Investing Thoughts: Part I

OM changed jobs this summer and the process helped hone his view of what’s important investing and makes for a good investor.   Rather than discuss all of the thoughts in this post, OM is going to touch on a couple of items and hopefully tie it to himself and this portfolio.  For long-time readers, it will hopefully offer a deeper explanation as to the evolution of this portfolio (especially over the last 24-30 months), and some hints at how it might continue to evolve going forwards.

Successful investing is about the marriage of skillset and personality 
To those folks that know OM well, the following should all be quite familiar – (i) OM is a very skeptical fellow, (ii) if you ask OM about any idea (not just financial) and expect an immediate answer, it will be “No” (Mrs. OM heartily attests to this one), and (iii) OM knows lots of random crap and loves a good analogy.  What does that mean investment-wise?  Well, OM tends to start his investment thinking at “No” and work his way towards “Yes”.  He is pretty good at putting together disparate pieces of information (data, anecdotal points, history, liquidity and/or chart information, etc), and combining them with some heuristics to get to an investment theme.  This means that you should see that the majority of ‘positions’ in the book are thematic, with the non-thematic positions* largely residing in the Equity book.

Personality-wise, the most important trait is that Our Man is very comfortable being miserable, especially if he thinks he’s going to be correct AND get rewarded for being right!  This ties-in with the thematic approach, since hopefully the reader’s first reaction to a new thesis will range from “Really?” to “Ugh”.  OM thinks that investing, despite rising belief to the contrary ironically from both ‘value’ investors and quantitative investors, is a mix of analyzing data and understanding psychology; knowing when (and how strongly) to apply each is vital.  Themes are likely to seem largely psychological initially, but should require confirmatory data (both ‘fundamental’ and price) as they progress and hopefully grow in the portfolio.

This also leads to a couple of things that OM hopes you won’t see in the portfolio going forwards (and long-time readers will certainly recognize them, unfortunately).  
- The best way to play a theme, especially on the short-side, is often through the second or third derivative due to the convexity or better risk/reward.  So, while OM may astutely and correctly recognize that Australian swaptions was a great way to play on a China slowdown back in 2010, he has no ability to trade Australian swaptions in this portfolio.  Furthermore, trying to put on an inefficient bastardised version of the trade (EWA puts, in that case) negated all that was great about the original idea (such beautiful risk/reward) and turned a ~10x return into a small loss!  Thus, while you might hear from OM about weird and exciting ways to play an idea (I’m looking at you L Michigan/Detroit CDS for those that want to short Autos), a poor man’s version will not appear in the portfolio.  If you see one, don’t hesitate to let OM know!!!!
- For OM’s style, it’s vital to determine between something is out of favor (or where OM early) versus just being wrong.  Those who’ve read this blog over the years will know that OM has increasingly used technical analysis to help with this.  Too many of the positions where OM has lost money had technical signals suggesting it was a bad idea (or certainly wasn’t a good idea), be it Greece (version 1) or OM’s willingness to stick with his US Dollar bull thesis through 2017 (let alone foolishly adding to it).   The performance of the currency book this year indicates it’s clearly a work in progress, but expect it to continue becoming a more prevalent piece of the decision-making. 

* But what of the Technical and Funds books I hear you cry!  And you have a valid point; both books both exist to help counter OM’s skepticism, an unfortunate side-effect of which is under-investment.  As OM has noted, the hope is that the books will outperform the market over the long-run with the base case being that they should provide long-term quasi-market exposure for a part of the portfolio which otherwise would be held in cash.

Position sizing is the most under-appreciated skill in investing 
The older OM gets, the more he finds himself agreeing with Stan Drunkenmiller that “the only way to make long-term returns...that are superior is by being a pig.”  The key is to understand both when you have an idea that truly excites you and when to bet big on it. 

For OM this means accepting that every investment position has a beginning, a middle and an end, and being patient enough to wait until the middle to size a position up and ruthless enough to start cutting it back and exiting as we get towards the end.   Thus for OM the risks are being too big too early (i.e. in the beginning phase, leaving you only bad choices going forwards), not being big enough in the middle period, and having too big a position for too long when an investment is coming towards its natural conclusion.   The bullish US Dollar trades during 2017 were a conspicuous failure to be ruthless enough on cutting back a position that was in its end-game – a bull market that’s in its 6 year (historically it’s about how long USD bull markets have lasted) with a technical picture that was deteriorating.

