June 2012 Review

Portfolio Update
- June saw the second (much smaller) tranche of the redemption discussed in April, with Our Man again deciding to reduce the cash position slightly and concentrate the exposure into the existing portfolio.

Performance Review
The markets bobbed around without any clear and consistent trend for the vast majority of the month before rallying strongly in the final days, after the latest European summit seemed to suggest another plan to ‘fix’ things.  The month was a different one for the portfolio, which various elements moving in different directions as some idiosyncratic company-related events largely made up for the broad under-performance of the more macro-related elements.  The end result however was rather flat performance (+0.07% in June), which pretty much summed up the first-half of the year (-0.01% YTD)

Unsurprisingly, given the sharp rally in the market and the late-in-the-month positive sentiment towards Europe the Puts/Hedges (-56bps), and the Currencies (-32bps) books were the main negative contributors.  The China Thesis (-39bps) also hurt performance, with hopes of a soft landing in China and the potential for recovery in Europe (China’s largest export market) working against the book.

Against this, the equity-centric books were the positive driver’s of performance.  The Value Equities (+61bps) book was aided by the constructive market environment, with THRX benefiting from the positive sentiment in the biotech/healthcare space which saw a number of transactions, including GlaxoSmithKline’s completion of its acquisition of 10mn shares in THRX that was announced in April.  The Energy Efficiency book (+77bps) was the largest contributor to the portfolio.  The book was driven by the performance in XIDE, which announced reasonable numbers.  The company has a checkered history with constant Given the company’s terrible history of restructuring and constant charges the company rightly trades at a discount to peers; however, the hints that the current management are reaching the end of their restructuring after bringing the company out of bankruptcy could have a substantial impact on the firm’s Earnings, ability to capture some of the market (in micro-hybrids) that’s becoming available to them, and their rating.  We shall see, over the next couple of years, if it’s another false dawn in Exide’s emergence.

Elsewhere the Treasuries (-8bps), Bond Funds (+4bps) and NCAV (+1bp) books had a very limited impact on performance.

Portfolio (as at 6/30 - all delta and leverage adjusted, as appropriate)
18.9% - Bond/Absolute Return Funds (DLTNX and HSTRX)
6.5% - Value Idea Equities (THRX, and DRWI)
5.1% - Treasury Bonds (TLT)
2.8% - Energy Efficiency (AXPW, and XIDE)
0.5% - NCAV Equities
0.0% - Other Equities (none)

-1.9% - China-Related Thesis (60bps premium in EWZ Jan-13 puts)
-0.5% - Hedges/Put Options (19bps in IWM Jan-13 puts, 17bps in SPY Jan-13 puts and 12bps XLY Jan-13 puts)

-12.4% - Currencies (EUO – Short Euro)

59.0% - Cash 

Disclaimer:  For added clarity, Our Man is invested in all of the securities mentioned (TLT, DLTNX, HSTRX, THRX, DRWI, AXPW, XIDE, , EWZ puts, IWM puts, SPY puts, XLY puts, and EUO).  He also holds some cash.  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.

It's Okay to Not Know...

“[T]here are known knowns; there are things we know that we know.

There are known unknowns; that is to say there are things that, we now know we don't know.

But there are also unknown unknowns – there are things we do not know, we don't know. ”

— US Secretary of Defense, Donald Rumsfeld

While I was never much of a fan of Secretary Rumsfeld, it always struck me as peculiar the people took such issue with this statement as it seems a fairly logical distillation of a rather complex thing.  Given that a number of Our Man's friends, acquaintances and contacts are in the financial world, it's even stranger that folks criticized the statement as it would seem to me that unknown unknowns could just as easily be called Black Swans.  Though, I suppose it was made in a pre-2008 world when black swans weren't as popular a topic.

So, why bring up Secretary Rumsfeld’s quote now?  Well, despite what you might hear if you have the misfortune to tune into CNBC, it’s okay to not know or have any conviction in a particular outcome.  It is however, important that you realize that you have limited conviction and behave accordingly.  We’re taught that if we do the “work” – if we research, think about and analyze a problem – we’ll find the answer (i.e. reach a conclusion in which we have conviction).  It’s those known unknowns and the pesky Black Swans (unknown unknowns) that mean this isn’t the case in reality.

