentives based - watch what the government does not what it says. OM is doing that by stealing Bill Bishop of Sinocism’s playbook for signs of China declaring victory.   OM doesn’t expect to be a buyer of much until we at least start to see:

• Xi visit Wuhan
• The Two Sessions is re-arranged
• Kids are sent back to school

OM’s operating assumption is that the uncertainty is the West will linger until there is greater clarity on COVID-19’s spread and impact, and the stock market will reflect this.  The longer it lingers then the worse the economic impacts of COVID-19 will be.  Even at this stage, OM suspects we’re starting to approach the point where we need both fiscal and monetary stimulus and the much like in 2008, it’s not going to come (in enough size) immediately.  Finally, the UK with an emboldened Prime Minister, a new Chancellor and a new Governor of the Bank of England might even be the first country to go full MMT on us!

So what is OM doing with the portfolio?

Unfortunately, nothing so far. 

Here are the things on his docket for the coming days/weeks:

- Technical Book: It saw its sell signal near the end of February.  Real-life issues meant OM failed to exit it during last week’s bounce, he won’t be so remiss next time.

- Uranium:  Though it has largely held up pretty well, OM is looking to exit the Uranium ETF (URA) position that is about 50% of the uranium exposure.  This reflects the reconstitution of the ETF to provider broader uranium exposure, and not just to the miners.  OM’s thesis is focused on the miners and a new more appropriate ETF (URNM) launched at the tail-end 2019.  Expect the capital to end up there eventually.

- Emerging Markets exposure:  OM has a LOT of it – Greece, Vietnam, Brazil and India are ~40% of the portfolio.  Irrespective of the long-term outlook, in times of financial stress emerging markets are never the place to be and OM will be trimming this exposure back.  This was not an unknown risk, and he should have been more proactive much earlier in the year!

- Software-as-a-Service: is largely flat on the year, despite everything.  OM suspects that it goes one of two ways from here: 

(i) COVID-19 fears are quickly dispelled and Software becomes that mythical investment; it protected when there was huge uncertainty and is also growing rapidly.  If so, OM expects to hear justifications that surely such a business, which was valued at 10x Sales before the model proved itself in times of economic stress deserves a higher multiple still?  And so, a real bubble shall have its narrative (and crypto as the logical extreme of this concept will go crazy).

(ii)  Or perhaps SAAS stocks are just 2020’s version of commodity stocks in 2008 – bullet proof and up healthily in mid-2008, until they collapsed to end the year down ~80%.  If so, they’re probably an attractive buy with far far better valuations at that point!  

Either way, OM will be exiting his position in the broad Software ETF (IGV); originally, it was the best of the bad proxies for SaaS.  OM would rather add capital to the existing position in the WisdomTree Cloud Computing ETF (WCLD), a recently launched SaaS-specific ETF, when it becomes clearer which path software will take.

- Shipping:  Oh shipping, that beautiful delightful hot mess.  See the most recent post!

Disclaimer:  Nothing above represents a recommendation in any way, shape or form so please don’t even think of trying to take it that way.  For added clarity, while Our Man is invested in all of the securities mentioned that’s a terrible reason for anyone else to do so.  Our Man also holds some cash and a few other securities (of negligible value).  You should not buy any of these securities because Our Man has mentioned them, but should do your own work and decide what’s best for you given your own circumstances/risk tolerance/etc. 

Ptf Update: Themes – Vietnam, India, and Brazil

Our Man began an update on the thematic positions but it quickly got rather wordy and overly complicated.  Fortunately he stumbled across the below AT Kearney chart, that helped him tie things together more simply.

 
Three of Our Man’s Thematic positions fit the same broad template; relatively young countries that are moving towards capitalism!   Vietnam, Brazil and India all have relatively large millennial cohort (in size and as a % of the population), currently aged 23-27, who are currently entering and driving the work force.

 

Source: AT Kearney

While this is interesting, when combined with an economic move from socialism towards capitalism and supplemented by an attractive long-term chart/technical set-up then OM is interested!  It will not always work, the moves towards capitalism are incremental and these are emerging markets so the absolutes (politics, economics, etc.) are largely in the darker shades of grey.  However, while the move from darkgray to silver is but a modest step away from darkness, the delta - or rate of change - for stock markets is meaningful.  Finally, OM suspects that the technological changes that we are seeing will speed up the process, when compared to historical examples.

