OM’s Philosophy: How Today’s Portfolio Fits

As a follow-up to OM’s last piece on his investment philosophy and strategy, this one looks at how the current portfolio fits within that framework.

Dislocations – 35.4% NAV, as of end of June 2018 
OM seeks to take advantage of dislocations – areas of the market where performance has been abysmal and investors have lost hope.  In addition to cheap valuations and fundamentals that are turning around, these investments require a narrative to help encourage investors to reexamine the opportunity.

Brazil (20.3% NAV) 
The longer-version of the thesis can be found here.  The shorter version is that Brazilian equities lost 80% (in USD-terms) between 2011 and 2016, and investor sentiment reached a nadir in early 2016 as the Carwash Scandal enveloped Brazil’s elite culminating in the successful impeachment of President Rousseff.  With sentiment at a trough, there were positive signs; new President Temer was viewed as competent and a short-term fix, and the length-and-depth of the recession meant that politicians were open to reform (especially pension) and companies had spent 5-years cutting costs to survive (i.e. created operating leverage to any pick-up in demand).  This was supplemented by the macro environment picking up (Brazil exited recession in 2017) and stock prices rising.

However, the big current question is whether the narrative peaked in December 2017, when Brazilian stocks continued to rise even as the planned pension reforms were shelved.  If so, this position should be vastly smaller especially considering the uncertainty of the upcoming election.

Uranium (9.5% NAV) 
Uranium remains the most frustrating position in the portfolio, which is a sign that it should probably be a smaller one.  Nothing has changed in the thesis;
- The primary demand is nuclear power plants which are slowly coming back online (post Fukushima) and being built (mainly in China and India).  These plants have long-term contracts (2-10yrs) and the majority of existing contracts come due in the 2018-2020 time frame.
- The supply-side is now rational.  A multi-year price war saw suppliers seek to build/retain market share, but the continued falling price meant there was no investment and most mines currently operate at a loss.  Two suppliers (Cameco and Kazakhstan) now control over 50% of the market, and have both been disciplined and aggressive in shutting down capacity.  Our Man hoped that these public demonstrations of supply-side discipline, especially the major cuts coming into 2018, would help start to drive the narrative and price but despite strong rallies on the shut-downs, there’s been little price follow-through.

Greece (5.6% NAV) 
Greece suffered through the Great Depression (and more) and everyone’s still annoyed/frustrated with them, with investors having been burned more than once.  However, Greece exited its third (and final?) adjustment program a couple of weeks ago and the IMF/EU came to a French-brokered understanding re. its future debt path earlier in the year.  While there is much reform that still needs to happen, it’s also too easy for outsiders to discount what’s already been done (e.g. reforms making it easier to fire workers, new laws to work out NPLs, etc.).

OM has limited the position size since while all the ingredients are in place there is no compelling narrative to force people to look at Greece again.  As such, OM is waiting to see (i) Greece come to market with another debt issue, and especially (ii) elections.  OM suspects that the latter will prove a strong driver of the narrative, especially if Kyriakos Mtzitokis’ New Democracy look like winning.  They represent a much more palatable partner to investors/the EU/the ‘media’/etc. than current Greek PM Alex Tsipras and his Syriza party.

Thematic – 28.8% NAV, as of June-end 2018 
This represents OM’s exposure to long-term secular themes.  The themes likely won’t change much over time though the underlying components and position sizes may do.

The 3^rd/4^th Industrial Revolutions (14.2% NAV) 
The Digital Revolution (3^rd Industrial Revolution) was the shift from mechanical/analogue technology to digital electronics; at the simplest level think sending mail to email.  It began with the invention of the transistor (1947) which led the advent of digital computers, and it continues through today cellphones and the Internet.  The Fourth Industrial Revolution is building upon and extending the Digital Revolution, and seems likely to transform society in the coming years/decades.  So far, it has been characterized by breakthroughs in fields such as robotics, artificial intelligence, machine learning, autonomous vehicles, genome science, and cryptography.  Most will have at least heard of some/most of these fields, but they are all still emerging and their impacts and relative importance isn’t yet known.

Our Man has long-held various technology and biotech names in the old Equities book; while the companies have their own attractive traits, these “Industrial Revolutions” are the overarching theme that binds them together.  OM suspects that by classing all the positions that are predominantly driven by this theme together, it will help from a sizing and risk management perspective.

