alpha, catalyst, developed markets, emerging markets, EUR/USD, European sovereign debt crisis, foreign exchange trading, foreign stock listings, frontier markets, FX rates, Human Capital, macro perspectives, Margin of Safety, portfolio allocation, portfolio performance, stock screener, value investing, value investing bloggers
Oh Gawd, when will I learn..?! Last time ’round, the ‘pretty panties‘ phrase grabbed a whole new wave of (doubly) frustrated web searchers & readers. Who knew? But perverts¹ are people too! A majority even have jobs, I suspect. And many of these hand shandy artists are probably good savers (limited range of interests, they stay home a lot…). They might just appreciate some investing insight! In fact, gentlemen, we can rebuild them. With their powers of concentration, and attention to detail, surely they’d make excellent value investors?! My dear mother would be so proud if I converted even one of these bishop buffers…
So we’ve reached Post 100 – time to show off my pretty panties a little?! This blog’s mostly been about my stock picks and, more recently, I’ve stepped back to write more about macro perspectives. What’s perhaps been missing, as I’ve noticed with many other blogs, is a closer look at portfolio construction, allocation and metrics. This is a big oversight on my part – if you’re a regular reader, you already know this aspect of investing is actually v important to me!
I think I’ve already given some good insight into my approach to portfolio construction. It really comes down to constant reading, as I search for (ideally) a Great Story, a Great Stock, and a Great Price! Mostly, I file ideas away for future reference, a single attribute of the trifecta is not enough. However, if you can tick the box on two, or even three, of these attributes you can really skew risk/reward in your favour. Another reason stock screeners leave me cold²: You find a safe & cheap share price you’re itching to buy – it’s too easy to forget insisting on a great story & stock also. Or worse, it’s human nature to subtly twist or interpret more qualitative info. to support that great price. But a great price alone rarely equates to an exceptional investment³. The reverse approach is far better, I believe:
Figure out the big picture/investment theme, find quality stocks & management (ideally with a catalyst) to exploit the theme, and insist on a great price before pulling the trigger. This shouldn’t demote the importance of price – in fact, it’s the highest priority attribute. The beauty of this approach is once you line up a great story & stock, it’s hard to fool yourself on price – safe & cheap is pretty black or white, if you’re a value investor!
As you can see, my stock picks are often just the end result! They originate from, and are determined by, my approach to portfolio construction & allocation. Hopefully, this is also a source of ‘alpha‘… There’s heated debate about the merits of asset allocation vs. stock selection but, regardless, it’s pretty clear allocation is a significant driver of investment returns. For the rest of this post, I want to focus on perhaps a neglected aspect of portfolio allocation: Currency Exposure.
Yes, long-term, stock returns should likely far exceed your net currency returns. But that’s no reason to treat FX exposures simply as a by-product of stock selection. Currency trends have a significant impact on underlying corporate strategy & performance, so an FX perspective is a prerequisite to your stock selection. Also, currency’s where investors often display their worst ‘home bias‘ – deliberate diversification is always the healthier choice! And there’s another benefit, currencies are difficult! What?! Well, picking stocks, you can skimp on analyzing the macro environment – but currencies require a hell of a lot more analysis. This is painful, but v useful… And that analysis also provides great context (and practice!) for identifying & researching investment themes. OK, here’s Level I of my current currency allocation:
Unfortunately, this just illustrates the currency denomination of portfolio cash or investments. Not much use, except for transactional purposes: Maintaining a variety of currency a/cs, and/or using stock sale(s) to fund a stock purchase in the same currency, is an efficient strategy. But it’s got little to do with your true FX exposure. You really need to ignore the domicile/listing of a company, the currency of its stock quote, the currency of its balance sheet etc. – all of which might be different & irrelevant! You can likely ignore currency hedging too – most companies only hedge a percentage of their FX exposures (for a year or less) at best.