OM suspects this will be the primary ongoing battle for the rest of his investment life.  However, to try to help matters and force himself towards the best decision, he’ll hopefully be clearer in stating where he thinks investments are in their lifecycles.  Initially, the assumption will typically be that OM is early to the investment and they’re all in the beginning.  Increasingly confirmatory data (both fundamental and price) is likely to signal a move towards the middle and should be reflected in an increased position size.  Finally, as we get to the end the theme will hopefully be very well worn (and things like this will appear in and on the cover of the Economist) the bar for adding to a position should be significantly higher (perhaps impossibly so) as OM should be exiting stage left.

Hopefully, this post will serve as a nice appetizer to hopefully add some context to the main course of the coming portfolio update.

Portfolio Update - Summer 2015

It’s been a while since OM gave a portfolio update, but after much promising, here it finally is…

International/Country – 34.6% 
The International/Country book is made up of 2 main exposures; Europe and Argentina.
- Europe (~19%): About 3/4 of Our Man’s European exposure is split between Spain and Italy, with the balance in Greece.  This reflects the long-term cheapness of Spain and Italy (on a CAPE-basis) coupled with the stronger technicals and higher probability that these countries are through the worst of their problems.  Greece appears exceptionally cheap, though this may prove superficial given the scale of the economic depression that the country has been through since the Financial Crisis.

- Argentina (~12.5% spread across 5 names):
The catalyst for the Argentinean positions is the upcoming Presidential election in Q4, and the positive news is that both of the primary candidates appear to understand the need for change, to improve the economy and to settle with the bond holdouts (giving Argentina access to global bond markets).  The big questions surround the timing and the ability of the candidates to execute.
The worries about Scioli center on whether he is too close to the existing regime, something that his VP choice (an ally of the President) only fueled.  However, he has the broad support of the Peronists and thus is likely to be able to push changes through, though this will be in a more gradual manner as he builds consensus.  As such, there remains the risk of an economic issue/crisis before change is implemented and can have an effect.
Macri is the bolder ‘change’ choice, as he is likely to attempt to try to do things much more quickly.  The questions surrounding him are whether, after the initial honeymoon period, he’ll be able to push things through (given his status as an outsider) or will he be bogged down fighting the opposition.

- GVAL: Is a very long-term holding; given this OM wanted to wait a full cycle before making any decisions on it, thus if was sized very small.  So far the performance has been disappointing, though the performance was (and still is) expected to be characterized by periods of large under/over performance.

Technical book – 34.1% 
As mentioned when it was implemented, the Technical book has a longer-term bias and changes are not expected to be made to it on a regular basis.  Thus unsurprisingly this year has shown no changes, especially with the market being in a ‘dead zone’ between 2040 and 2135 for the the last few months.  It’s broadly OM’s expectation that this is a long consolidation that’s likely to break the upper limit and start a strong move lasting into 2016.  So far that hasn’t happened, but despite some internal weakness in the market (advances/declines, and ever decreasing breadth, coupled with the reaction to companies missing/making numbers), it would likely take a move comfortably sub-2000 for the Technical book’s sell signals to be triggered.  (Editor’s Note:  And this is why you don’t leave a semi-written blog post waiting to be finished for a month or two.  The market closed on Friday at 1971, right around the level where the Technical book’s initial sell signals are triggered)

Equity Book – 22.5%
At this point there are 4 names in the book:
- RDY and TTM are both Indian stocks though there is no great theme to these investments.  There has also been no great change to either story; the generics business continues to grow strongly (RDY) and Land Rover/Jaguar have started to roll out new models and the rationalization of the manufacturing underway (TTM).

- VIPS and JD are both Chinese Internet retail/consumer plays.  China’s development has come at an interesting time, coinciding with the technological jumps that come with the Internet, meaning that that the country’s retail model could be very different to those of the already developed world as it moves more directly/aggressively to the internet (and mobile) rather than brick-and-mortar stores.  This wouldn’t be the first time we’ve seen a developing country skipping a step as it modernizes; most obviously with India moving straight to mobile telephony rather than putting fixed telephone lines down across the country.
As with (seemingly) all Chinese companies, there is speculation as to whether these companies are ‘real’ and though OM has never been to China, he has sources who’ve met both companies, seen their sites, etc and is thus confident that both companies exist and have real businesses.   
VIPS is comfortably the larger of the two positions, owing to the fact that (despite being an ‘Internet’ company) it’s profitable & generates cash – while some are disappointed by its recent growth, OM sees not competing aggressively for bad business to increase revenues (at the expense of margins, profits, etc) as a sign of good long-term management.