I bring this up because Our Man’s portfolio continues to run relatively low exposure and the performance is where it has been all year, roughly flat.  The low exposure is a reflection of my lack of conviction; that I don’t know.  On the Equity-side, this is easy to explain – while the current positions have sufficient assets or earnings to make them ‘cheap’, most of the driver of future returns is based upon some form of change or future growth.  While I believe that you’re paying little to nothing for this growth and/or I’m more positive on the probability of its occurrence, potential size, and proximity, it’s also very likely given their uncertain nature that these factors will be influenced by the macro environment.  Thus, the positions are undersized to reflect my well-known macro skepticism.  What will cause the equity book to grow?  Well, a change in the macro conditions, a change in the risk/reward in existing names, or adding new names or a theme to the book; expect to hear more on these topics soon.

So, if I’m bearish, why are the Puts/Hedges and China thesis portfolios so small?  Well, for the following reasons: we’re not there yet and the Fed (and other Central Banks).  While my bearishness is unchanged and the economy remains relatively weak (and I think noticeably weaker than people realize) it isn’t yet absolutely weak.  As discussed before, my two favourite indicators for getting a sense of where the economy stands today are the Philly Fed’s Aruoba-Diebold-Scotti Business Conditions Index and the Chicago Fed National Activity Index. 

The second reason is the Fed who have shown a belief that throwing liquidity at problems will solve them, despite the lack of evidence that it does any more than provide a temporary sugar high while potentially creating greater distortions in the markets.  However, their willingness to do so seemingly every year (surely a sign of its outstanding success) means that there is a higher bar required (i.e. the economy must be weaker than historically) or signs of greater exogenous weakness (China and Europe) before I’m willing to increase the size.  

In short, my current level of conviction is relatively low ("I don't know") and thus the portfolio's level of exposure is low. So I'm spending my time doing two things (i) waiting for the data to change and help me build some short-medium term conviction in the existing theses, and (ii) looking into, researching, thinking about and analyzing some new ones.  When I've either built greater conviction in the existing theses or am close to putting new ones into the book, then this blog will become more lively and the portfolio's exposure and risk will start to increase.

Things from my Google Reader: Jun-12 Edition

Apparently, it has been almost 9 months since Our Man updated you with articles of interest that he’s been reading.  Thankfully, this isn’t a reflection of a drop in the quality of his reading material but instead solely represents at how poor he’s been posting it to this blog – apparently, putting the information together in a word document and expecting it to post itself, doesn’t work so well.  Thus, there is much catching up to do…so expect a plethora of “Things from my Google Reader” posts this summer.  This one will follow the typical format, with the most financial-orientated links at the bottom!

- A Nice Cup of Tea 

As you know, Our Man is a Brit and there’s nothing Brits like more than a cup of char (in fact, I’m having one now…as I write this).  I also have to say that American tea-making standards are pretty low (Mrs. OM is a fan of putting the milk in first, perish the thought!).  So, in this stressful world (and especially for my American friends) let George Orwell’s 1946 article school you on this important matter.  (George Orwell, Evening Standard)

- “Keep Calm and Carry On” (Video) 

I’m sure you’ve all seen the slogan on t-shirts and posters, but have you ever wondered where it came from?   This short film tells you the story behind the poster; from its origins at the start of the second World War, to how it was rediscovered in an English bookshop in 2000 and introduced into the public consciousness.

- Coaching a Surgeon:  What makes top performers better?