Vietnam
One Sentence Thesis:  Young Confucian country following the mercantilist path of predecessors (Korea, Thailand, China, etc.) as it slowly opens to capitalism.
Vietnam is one of the clearest examples of the above traits.  It is following the mercantilist path previously trodden by Asian countries including Korea, Thailand and China, of focusing on securing foreign corporate investment to help develop into a manufacturing hub while slowly opening up to global trade.  While this began last decade, Samsung’s decision to build a second Vietnamese smartphone factory in 2014 helped accelerate the process.  Today Vietnamese subsidiaries are Samsung’s biggest production base responsible for 30% of its revenue, and Samsung represents over 25% of Vietnam’s GDP! 
 

To help solidify its attractiveness within manufacturing supply chains, and secure further foreign investment (such as for Google’s hardware), Vietnam has slowly been opening its markets to trade and moving from Communism to a China-like capitalism/communism hybrid.   Examples include the recent agreement with the EU on a trade deal and an aggressive schedule of privatizations.  Finally, Vietnam has been a beneficiary of the US trade war with China, which has provided further incentive for multinational firms to invest in the country.
 

However, like all things emerging markets this will be a slow and lumpy process. Vietnam is not China; it is size constrained (100mn people) and supply chains take a long time to be built.  Despite this, unless there is a significant change (such as in the trend to becoming a more open economy, or valuations get too crazy, or increased likelihood of a major economic downturn, etc.), Vietnam appears to be in that most virtuous part of circle where the benefits from becoming a manufacturing hub start to spill over into other sectors.  As such, expect it to be to be a 4% to 8% position in the portfolio for a looooooong time, and that the small incremental changes mean that OM will  talk about it far too little!
 

Brazil
One Sentence Thesis:  An economic and market collapse coupled with a massive political/business elite scandal opened the door for unlikely President and his key minister’s Chicago-school economics approach. 

Brazil was originally a dislocation investment and was once the largest investment in the portfolio!   Our Man won’t rehash the entire story for you but the cliff notes are; one of the country's longest and worst recessions, a stock market collapse (80% in USD terms) and a massive corruption scandal the enveloped the ‘elite’ business and political class, all of which culminated in the successful impeachment of President Rousseff.

 
While OM could have managed the dislocation investment better, the 2018 election and the appointment of Paulo Guedes – a Chicago-trained economist – as economic tsar helped confirm Brazil as a thematic investment.  Guedes’ economic plan is what you’d expect from a neoliberal economist – deregulation, privatization and pension reform.  Pension reform is the most important in Brazil; for the last 20-years various forms have been in the works as a necessary component to shoring up the government’s finances and none has succeeded.  However, Brazil’s lower house of National Congress approved a pension reform bill last month, which will now head through committee and the Senate with final approval of the legislation likely in October.

 
The success of pension reform should be a good first step – investment has remained weak in Brazil, with international businesses viewing pension reform as a litmus test of the economic team’s ability to pass its agenda.  OM’s expectation is that successful passage of pension reform will prove a strong first step in restoring the market’s confidence in the economy and the political stability in Brazil.  While Brazil is unlikely to be held for as long as Vietnam, and OM is more sensitive to the medium-term charts/technical picture, it is still likely a multi-year holding in that same 4-8% NAV range.
 
 

India
One Sentence Thesis: Modi’s re-election with another large majority likely means continued steps towards his version of national capitalism and reduced bureaucracy.
Back in 2014, when Narendra Modi swept to power to become Prime Minister of India it was a time when many believed in hope and change for India.  This partially reflected a Modi campaign, and his reputation as Chief Minister of Gujarat, that was focused on economics and cutting bureaucracy.  It also took advantage of a decade of Congress party rule that collapsed under disappointing economic conditions and a multitude of corruption allegations. 

Like all things emerging markets, it wasn’t so simple.  While PM Modi has made strides to reduce bureaucracy, he has also introduced his version of state or national capitalism and in so doing failed to live up to some of the high expectations the market held for him.  However, 2019 saw PM Modi re-elected in a landslide and OM is quite aware that it is often in the second term that the largest economic changes can be made (from US/UK history, think Reagan’s second term or Thatcher post-1983 election victory).  There have already been suggestions of wide-reaching changes to the civil service and we are likely to see further expansions of Modi’s national capitalism.  While much of Modi’s platform and approach is far from perfect, as noted previously investing in emerging markets is often about incremental progress.   Our Man increased the India position in early 2019, as it became clear that Modi was going to comfortably win re-election, and it is in the midst of its 4-8% range.