Instead, focus on/track the underlying currency exposure of each portfolio company/fund. For example, Argo Group (ARGO:LN) has a London listing & a GBP stock quote, a USD balance sheet, but in reality their underlying exposure’s to emerging market currencies. Then there’s Petroneft Resources (PTR:LN): It’s Irish, has a UK listing & GBP stock quote, it operates in Russia, but its underlying exposure is to the USD. Here’s Level II, my underlying currency allocation:
OK, Level II looks markedly different! This is more like it. But let’s take this analysis to its ultimate conclusion. Like most investors, I’ve other (non-stock) financial investments4. These can be chunky exposures, and you probably have less discretion in the denomination of these assets (and related liabilities). It’s important to include and monitor these exposures within your currency allocation. This allows you to consider compensating currency allocations elsewhere in your portfolio. [I haven’t found it useful to do so, to date, but you might also consider including these assets/liabilities into your investment allocation analysis. I also note with interest the growing body of work arguing that incorporating (your) Human Capital into any portfolio allocation analysis can ultimately lower risk & improve diversification7.] Here’s Level III, my total underlying currency allocation:
This ultimate currency allocation is reasonably deliberate – but when I talk currencies, I’m definitely not suggesting FX trading! For a host of reasons, it makes perfect sense for your currency allocation to only evolve slowly over time.
My biggest frustration is the emerging (& frontier) market/other currencies allocation, at 23%. I’d be v comfortable doubling this exposure! After all, we’re talking about countries/currencies who mostly have much better growth (prospects), and far better trade, current a/c and fiscal deficits. Of course, they also exhibit far superior Debt/GDP ratios, far lower entitlement commitments, and far younger populations. But the only way to achieve that exposure is by buying more emerging/frontier stocks… Duh?! Well, that’s not the case with the USD, for example – I can access exposure in a huge variety of ways, not just by buying ‘plain vanilla‘ US stocks.
I’m perfectly happy with much higher emerging/frontier exposure long-term – but it’s hard for me to achieve. I expressed my reservations about ETFs before. I also don’t want to over-estimate my ability to tackle emerging/frontier investing on a stock-by-stock value investing basis..!? Sounds glamorous – but it’s a bloody tall order, and surely promises to tear you a new one at some point. Closed-end funds are perhaps the best compromise, but a good investment objective vs. a good investment performance vs. a good/great NAV discount is pretty hard to reconcile… Emerging market companies listed in London (and New York) might offer the best individual stock selection opportunities (Avangardco (AVGR:LN) is a good example). Gaining this exposure will likely have to be a medium-term goal.
Conversely, I’d like far smaller developed market currency exposure. The other big hurdle here is the fact exposure to the likes of distressed & other alternative strategies, natural resources, etc. is invariably offered in USD (or GBP, or EUR). I could add some currency hedging. But I don’t think that’s a satisfactory long-term solution, and I suspect it just makes one far more susceptible to FX news, noise & trading. If I can eventually target increasing my emerging market/other currencies allocation to about 45%, that allows me to scale down elsewhere: Let’s say to 25% on EUR, 17.5% on USD and 12.5% on GBP.
Yes, I’m comfortable with an unchanged (even higher) GBP allocation. I think it’s currently v under-estimated: It has open access to Europe, a tremendous advantage long-term. In return, the EU can interfere with their fiscal & regulatory policies (the last thing on their minds right now!). But so what? The UK can always compensate, it has an independent central bank & currency! Additionally, it’s an incredibly open economy, with regard to trade and to M&A. This corrects currency under/over-valuation far more quickly than we see elsewhere. Do you really think central banks/sovereign wealth funds will keep buying USD, EUR & JPY for ever? Of course not, they want to diversify and there is a definite appeal (and room) to add more GBP in their portfolios.
Right, I hadn’t meant to save the EUR vs. USD debate ’til last… But is there really a debate here? My higher EUR allocation isn’t about choosing the merits of the EUR vs. the USD – it’s more about being forced to pick your favourite leper! Then again, who can tell me they sincerely believe the US government & Federal Reserve will support & produce a US dollar that’s stronger long-term than the EUR? Puhleaase, I’ve a cure for cancer to sell you – will only cost you a 100 bucks…sorry, a 100 euros! I think all common sense, data and history suggest the EUR’s the better ultimate bet than the USD. At least in relative terms… 😉
Meanwhile, the USD may derive some support vs. the EUR, considering it’s further ahead in the (now usual) bank bail-out, fiscal stimulus, money printing & recovery cycle. But that’s minor vs. the support of its safe-haven status. [And look at the equity markets: They certainly seem to have this potential growth differential/lag more than priced in – Europe’s now on at least a 30% P/E discount to the US.] What a topsy-turvy world we live in that the epicentre of the ’08 financial crisis is rewarded with safe haven status?! And where the US hurtles towards PIIGS (European?) status, but meanwhile is awarded a yield of 1.63% on its 10 year bond…
Milton Friedman coined (and Nixon conceded) the phrase ‘We are all Keynesians now‘. How much longer before the US establishment concludes ‘We are all Europeans now’?