Given that top class athletes and singers have coaches, so why don’t you have one for whatever you do?  Irrespective of your training for your job, can you perform at your best on your own?  Clearly, some occupations lend themselves to this concept better than others but it’s a fascinating concept and well worth you reading about one surgeon’s experiences and research.  (Atul Gawande, New Yorker)

All things China

As y’all know, Our Man has been somewhat skeptical on China for a long-time.  While this was originally a contrarian view, the debate over China has progressed from whether China will (ever) slow-down to whether there will be a soft or hard landing and what’s a reasonable rate of growth to expect from China going forwards.  Here are some interesting articles that illustrate the change in tone over China, from the last few months:

- Professor Michael Pettis and the Economist’s Free Exchange blog have a two-legged wager on whether China will overtake the US within a decade and what Chinese GDP growth will be. (Michael Pettis’ blog & The Economist)

- Jonathan Weil finds that Chinese big banks look more like paper tigers, in large part to the remnants of the last time the government had to bail them out (something Our Man has discussed before). (Jonathan Weil, Bloomberg)

- Arthur Kroeber wonders if it will be social discontent and income inequality that will lead to China having issues (Arthur Kroeber, Foreign Policy)

- John Hempton is the most skeptical of all, suggesting China’s a “kleptocracy of a scale never seen before in human history” and tries to explain how it’s financed, and what might make it fail.  (John Hempton, Bronte Capital)

Financial Regulation – Some Andy Haldane love!

Financial regulators have done little good over recent decades, in large part because they’ve failed to understand Finance.   One of the few exceptions is Andy Haldane, the FSA’s Executive Director for Financial Stability, who Justin Fox (at HarvardBusiness Review) dubbed “the regulator who explained the world”. 

Personally, I was more impressed by the way the way he applied work from other fields and considered their impacts on finance.  Some of my favourite Haldane articles/speeches:

- “Patience & Finance”, where he looks at the role of patience in decision-making and the impact of patience, or rather succumbing to impatience has had, on finance.  (Oxford China Business Forum, in Beijing) 

- “The Short Long”, on whether the world (and stock market in particular) is becoming more short-sighted and myopic.

- “The Doom Loop”, where he talks about equity and the banking system. (Andy Haldane, London Review of Books)

May 2012 Review

Portfolio Update 

There were no changes to the portfolio during May. 

Performance Review

In similar fashion to both 2010 and 2011 the old stock market adage “Sell in May and go away”, proved to be useful advice as the S&P 500 tumbled by over 6%.  Unsurprisingly, it was as macro fears across the globe raised their heads once more.  In Europe, the slow-moving car crash continued as Greece’s elections brought matters to a head, with the possibility of Greece’s exit (which seems to have been term a “Grexit”) being openly discussed for the first time, while Spain seems to be doing its best to follow Ireland’s version of the bank & real estate debt problems!  The news outside of Europe wasn’t much better as speculation and debate continues as to whether China will have a hard landing or will instead avoid it through another large stimulus program in the full knowledge that the 2009-stimulus program only made their long-term economic rebalancing much harder.  Not to be left out, the US showed continued signs of softening in the economy, though it’s yet to reach levels where the talking heads are speculating about recession.  

Given the portfolio’s slightly negative/bearish tilt it fared reasonably well during May rising 1.13%, though it still remains underwater for the year (-9bps YTD).  The breakdown of performance was unsurprising.  The China book (+47bps) and Puts/Hedges (+42bps) both benefited as equity markets fell, with the Treasury book (+39bps) benefiting from the flight to quality.  The largest contributor was the Currencies book (+77bps) which benefited from the USD strengthening against the Euro following uncertainty in Europe, especially the fears that Greece would exit the Euro and speculation this could lead to contagion across Europe.

Equally unsurprising was that the equity-orientated books suffered heavily during the month, with both the Value Equities (-61bps) and Energy Efficiency (-46bps) books hampering performance.  As regular readers know, the names in these books tend to be smaller-capitalization companies where either a large part of their value is in (expected) future growth (i.e. the Energy Efficiency book) or where there is some uncertainty be it over legal issues, the value of an asset, the company’s normalized earnings, or corporate behavior/action.  Unfortunately, these traits mean that if there is no idiosyncratic even affecting the names in these books, they can be sold off heavily during bouts of uncertainty.  The Bond/Absolute Return Funds (+2bps) and NCAV (+12bps) books weren’t significant contributors to performance.