- Currencies (21.9%) & China Thesis (11%) 
Our Man has stated a number of times on this blog that he’s a dollar bull.  It’s his highest conviction belief that we’re in a dollar bull market, a true secular bull market in the dollar, which is something we’ve not seen for decades.  While it’s not ignored OM doesn’t really think it’s fully realized that the Federal Reserve hasn’t raised rates in over a decade, and the US Dollar hasn’t been in a true secular bull market for almost 20 years.  While the dollar’s recent rally has been noted by the markets, it barely compares to historical secular bull markets such as the 90% rally in the 1980s and the 50% rise in the 1990s!  Furthermore, with a more globalized world now, the impact of the rising dollar is likely to be larger than people expect – instead of Poles with loans in Swiss Frances, it’s going to be global corporates that have borrowed in US Dollars (especially in those countries, *ahem* China, where a pegged currency has led to the rapidly crumbling illusion of no currency risk).  As for China, the slowdown has clearly impacted commodity prices (a number of which are at, or threatening, their 2008/2009 lows) and it’s spilled over into the currencies of the commodity countries.  The China book’s Short Australian Dollar position has been great and OM expects it to be volatile but very profitable for a while.

- Precious Metals – 9.3% 
While OM’s medium-term thesis here - that Precious Metals are going to have a strong bounce (the kind that would have the would-be gold bugs believing again) - may prove to be correct he took the position too early, much too early.  OM would have been better off waiting for that final leg down, rather than getting into the positions.

Australian Interest Rate Swaptions.....(Huh, you what?)

Some time ago, Our Man mentioned his bearish views on China (see A, B and C) and how he was looking at Australia (and especially Australian Interest Rate Swaptions) as a way to play any China slow-down.  Since Our Man is trying to pitch it to a few people, here's the thinking behind that idea, in all it's glory.

Thesis:
The markets expect that Australian interest rates will exceed 5% in 2-years time but I believe that they will be substantially lower.  Thus by purchasing an interest rate swaption that gives one the right (but not obligation) to receive, in 2-years time, interest at the rate of 4.5% on 1-year money will prove spectacularly attractive. 

Why do I believe it is mispriced?
a. Australian GDP growth isn’t entirely what it seems:
Australia is viewed as having escaped the Financial Crisis, with only 1 quarter of negative real GDP growth.  However, this belief ignores that Australia had 3 quarters of negative nominal GDP growth (please see graph below on right), implying that in 2 of those quarters prices fell even as volumes increased.


Australian growth benefited directly from an aggressive stimulus package (c$30bn, or 3% of GDP) and through the RBA cutting interest rates.  These measures had a significant impact on household disposable income, causing it to rise by 10% y-o-y to Sept-09, despite labour income (the largest component) contributing a mere 0.4% (per Gerard Minack of Morgan Stanley Australia, February 24, 2010: The Odd Expansion).  Minack estimates the primary factors behind the household disposable income growth were the stimulus package (4% increase to household disposable income) and the RBA’s rate cuts (5% increase).

b. Australian Private Debt Levels are similar to the US Peak
While Australia’s government debt (<25% GDP) is in good shape, the same cannot be said of Australian Household Debt, which has just crossed 100% of GDP, and over the last couple of years has surpassed even that of the US (please see graph below on the left; courtesy of Steve Keen's Debtwatch). 

The increase in this debt during 2009 was largely driven by an increase in the Australian First Home Owners Grant both at the federal (A$7,000) and state (e.g. New South Wales – A$3,000) levels.  However, unlike the US equivalent, the Home Owners grant can be put towards the deposit on a house, meaning that it is quasi-leveragable by reducing the down payment that the buyer must provide, from their own funds, in order to meet a bank’s LTV target.





c. Australian House Prices are in a larger bubble than the US was at peak!
The impact of the sharp rise in household debt on house prices is clearly visible; after consistently tracking CPI since the mid-80s, house prices in the major Australian cities rose sharply as household leverage increased (please see graph on right).