If you’d like to read a simple primer on the 4^th Industrial revolution, here’s a good one from World Economic Forum.

Argentina (8.0% NAV) 
Argentina started in the dislocation book; Kirchnerism from 03-15 resulted in a poorly managed and distorted economy, with no access to global capital markets.  However, political change was imminent; President Cristina Fernandez de Kirchner couldn’t run in the 2015 elections, and any of the 3 candidates would be more market friendly.  She was replaced at the end of 2015 by President Macri, the most market friendly of the candidates.  President Macri began an impressive liberalization of the economy including removal of currency controls, inflation targeting independent central bank, settling with the bond hold-outs allowing Argentina to access capital markets, etc.  

The thematic bet is long-term that Macri-ism succeeds and Argentina becomes a ‘normal’ country and market economy, with single digit inflation and normalized interest rates.  This allows the development of a broader credit market (both corporate and personal) and businesses have greater ability to plan/invest for the future.  Think of the US in the early 1980s, following Volker’s raising rates to tame inflation, as a good but vastly simpler historical rhyme.

India (4.9% NAV) 
The long-term bull case for India is widely known, and OM doesn’t have much special insight.  The thematic case starts with the 2^nd largest country in the world, which also has great demographics and is (relatively) technologically advanced.  These natural advantages are supplemented by some self-help.  While there is much to criticize the Modi government over, it has made some structural shifts (taxation changes, bankruptcy code and financial reform, etc.) and the push to digitize the economy, highlighted by the introduction of Aadhar (a unique individual ID number based on biometric information), is potentially world-leading.

Vietnam (3.1% NAV) 
The cliff notes for the Vietnam is that it looks like China/Thailand 15-25 years ago and is treading down the same path.  The longer form can be found here; expect Vietnam to be in the portfolio for a long time though the position size will vary depending on the pace of reforms, the strength of the economy and the proximity and likelihood of any MSCI upgrade (to Emerging Market status, from Frontier).


Idiosyncratic – 18.2% NAV, as of June-end 2018 
The idiosyncratic book is made up of two things; a small number of attractive individual stocks and some Funds.  These Funds take advantage of some structural inefficiency be it through active stock picking/time horizon or using a combination of (valuation) factors to systematically allocate capital. 

Texas Pacific Land Trust (TPL, 6.7% NAV) – if there could be a poster-child for the type of individual stock in the idiosyncratic book, it would be TPL.  It’s attractively priced, not covered by any Wall Street analysts (of note), not in any ETFs, and its business (oil royalties, land leases, and water rights) has no real peers to benchmark it against.  Throw in the uniqueness of its structure – it was created in 1988 as a result of the Texas Pacific Railway co going into receivership, and all it does is manage/sell land and use the proceeds to buy back shares – and nobody really knows or cares about it.   

Fannie Mae (FNMA, 0.3% NAV) – Either the government should not be sweeping all of FNMA’s profits to the Treasury and it’s worth multiples of the current price, or they should and it’s worth almost nothing.  For a resolution, it requires political decisions to be made on a topic nobody wants to make-them on (government’s role in the mortgage market) and with no immediate need for a decision.  Think of it as a glorified option with lots of unknowns and very attractive risk/reward payoff.  Also, it has no time decay but also no strike date…it could be here forever and worth the same, or worth multiples next quarter/year.

As previously noted, the Funds (11.3% NAV) are within the idiosyncratic book.
- GVAL and CAPE are both based on applications of Shiller’s PE Ratio (aka Cyclically Adjusted Price Earnings, CAPE).  GVAL applies it to International stocks (finding the cheapest stocks in the cheapest countries), and CAPE applies it to US sectors.  To Our Man’s mind Shiller’s PE Ratio/CAPE is a tool that is poorly applied in finance with too many trying to use it as a timing mechanism or reason for a short-term decision, whereas it’s real value is as a very long-term measure of relative value.  The intent of both ETFs is to buy things that are cheap on a relative basis (compared to other countries/sectors) and Our Man’s wager is that over the long-term this will prove to be more profitable than the market.
- CWS:  Our Man has read the Crossing Wall Street blog for most of the last decade, and this ETF is based off that blog.  CWS publishes an annual “Buy List” of ~25 stocks at the start of each year, which are equally weighted and then no changes can be made during the year.  Each year only 5 stocks from the Buy List have been replaced, with the others carried forward (with any additions) onto the new Buy List.  This longer-term focus (typically, 4-5 years on the Buy List) leads to a bias towards quality and value and if the process can remain disciplined this can lead to out-performance over time.