Portfolio (as at 5/31 - all delta and leverage adjusted, as appropriate)

17.6% - Bond/Absolute Return Funds (DLTNX and HSTRX)

5.5% - Value Idea Equities (THRX, and DRWI)

4.8% - Treasury Bonds (TLT)

1.9% - Energy Efficiency (AXPW, and XIDE)

0.5% - NCAV Equities

0.0% - Other Equities (none)

-2.4% - China-Related Thesis (92bps premium in EWZ Jan-13 puts)

-2.8% - Hedges/Put Options (37bps in IWM Jan-13 puts, 36bps in SPY Jan-13 puts and 25bps XLY Jan-13 puts)

-12.1% - Currencies (EUO – Short Euro)

61.8% - Cash

Disclaimer:  For added clarity, Our Man is invested in all of the securities mentioned (TLT, DLTNX, HSTRX, THRX, DRWI, AXPW, XIDE, , EWZ puts, IWM puts, SPY puts, XLY puts, and EUO).  He also holds some cash.  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.

April 2012 Review

Portfolio Update 

April saw some changes to the portfolio:

- Portfolio Redemption:  April is tax season in the US (and home improvement season in Mrs OM's mind!) and with this in mind Our Man and Mrs. OM decided earlier in the year to reduce their allocation to the portfolio at the end of Q1.  Given the large amount of cash in the portfolio and Our Man’s conviction in his names/theses, rather than selling positions to match the outflow, Our Man has reduced his cash position.  This has the impact of increasing the exposure to existing positions by c10%.

- NCAV Book changes:  As mentioned in the most recent NCAV post a number of positions within the NCAV bucket reached their sell-by date (see here for sell rules).  These positions were sold during April, leaving the NCAV portfolio with a solitary position.

Performance Review

April proved to be the portfolio’s first profitable month (+64bps) of the year though the portfolio is still negative for the year (-1.2% YTD).  While April saw the return of some uncertainty to the markets, which fell slightly over the course of the month, the portfolio’s profits were surprisingly broadly spread.

A number of books posted marginal gains/losses, which largely cancelled each other out.  The NCAV book (-4bps) was down for the month, though this largely represented the costs (mainly brokerage commissions) of exiting the majority of the portfolio.  The Currencies book (+7bps) benefited from the uncertainty in Europe and the China book (+2bps) from the mixed signals on Chinese growth.  The Puts/Hedges book (-5bps) was a mild detractor despite the small fall in equity markets

The Treasury Book (+21bps) and the Bond/Absolute Return Funds (+19bps) were both aided by the strengthening of US Treasuries over the course of the month, as uncertainty (especially over Europe) increased.  This uncertainty negatively impacted the Energy Efficiency book (-15bps) to a relatively large degree, given the speculative nature of one of the names (AXPW) and the mediocre recent history of another (XIDE).

The Value Equity book (+40bps), which has largely been disappointing to date, bucked the trend and had a strong month despite the small fall in the equity markets.  The performance was driven by the position in THRX, which rose after announcing that GlaxoSmithKline, its joint venture partner, was further increasing its stake in the business at a price above the then market value. 

Portfolio (as at 3/31 - all delta and leverage adjusted, as appropriate)

17.7% - Bond/Absolute Return Funds (DLTNX and HSTRX)

6.1% - Value Idea Equities (THRX, and DRWI)

4.5% - Treasury Bonds (TLT)

2.3% - Energy Efficiency (AXPW, and XIDE)

0.4% - NCAV Equities

0.0% - Other Equities (none)

-1.5% - China-Related Thesis (46bps premium in EWZ Jan-13 puts)

-2.4% - Hedges/Put Options (24bps in IWM Jan-13 puts, 20bps in SPY Jan-13 puts and 13bps XLY Jan-13 puts)

-10.7% - Currencies (EUO – Short Euro)

62.5% - Cash

Disclaimer:  For added clarity, Our Man is invested in all of the securities mentioned (TLT, DLTNX, HSTRX, THRX, DRWI, AXPW, XIDE, , EWZ puts, IWM puts, SPY puts, XLY puts, and EUO).  He also holds some cash.  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.