Given that sharp move in nominal house prices, it is not surprising that the recent 6th Annual Demographia International Housing Affordability survey ranked 3 Australian cities amongst the worst 4 globally (and 10 in the top 20).

The size of the move in Australian house prices is particularly stark, even when contrasted to other countries where we’ve seen housing bubbles (please see graph on left, courtesy of Steve Keen's Debtwatch and The Economist). 

In particular, it’s noticeable how the reintroduction and increase of the First Home Owners Grant by the Australian government in 2009 has had a far more pronounced impact than the US equivalent, and succeeded in not only arresting the fall in house prices but managed to drive them higher.

d.  China
Australia has been a major beneficiary of China’s aggressive stimulus during 2009; with China representing 25% of 09-10 exports of which around 2/3 are natural resources.  Thus the Australian economy, and Australian households, would be significantly impacted by any slowdown in China.  Since there is much discussion in the financial world regarding whether China is or is not a bubble, and as I personally believe that it is (see A, B and C), this trade represents a cheap and effective way to play the possible unwinding.

Timing
Now is the perfect time to put the trade on:
I.     Australian economic data has started becoming more mixed (e.g. Feb’s weak retail sales numbers).
II.    Australian banks have started to tighten credit and cut their Home Loan-To-Values (Westpac has cut their LTVs from 92% to 87%).
III.    The expiration of the increases to the Australian First Home Owners Grant during 2010 (many of the State supplements, such as those in Victoria and New South Wales, expire in June-2010).
IV.    The emergence of inflation in China, which is likely to lead to tightening of credit and rates there.

Why Australian Interest Rate Swaptions?
I believe that this trade represents an exceptional opportunity and the most efficient way to play both a slow-down in China and a decline in the Australian housing/credit markets.  The underlying reasons are:
1)    Time Horizon: The nature of the instrument means that the trade has 2-years, an exceptionally wide window, in which to work. 
2)    Risk/Reward:  As the trade is a swaption, the maximum loss is limited to the premium.  Furthermore, the swaption offers a large time window for my opinion to be correct, yet (like CDS but unlike equity options) the cost does fully represent the width of the time window.  Finally, interest rate swaptions (like CDS) do not price in significant tail events (e.g. Australia being forced to institute a zero-rate policy) due to their expected improbability.
3)    Liquidity/Reducing Counterparty risk:  Interest rate swaps, options and swaptions are exceptionally liquid products and traded by numerous banks, meaning the trade can be put on in large notional size and counterparty risk can be limited with each bank.
4)    The willingness of Western Central Banks to aggressively cut rates to support economic growth and to head off solvency/credit events (as seen in 2007-09) makes interest rate options an attractive investment.  This is even more true of Australian interest rate options because of the predominance of floating rate mortgages there, which means that interest rate cuts will directly increase disposable income.

For illustrative purposes (based on contacts from a number of investment banks):
Instrument: AUD2y1y 4.5% Receivers 
Cost: 12bps of notional; this also represents the maximum loss on the position
Return (if option exercised): (4.5% - Bank-Bill Swap Rate ) * Notional

Example: If Bank-Bill Swap Rate fell to c3.25% (i.e. the levels seen in 08-09), the return would be 125bps of notional, a c10x return on the invested capital.



Huh, you what?
You lost me at interest rate...let alone that whole swaption thingy...besides, even the E*Trade baby won't sell me those things.  Well, Our Man is in the same happy little boat, as far as this portfolio is concerned....it's just not easy to play a short thesis on Australia (and its banks/construction sector/home builders/etc).  The way Our Man's looking to implement it is probably be through options on EWA (iShares Australia).  However, given the general lack of options, the liquidity of EWA and their cost, it's a less attractive trade than the interest rate swaptions.  What does that mean?  Well, it means our timing has to be a lot better and our sizing is going to be smaller.  Rather than spent 100bips of premium steadily buying swaptions (that don't kick-in until 2-years after the purchase date) over the next 6-12months, Our Man's going to be looking at 3-6month options on EWA.  That means Our Man's certainly going to wait until the trend in EWA is down and the Australians have made their first rate cut, before looking at putting 25-50bips into the trade over the following months.