Disclosure: OM is (obviously) long all of the themes mentioned above.

Things from my Newsblur; 2019 Part I

Let’s begin this year as we mean to go on, with an early edition of “Things from my Newsblur”.  As usual, the most investment-related stuff is at the end.

Dwarf planet 'The Goblin' discovery redefining solar system
Approaching Halloween last year, one of Our Man’s son’s was very into space and especially the hypothetical Planet 9 and the  Dwarf planets.  Imagine the joy, at (i) the discovery of a new dwarf planet, (ii) that it’s called ‘The Goblin’, and (iii) that its existence and orbit further suggest Planet 9 is out there.  Happy days, though the song needs updating!
(Hannah Devlin, The Guardian)

Women’s Pockets are Inferior
Mrs. OM hcompains about the frustration of women’s pockets, and especially the decorative faux pockets.  Well, here’s the data (and cool graphics) on the differences in pocket sizes and shapes in twenty of the most popular blue jeans for men and women.   Spoiler alert:  No shock but the data proves that women have a right to be upset!
(Jan Diehm & Amber Thomas, Pudding.cool)

Rodney Brooks: Tech Prediction Scorecard, January 2019
Predicting the future is fraught with the risk of looking foolish…and more so when you’re looking at to 2050 and thinking about technological change.  A year ago, Rodney Brooks made multiple predictions on self-driving cars, artificial intelligence and machine learning, and the space industry.  He will revisit them and highlight the progress, as well as where he is on track or off base.  If you only read one blog post on those subjects, each year, make it this one.
Why is it interesting?  Well, the future is interesting, and Dr. Brooks is more qualified than most to hazard these guesses.  Additionally, we can see how the data and his thinking evolve each year - process matters!  Dr. Brooks is the Panasonic Professor of Robotics at MIT, where he was also the Director of the MIT Artificial Intelligence Lab.  He’s also a Founder, former Board Member and former CTO of iRobot.
(Rodney Brooks, his blog).

Vietnam is Winning the US-China Trade War
With the current US-China trade war picking up, and the sense that it’s the start of a new dynamic between the two countries rather than a one-off spat, technology manufacturers are starting to set-up factories elsewhere.  This coupled with Vietnam opening up to free trade (e.g. the TPP and a trade deal with Europe) has meant that “Vietnam, once dependent on garments and other cheap exports, has begun to rival China’s tech sector.”  This is not something new, but merely Vietnam starting to tread down the path that Thailand took ~30yrs ago, and China ~20-25yrs ago.  Absent a major change, expect Vietnam to be Our Man’s portfolio for a looooooong time!
(Bennett Murray, Foreign Policy)

How Open-Source Software Took Over the World
Regular readers will know that OM has been reading about, linking to, and mentioning software (especially enterprise) a lot recently.  Five years ago, the idea that open-source software was viable let alone would be dominant was met with skepticism from investors.  The world has certainly changed, with IBM’s purchase of Redhat (for $32 billion!!) headlining a list of multi-billion dollar takeovers, IPOs and companies!  Mike Volpi goes through the evolution of open-source software from Linux and MySQL, through the second generation and how it evolved towards Software-as-a-Service business models enabled by the cloud.
(Mike Volpi, TechCrunch)

But…
AWS, MongoDB, and the Economic Realities of Open Source
What if enterprise open-source software is music; and the software cos are the record cos?  Music like open-source software is relatively worthless once it’s been produced, since it can be copied endlessly.  Record companies don’t sell music, but rather the tools that make music usable (i.e. CDs in the good ole days)…and it is the same with open-source software, especially in the cloud era.  Therein lies the rub, will the value accrue to software cos (or record companies) or to those companies (and products) like Amazon Web Services, Microsoft's Azure, etc. (or Spotify, Apple Music, etc in the case of music) that provide the convenience to the end customer.
(Ben Thomspon, Stratechery – if you like technology and read nobody else on a weekly basis, read Ben!).

Portfolio Update (and Vietnam)

Well, that was fun!  After a serene 2017 and a rampant January, Mr. Market handed out a harsh dose of reality during February with the S&P 500 Total Return falling 10%+ intra-month before recovering.  In the midst of this, OM did very little during the month; adding to the Greece position and beginning a new one in Vietnam.  Let’s touch a little on both decisions, before looking more broadly at how the volatility is impacting OM’s view going forwards. 