Perception & Reality

“It was six men of Indostan
To learning much inclined,
Who went to see the Elephant(Though all of them were blind),
That each by observation
Might satisfy his mind”

- Verse 1 of Blind Man & the Elephant, John Godfrey Saxe

Our Man’s father is likely quite disappointed that he's quoting the John Godfrey Saxe poem (rather than say the version in Persian Sufi poet Sania's "The Walled Garden of Truth"), since the parable about “the blind men and an elephant” is of Indian origin.  The story tells of how 6 blind men come upon (or are introduced to) an elephant and each touch it to learn what it is like.  The men touch a different parts of the animal (side, tusk, trunk, knee, ear and tail) meaning that when they compare notes, each of them have a completely different (and incomplete) opinion of what an elephant is like.

The markets and global economy have offered a similar conundrum over the last 4-6 weeks, and like the blind men, there’s some evidence to support most perspectives. 

For example, the advance estimate of Q1-12’s real GDP growth (in the US) came in at +2.2%, a healthy enough number but beneath analyst estimates (of +2.5%) and the previous quarter (Q4-11: +3.0%).  On the surface, we should be pleased, after all GDP has now grown for 11 consecutive quarters.  Things seem less rosy when we consider a little more data and realize that the economy has only now returned to its 2007-peak and that historically-speaking, the pace of our post-recession growth is exceptionally slow.  This disappointment becomes clearer yet when we consider the extraordinary measures, including a zero-interest rate policy, massive budget deficits and the numerous attempts at unorthodox monetary policy (including QE1, QE2, QE-Lite, Operation Twist, etc), which have been used to try and stimulate the economy and drive growth.

And what to make of Europe?  The initial success of their unorthodox monetary policy (LTRO – where the ECB flooded European banks with cheap 3-year loans, and encouraged them to buy European sovereign debt with the money) was undeniable, silencing talk of potential crises in Italy and Spain by helping drive long-term bond yields substantially lower.  For example, Spanish 10-yr yields fell from over 6.7% in December to under 5% when the LTRO ended on 29^th February.  Yet, barely 6-8 weeks later the same bond-yields are rising slowly back towards their pre-LTRO level and the worry is that LTRO has failed to buy enough time.  Furthermore, if the (admittedly British-centric view that) Euro was a political creation rather than an economic one, then the political carnage bears noting.  Every one of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) has seen its government swept away, or replaced by unelected EU technocrats (e.g. PM Mario Monti in Italy, or PM Lucas Papedemos in Greece), irrespective of the previous ruling party’s history* and achievements.  Additionally, with politicians working not for their citizens but focused on defending the “Euro project”, nationalism (and the hard-Right and hard-Left) is on the rise not just in the PIIGS but in the core countries.  The last fortnight has seen Netherlands’ government collapse after the Freedom Party’s Geert Wilders brought down the coalition after openly calling for defiance against the "Diktats from Brussels".  Then there is France, where the National Front recorded their best ever election performance (17.9% of the vote) in the first round of voting and the recently formed Left Front (11% of the vote) almost doubled their share of the vote.

Finally, there’s China.  The last few weeks have seen a divergence between the different manufacturing PMI (Purchasing Managers Index) readings, with HSBC’s showing a continued slowdown and the official government one showing a decent bounce-back.  These readings followed the weaker than expected Q1 GDP Growth (+8.1%), which was the lowest reading since the end of the 08-recession.  While it’s clear that China’s growth has slowed, the prevailing attitude remains that the government remains accommodative and that the slowdown is contained and being managed with limited risk of a hard landing (GDP growth of <3%).  For the skeptics (including Our Man) however, the worries of falling house prices and the impacts of non-economic credit-driven investment continue to mount.