Technical - 32.9% NAV, as of June-end 2018 
The Technical book was added back in 2014, to help compensate for OM’s natural skepticism by formulaically take long positions (in the levered ETFs for the S&P 500, Dow Jones and Nasdaq 100) to capture long-term trends in these markets.  The position-sizing of these positions is also rules-based, and more information on the genesis and rules for the Technical book can be found here.


Hedges/Shorts 
None currently.

Risk, Uncertainty, Opinion and Execution

Our Man hasn’t really written a post of substance in a while, for a mixture of good and bad reasons.  On one-hand, Our Man doesn’t really like to write when he has little of note or new to say, and on the other he spent most of the last 6 weeks obsessing over the Giant’s unlikely Super Bowl run!  However, with the Super Bowl clinched and the market partying like it is 1999…what better time to put down on paper some of the things that Our Man is pondering.

First, let’s take a step back and start on a philosophical note, and discuss the difference between risk and uncertainty as the two often become conflated when people talk about the markets.  To my mind, risk refers to an event (or series of events) that can cause a significant loss to the markets (market risk), or to one’s portfolio (portfolio risk).  Uncertainty is something different; it refers to a greater number of potential and viable pathways or routes for the market, some of which may entail great risk and others very limited risk.  What is important though is that because there are a greater number of viable pathways, the certainty that any particular one will be taken is low.  This means that the impact from small changes in information is magnified, because each change can be can easily extrapolated forwards as they new reality and thus change the markets potential route.  Of course, if the next piece of information contradicts the existing set, the probabilities change once more resulting in new potential routes.  While it’s tempting to assume that risk increases as things become more uncertain, that isn’t necessarily the case.

Secondly, in investing as with many other pursuits, it’s vitally important to separate out opinion from execution, and understand their relative importance.  While this sounds simple, in practice it’s somewhat more difficult – opinions are the most interesting part of being engaged on a subject, everyone has one and most aren’t shy about sharing them (irrespective of how well-formed they are)!  In short, people want to talk about (and listen to other peoples thoughts on) whether the market is going up, if Greece is going to exit the euro, will China have a hard landing, or are Eli Manning and Tom Coughlin certainties to make the Hall of Fame!  However, while opinion is interesting and fascinating, it’s what you do with those opinions (i.e. execution) that really matters.  Let’s imagine China were to have a hard landing; if you held this opinion in advance, that’s great but it’s not necessarily what makes you money – that’s driven by how you choose to express China hard landing (what companies/countries/etc, and what instruments), the resultant risk/reward of those choices, along with when you choose to put the trade on (is the hard landing coming in 2012, or 2013, or later…or should it have already come) and how you size it (if you’re too big too early, you may not be able to hold your position until the day it works, but too small or too late and you don’t make any money).  Unfortunately, while the sizing, timing and expression of a trade (i.e. the execution of an opinion) is what will drive returns, its importance is undervalued and largely ignored in the swirl of opinions.

So, why talk about this today?  Well, it’s a subject Our Man has touched on before and ponders a lot about, but it’s also one that has greater resonance today given Our Man’s skepticism and the market’s strong start to the year.  Opinion-wise, Our Man’s main skepticisms surround whether Europe is heading towards a long-term solution towards the sovereign debt issues, if the China-story is real or just another credit & investment-driven bubble, whether corporate margins are unsustainably high and if the US economy can continue to muddle-through.  Of these, the strength of the US economy is the one that the market has largely dismissed (though it’s doing its best to dismiss them all), as a result of the improving macro economic data that has come out with the consensus being that the US economy has hit escape velocity (again!).  Our Man would point out that while the leading data has been muted, most of the improving data has been coincident and lagging and thus extrapolating where we are now (or were yesterday) to project where we will be tomorrow is fraught with error, far smarter people have gone into far greater depth on this so he will leave you to read their words of wisdom. 

See, Our Man fell into the trap of wanting to talk about opinions, even after commenting on the frequency of such discussion.  So, enough about opinions, what about execution!  When talking about execution, Our Man will focus on the broad Equity books, the China thesis, and the Puts/Hedges books.  This is simply because the majority of the risk, and prospective returns, lie in these books - the Treasury Bonds and Bond Funds, which make up most of the exposure are unlikely to be a major driver of returns (either positively or negatively) except in extreme scenarios, and neither is the NCAV book or the position in the Euro*.  There is some other Equity risk in the portfolio, split largely between the Value Equities and Energy Efficiency books; in both cases it's relatively idiosyncratic, and invested in smaller more speculative names, hence the small position sizes to limit the potential losses.