Greece 

While the market was hitting its lows, Greece successfully issued a 7-year bond in an oversubscribed offering.  This alone reflects the change in investor perceptions, and is further highlighted by the 3.5% yield on the bonds (or a mere 75bps above similar US Treasuries)!  There remain hurdles to clear, most notably agreeing suitable debt relief and a post-bailout monitoring arrangement, but OM saw the successful bond issuance as another sign that things are on the right track.

 Vietnam

The argument for Vietnam is a simple one; it looks like China/Thailand 15-25 years ago and is treading down the same path.

- After the property bubble, there was a long and drawn out restructuring in the bank sector that started in 2011.  It took till 2015 before real estate transaction volumes really started to recover.  Now, with the real estate sector stabilized, the strength of the rest of the economy is becoming more apparent; growth is good, inflation is under control (2.5-5%), rates are low, and the government is using foreign inflows (see below) to build reserves.

- Vietnam has one of the lowest labor costs in Asia, with a young and educated demographic profile.   This comes at a time when labor costs in China (and Thailand) are rising due to an aging population.

- Vietnam is already a consumer-centric economy (65% of GDP) meaning the combination of good demographics (an influx of young workers) and job opportunities (see next point) sets up a virtuous cycle of opportunity.

 - Vietnam is seeing substantial Foreign Direct Investments (“FDI”) from global multinationals.  This began with Samsung’s $13bn investment in 2014 (and follow-up commitment of $7bn more by 2017) and has continued apace with 2017 setting a new record.  The Vietnamese government is continuing with reforms to further encourage foreign multinationals to set-up and invest.

 - In the medium-to-long term, if Vietnam is to follow in China’s footsteps and become the next up-and-coming Asian manufacturing powerhouse, further industrialization and urbanization lies ahead.

- The Vietnamese government has targeted a 70% market cap to GDP ratio (currently ~46.5%), which seems achievable given that similar countries include Singapore (200%+), Thailand (~90%), Philippines (~80%), and Malaysia (~120%).  The government is facilitating this through easing foreign ownership restrictions, privatizations and equitizations.  From OM’s Argentina discussions, you will remember these are all key criteria in moving from being a “Frontier” market to an “Emerging Market” and the wall of $ that brings.  For those that enjoy history’s rhymes, Vietnam’s government floated the company’s largest beer company (SABECO) in late 2016, and just sold a majority stake to ThaiBev.  The historians amongst you will note that back in 1993, Tsgintao Brewery was the first Chinese state-owned company to list in Hong Kong creating the H-share market that has blossomed today.

This week brought further confirmation of the interest in Vietnam, with Warburg buying a stake in Techombank and Amazon poised to enter the country, which both help indicate the strength of the long-term opportunity.

Overall

So what did February change in OM’s outlook?  In the immediate-to-short term, not a lot - new highs are likely coming and the speed of their arrival (the quicker the better) will provide more clues as to how far the market might run in the medium-term.  However, it is equally clear that the probability of 2019 being spectacular (think 3,500 on the S&P 500) was significantly diminished by the depth of February’s slump. 

As such, while OM is certainly not forecasting any end of the bull market it’s certainly wise to start preparing for it.  This is something OM is pondering and will be the focus of an upcoming post, but to whet your appetite here are the three positions that are likely most at risk of seeing their position sizes reduced:

- Brazil:  OM’s Brazil positions are very indicative of where the market finds itself, somewhere between rolling over and surging to impressive new highs.  Technically, it’s one of the clearest/most interesting charts out there – based on OM’s analysis, either we see 89-90K on the iBovespa relatively soon and are on the pathway to impressive new highs, or there’s likely a much more substantial pull-back.  Fundamentally, OM continues to like Brazil but with an election coming up later in 2018 it’s unlikely to remain vastly outsized unless we see that push to impressive new highs.

- IBB:  Biotech has done fantastically over the past few years, but of all the things OM owns it looks the closest to exhaustion.  Given how far it has come a pull-back could be substantial, and OM worries that should that occur the receding tide will reveal more Theranos’ swimming naked!   The decline won’t be as dramatic as Tech’s 99/00, but OM is using that as his broad heuristic and will be happy to wait until he hears other investors proclaim how they don’t invest in biotech/binary situations before diving back in.

- Uranium: Fundamentally, and conceptually, OM loves the Uranium thesis – it’s probably his favorite in the book.  However, as the chart below shows the price action sucks – sharp bounces when the production cuts were announced but no follow through.   Unless things turnaround, and soon, expect the position to be vastly reduced.