What does this all mean for Our Man?  Not much, as observers of the portfolio would recognize.  The opportunity to generate strong investment returns is at its peak when; (i) your perception of reality diverges significantly from the mainstream, (ii) you have high conviction that your perception accurately reflects reality and (iii) reality is likely to be acknowledged in the markets (or instruments you’re trading) within an acceptable time period.  This allows you to take risks that others feel imprudent and to do so in size, with some faith that if you’ve sized the positions appropriately (and in the right instruments) you can hold them until reality conforms to your perception (or your perception adjusts).  Today, Our Man’s issues is primarily temporal; I have a more bearish medium-term view of global growth (especially Chinese) than most and reasonable conviction in it, but more limited faith that the markets will conform to this view in the near-term.  As such, the portfolio continues to hold smaller (than optimal) positions that reflect my views and will allow it to participate should things change quickly, but also substantial amounts of cash that waits for greater clarity before being invested.



* To put this into context consider:  Ireland’s Fianna Fail, the largest party in the government in every election from 1932 to 2011, lost over 1/2 of its share of the vote and 3/4 of its seats in 2011.  Greece’s PASOK, which has dominated Greek government since the collapse of the country’s military dictatorship in 1974, are polling at 15% (vs. having never won less than 38% of the vote since 1981!) for Sunday’s election.

 

March 2012 Review

Portfolio Update
There were no changes to portfolio during March.

Performance Review
While March seemed superficially very similar to January and February there were some noticeable underlying differences, with Emerging Markets performing noticeably poorly led by Shanghai Stock Exchange Composite Index which fell over 6%.   In the US, the coincident macro data continued to be reasonable though showed signs of tailing off, while in Europe the markets rallied before relief over Greece’s deal with its creditors slowly waned over the course of the month.  Unfortunately, Our Man’s portfolio made no headway, falling 45bps (YTD: -1.8%).

The sources of the profits/losses during the month should not be surprising to regular readers.  The Puts/Hedge book (-38bps) and Treasuries book (-17bps) both suffered from the continued preference for risk assets in the US and were consistently negative contributors throughout the month.  Elsewhere, the Bond Funds (-6bps), China (-7bps) and Currencies (-3bps) were small negative contributors though all spent the majority of the month around the flat.  On the positive side, the NCAV book (+22bps) was the dominant contributor driven by the merger/takeover of one of the positions (OPXT) which alone lifted the entire book c15% in the final days of the month.  The Energy Efficiency book (+11bps) benefited largely from the market’s rise. 

The sole equity book that did not help performance was the Value Equities (-6bps), which also contributed negatively (about -26bps) over the quarter despite the market’s 10%+ rise.  While divergence from the indices is, of course, to be expected when the book contains a mere 2 names and is thus driven predominantly by idiosyncratic factors, both of the positions (THRX and DRWI) are down for the year.  While there were no major changes to the underlying fundamentals and news of either position, both have risks hanging over them that have yet to dissipate.  DRWI is scheduled to complete a transaction for Nokia-Siemens wireless business in the coming months, which while transformative for the company also brings with it execution risk as they turn their large pile of cash, into a revenue producing business that they have to integrate manage effectively.  THRX, together with its key partner GlaxoSmithKline, continues to work on trials and approval process for the compounds in its drug pipeline with regulatory submissions planned for a couple of programs.  Our Man’s sense is that for both these companies, it will be their success at managing these factors & processes that will largely determine their stock price moves over 2012 rather than the movements of the market.

Portfolio (as at 3/31 - all delta and leverage adjusted, as appropriate)
15.9% - Bond Funds (DLTNX and HSTRX)
5.2% - Value Idea Equities (THRX, and DRWI)
3.9% - Treasury Bonds (TLT)
2.3% - Energy Efficiency (AXPW, and XIDE)
1.7% - NCAV Equities
0.0% - Other Equities (none)

-1.9% - China-Related Thesis (40bps premium in EWZ Jan-13 puts)
-3.8% - Hedges/Put Options (22bps in IWM Jan-13 puts, 20bps in SPY Jan-13 puts and 15bps XLY Jan-13 puts)

-9.6% - Currencies (EUO – Short Euro)

65.2% - Cash

Disclaimer:  For added clarity, Our Man is invested in all of the securities mentioned (TLT, DLTNX, HSTRX, THRX, DRWI, AXPW, XIDE, , EWZ puts, IWM puts, SPY puts, XLY puts, and EUO).  He also holds some cash.  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.