So where does the main risk lie?  Well, as you know, Our Man's strongest opinions are his skepticism of China's growth and of the strength of both corporate earnings and the US economy.  Thus, unsurprisingly, the largest risks (and potential returns) are likely to be found in the Put/Hedge and the China Thesis books.  In both cases, Our Man's skepticism is expressed through out-of-the money put options; on Brazil (China Thesis) and on Market Indices and Consumer Stocks (Put/Hedge book).  Given the use of put options, the risk is easy to measure - the most the portfolio can lose over 2012 is the premium that Our Man has spent to buy these options (as they expire in Jan-13).  So far, Our Man has spent a total of 80bps on his China Thesis and 175bps in the Put/Hedge book, for a total of c250bps maximum loss (put premium) in 2012.  Again, impactful but not disastrously large amount should Our Man be wrong...however, I hope you noticed the "so far".  It matters because Our Man has mentally budgeted spending up to 500bps of put premium (i.e. a 5% maximum loss) in these two buckets, over the course of 2012.  To get there, it will require time, greater opportunity (or put another way, greater prospective return from each unit of risk) and higher conviction.  In practice, this is likely to come from a combination of higher stock prices (so that out-of-the money puts, struck at the same level as existing ones, become cheaper) and the underlying coincident data (on China, and/or the US economy/consumer) to hold steady or weaken.  This means, for example of the US-centric positions, the ideal scenario for Our Man is a market that rallies to 1,500 (S&P 500) while coincident economic/consumer/earnings data weakens, which would cause short-term loss on existing positions but the opportunity to add aggressively to them.  The main risks of course are that the coincident data continues to remain strong, the leading data improves and that the consumer and corporations prove resilient.  This is what Our Man has and will be watching in the coming weeks and months, to help him better execute on his bearish opinions.

* While the size of the Euro position looks relatively large (after adjusting for leverage), it would take an extreme scenario for it to be the major driver of performance.  For example, if we woke up tomorrow & the Euro was trading at its best point in 2011 (a move of 13% overnight), the loss would be c125bps…painful but not something that would ruin the portfolio.  By the same token, if it traded at its 2010 lows (a move of 10% overnight), the profit would be c100bps – once more, not something that would make a successful year.

Things Our Man’s pondering

In the words of President Eisenhower; “plans are nothing, planning is everything” - here are some of the things that Our Man’s been looking at.  They’re a mixture of some of the existing ideas in book and some new things that Our Man’s been reading up on and thinking about.

- "Lower for Longer” trades
As readers will know, Our Man believes that the Fed (and ECB and BoE, in Europe and the UK) will ed up having to keep interest rates lower, for a far longer period, than most people expect.  This is because I believe the ongoing impact of debt-deflation mean that the economy remains weak without the support of the government (either directly through Stimulus, or indirectly through Quantitative Easing).  While it is hard to execute this idea very efficiently (i.e. by using interest rate receiver swaptions) given the instruments that Our Man can use, the idea is reflected in the portfolio.  At the moment, this is predominantly through being Long 20Yr+ Treasury Bond position, though over time this exposure may be expressed through Long 20Yr+ Treasury Bonds, Zero-Coupon Bonds and options on either of these.  In the short-term however, Our Man would like to see the idea of inflation and the need for rate rises further embedded within investors’ expectations before increasing or re-adjusting the position.  As such, while it will hurt the NAV in the short-term, don’t be surprised to hear Our Man cheer some of the following: month-on-month CPI numbers of 0.3-0.4% in the next few months, a European rate rise (with firming expectations of more to come - something that could potentially encourage Our Man to increase the S Euro position too), and a strong Non-Farm Payroll number or two.

- Tobacco & Other Deflation-proof Staples
These businesses tend to be somewhat…well, boring!  As such, their stocks are the kind of ones that investors ignore in these fabulous (bear-market) rallies.  However, that also leaves opportunity for those less excitable.  For example, Altria is up a mere 67% from its lows up a (paling in comparison to the market’s c100% rise), but people seem to forget it is also trading above its 2008 highs and pays a healthy 6% annual dividend yield.  Furthermore, as we all know, while smoking isn’t pleasant, it’s certainly a habit that’s difficult to kick.  Now all Our Man needs is to persuade Mrs. OM to drop her valid moral objections, and these names will finally make it into the portfolio.