btw The notion, particularly in the US media, that the EUR will suddenly collapse because of the sovereign debt crisis is rubbish! They’ve declared this literally every day now for the past two years! Then again, the media & all the talking heads are never held accountable for their guff. How about a TV channel where every journalist & guest’s portfolio scrolls by as they talk – it would certainly be more informative (particularly if you mute the sound!). Sometimes it’s far smarter to just listen to the market.
Take a look at the chart, does anybody realize the EUR’s traded higher over the past 2 years!? It even peaked over 1.4500 on a few occasions. Everywhere you look, everybody’s short and thinks the EUR will collapse… So, who on earth is bloody left to sell?! As any trader will tell you, you need to sit up and pay v close attention when a market/price refuses to trade down on bad news (or vice-versa). Now, I’m not suggesting a massive EUR rally is coming! I’m simply saying the fears of a EUR collapse are fairly remote & completely over-blown – that appears to be the simple message of the markets right now.
OK, we’ll be looking at investment allocations next. To be Continued…
1 Here’s a tip, just label your fetish with a ‘…philia‘ – people will definitely think you’re classier, or perhaps just English…
3 Think about Japan over the past 2 decades: In the first decade, judging against prior history, investors got crucified grabbing shares at what looked like cheap prices. Of course, they weren’t… Then, in the second decade, prices finally seemed cheap…but to what end? What compelling investment theme was on offer? And poor RoEs, management neglect of shareholder value, and the absence of activist investors meant prices weren’t actually that cheap, and there was little chance of value realization anyway.
4 This definitely doesn’t include your main residence(s), or any related mortgages, unless perhaps you’re planning to sell up and downsize, or move overseas. In the boom years, property fuckwits5 were as idiotic as they were boring… Your home actually bears v little resemblance to an investment. In fact, houses may as well be trading sardines!6 Let’s demolish a few myths:
– Your house tripled in value – you’re a bloody genius! Er, no, you’re not – so did every other house in your neighbourhood and, in fact, your entire city and country. Unless you come from a nation of fucking geniuses?
– Your house tripled in value! So what? Are you planning to now live in a shack? The next house you buy is sure to cost as much, or more, than the house you sell.
– Your house tripled? And you do remember you pay 3-4 times the loan amount over the life of your mortgage? Not to mention the insurance, the maintenance, the security, your time & headaches, and so on. Let’s check that ‘profit’ again…
– Rent money is dead money. Are you kidding me, this is the king of the idiot phrases. Until your house price appreciation starts to beat inflation, what do you think your colossal interest, insurance, maintenance etc. payments represent? Yeah, dead money.
– If you persist in thinking of housing/property as an investment, why buy bricks & mortar? Buy the stock exchange instead! If you’re disciplined & smart, you can regularly buy property there at a substantial discount. And, as a bonus, you’ll likely get far cheaper/more professional management of your ‘property’.
– Aah, but you can’t get a loan to buy shares, I hear from the crafty fanatic… Judging by the last few years, is that so bad?! Anyway, this is a misconception – you’re buying shares in a property company that already has debt (likely obtained far more cheaply/efficiently than you could). If it has a 60% LTV, for example, your 40 grand share investment is actually buying you a 100 grand of property.
5 And speaking of fuc…sorry, the blue-shirt boys: Here’s the best explanation ever of why Irish gardai seem so bloody afflicted (to put it kindly).
6 ‘Margin of Safety‘ by Seth Klarman is definitely a great book (an updated edition is in order though), but who on earth’s paying $1,000+ for a copy?! Have a quick search ’round the web, you’ll find a perfectly good pdf of the book!
7 I guess the charmless phrase ‘don’t shit where you eat‘ speaks to further diversification of your Human Capital..!?