- China
This is a topic that Our Man has written about before and in the next week or so, we’ll be checking in to see whether the time is right to increase the small exposure to the Short China thesis.

- Japan
Before Friday’s earthquake, Japan was at the very top of Our Man’s list of things that he was cogitating, reading about and working on.  However events have changed that and it goes without saying that the human impact is far more important than the uncertain economic toll of the earthquake and tsunami.  As for Our Man’s thoughts, prior to Friday the outline was that a continued appreciation of the yen (vs. the USD) would eventually set the stage for the Nikkei to have an inflation-fueled run at its all-time high.  We shall have to see what happens in the coming days (and/or weeks) with the impact on Yen repatriations and Central Bank policy, let alone a whole host of other issues, all unknown at this point before making any major decisions.

- Previously discussed Themes: Energy Efficiency and Storage Theme and Water Theme
Both remaining attractive secular themes, though it has been hard to find ETFs or stocks that are not over-valued at this point.  Our Man has some names on his radar screen and continues to look for interesting opportunities in the respective spaces.

- Value Ideas
Our Man continues to scour for interesting value ideas, with a couple of names like Capstone Therapeutics (CAPS) and REalNetworks Inc (RNWK) almost at attractive levels.

Things Our Man's working on...

Unfortunately, the last few weeks has seen numerous distractions for Our Man (primarily, the small fund he was working out closing down and his US permanent residency interview) and as such he’s a somewhat behind in updating this blog. 

So without further ado, here’s a few of the ideas that Our Man is doing some work on.  Most won’t result in things that will head into the portfolio at this moment, but since Our Man thinks a number of the thematic-orientated ones are secular, there’s a reasonable chance that doing the work now will be somewhat helpful in the future.

Things Our Man is working on: Long Side
- Absolute Value (NCAV) Bucket
One of the strategies that has been consistently successful over time is buying stocks which have a market cap below their Net Current Asset Value (as developed by Benjamin Graham).  Our Man has a few screens, and will do a little qualitative work on each name he comes up with, but the idea is to build up a bucket of these names steadily over the next year.

- Value Idea Bucket
Our Man’s day-job was as an equity analyst, and as such he got to look at all sorts of companies on a bottom-up basis.  As such, expect a few names to potentially appear in this bucket as he goes about researching various ideas that wander across his radar.

- LED Theme
Our Man spent a lot of time studying, and recommending investments in, LED-related names at his old job.  LEDs are starting to become cost competitive in numerous areas (vs. other forms of lighting and backlighting) because they are more energy efficient (more light, less heat than the current forms of lighting).  The first wave of the LED implementation is seeing their use spreading rapidly in electronics devices (think your iPhone, Laptop, TV, etc), with the second wave being the holy grail in LED world (think the light bulb in your office/home, since the one you can see shining brightly outside in Times Square/Vegas is probably already an LED!).

- Lead Acid Battery Theme
Another thing Our Man spent his time working on was Batteries and Energy Storage.  While everyone and their dog, has proclaimed that Lithium-Ion Batteries are the future (all those shiny Plug-In Electric Vehicles), Our Man’s more impressed with their PR than their ability to power future Our Man's car!

- Water Theme
Blue Gold!  Oil was the most precious commodity of the 20th Century, Water will be of the 21st…

- Demographics
Are they destiny?  Our Man doesn’t know, but he does know that having lots of young people (think people entering the work force, starting to pay taxes and buy stuff!) is generally better for a country than having lots of old people (think Japan!).

- Brazil
Of all the BRIC’s, Brazil is the one that Our Man likes the most!  Why?  Demographics and Water (and other Natural Resources) are a good start!

Things to do: Short Side
- Copper/Australia: 
With China’s CPI rate coming in above their expectations, now’s the time to being to dust off the information on Our Man’s preferred instruments of choice, Copper and Australia.

- REITs (especially Hotel and Mall ones)
With cap rates tightening again, hotels having seen both Occupancy and PAR decline in 2009 (and PAR continue to decline in 2010) and Our Man’s concerns about the consumer, we may well be looking a little at the REITs.