The Inherent Contradictions of My Portfolio (or Who’s The Greater Fool..?) (Part IV)

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asset allocation, bubbles, bullish, developed markets, don't fight the Fed, emerging markets, frontier markets, macro investment thesis, Nifty Fifty, wall of money

Continued from Part III.

OK, so here’s an end-June snapshot of my current portfolio allocation:

[NB: And here’s my portfolio a year ago (from this post) – the majority of subsequent changes are obviously due to sales/purchases & the share price appreciation/depreciation of (mostly disclosed) holdings. Notably, my minor Hedge & Nat Resources allocations are now eliminated on sales of holdings, while my new US & Undisclosed (a new asset class I’m still working on) allocations reflect undisclosed new holdings. I’ll also highlight my Cash allocation’s pretty minimal, with the priority on Fixed Income (which is how I basically consider my Alternative Asset Opportunities (TLI:LN) holding) & Event-Driven (essentially, my NTR plc holding…noting, in particular, last week’s announcement of a return of capital/wind-down) 🙂 ]

Some big & small changes, obviously – but in the scheme of things, it certainly isn’t a radically different portfolio. But what were you expecting…did you really think I’d turn on a dime & completely transform my portfolio? Um, maybe if I was some hard-charging hedge fundie. But for the average investor, the more rapidly & radically one’s portfolio changes, the more likely it’s the result of poor/faulty decision-making! And I suspect this is even more true of thesis-driven investing – the biggest & most rewarding theses tend to develop/evolve over a long period of time, and likewise so should your portfolio…

Now, let’s consider some potential portfolio allocation implications, in terms of my current macro investment thesis. [Keeping in mind my recent Four Feds commentary]:

Emerging/Frontier Markets:  My underlying emerging/frontier markets thesis hasn’t changed a jot since I wrote this post (& its follow-up). But sentiment remains negative, with investors/commentators focusing on specific country surprises & disappointments, and the narrowing growth gap between developed & emerging/frontier markets. Currency weakness, esp. against the dollar, hasn’t helped either. But emerging/frontier markets are still the world’s growth engine, and will continue to trounce developed markets in terms of absolute growth. And the narrowing growth gap’s mostly due to starkly differing fiscal/monetary policies…investors might well ask themselves which policies are more sustainable? As for currency weakness – yes, it’s a short term hit, but it also improves their terms of trade substantially.

But doubters question whether a new export-led growth surge is even possible, citing lower developed market growth/demand. Which strikes me as a remarkably stupid argument…if you expect lower Western growth, surely it strengthens the case for high growth emerging/frontier markets investment?! Many which now appear to be reaching an inflection point, where domestic middle class/consumer demand’s emerging as a new growth driver, reinforcing or even supplanting existing export-led growth.

But let’s face it…as long as Western investors (US investors being the classic example) enjoy & increasingly anticipate attractive local market gains, they simply won’t bother with (or will actively avoid) investing in emerging & frontier markets. [Granted, a developed market bubble would probably spill over into those markets eventually]. And if developed markets crash ultimately, it’s only prudent to presume emerging/frontier markets will again be similarly punished. All in all, this doesn’t seem to offer the most compelling of propositions. On the other hand, it also doesn’t make much sense to turn one’s back on half the world & its myriad opportunities…

Which I think demands a cherry-picking strategy:  Selective exposure to the cheapest and/or highest growth markets (obviously balancing risk vs. reward). With Saudi Arabia opening up, GCC markets remain interesting (and with this week’s news, Iran is potentially a giant step closer to being the next great frontier market). Russia remains one of the perpetually cheapest markets in the world – but almost nobody’s buying it & valuations appear to permanently discount its current situation, so long term risk’s potentially asymmetric… As I’ve highlighted, Greater China still offers cheap access to one of the largest/highest growth economies in the world (growth in India is catching up, but valuations are much higher). And finally: I have a growing conviction Vietnam is the ‘new China’ – in terms of price vs. growth potential, it may be one of the best long term risk/reward propositions in the world.

[See also some related US/Europe commentary below.]

UK/Ireland:  UK & Irish stocks are still an exclusive alternative to Europe in my portfolio. [And they remain similarly priced – though Ireland offers relatively few large caps & the UK’s more heavily weighted towards financial & resource stocks]. But clearly, these markets have proven they’re two of the most flexible EU nations (Scandinavia is also an interesting alternative) – the UK obviously via its independent monetary/currency policy, and Ireland via internal devaluation. Which continues to present an attractive & defensive alternative – if economic growth & outlook keeps improving for Europe, the UK & Ireland benefit accordingly,  but if things head south again, they’re still the best-equipped to ride out the storm…

[Also, see here & here.]

Europe:  But in an environment fueled by regular infusions of ECB liquidity, an increasing (re-)allocation to Europe may now be a more attractive bet. [Particularly if Greek risk’s now effectively off the table..?!] Investing in PIGS distressed assets is one obvious way to play it – but that might still prove too aggressive (& isn’t so easy to implement via the listed markets, anyway). Large cap European equities have now become far more compelling, in terms of risk vs. reward, and they’d also add some useful portfolio diversification.

Which presents a bit of a challenge… Despite the EU/Eurozone & a plethora of pan-European indices, buying Europe’s nothing like buying the US for the average investor – it’s still a somewhat daunting exercise in learning about/adapting to the foibles of every single individual market. I mean, where do you even start..!? Not surprisingly, there’s a tendency for investors in Europe to stick close to their home market (& maybe London). A bias that’s compounded by their daily financial media exposure, which is almost exclusively focused on their local market, the US & the UK.

So, I really need to take the bull by the horns (!) in Europe. By deciding whether to delegate my allocation – to an ETF, or (ideally) a top-notch listed fund manager – or by putting some serious effort into identifying a decent selection of Euro large caps. Even a relatively mechanical survey of the top 5-10 stocks from each market (rather than the top stocks across Europe) would be a good place to start.

The great thing is, most large caps – regardless of how local their listing & IR might be – are pan-European in exposure. And they tend to be more global than their US equivalents, often boasting substantial and long-lasting emerging & frontier market exposure. In fact, such companies may well kill two birds with one stone…presenting a perfect opportunity to access higher emerging/frontier market growth, while also benefiting from escalating developed market valuations. [As a sector, luxury stocks are an excellent example, though valuations often leave a lot  to be desired!]. This exposure’s also intriguing in light of the euro’s more recent weakness. Analysts are often slow to (fully) recognise currency gains, and European companies can also be a little slow to exploit euro weakness, so I suspect this will prove to be a good news story that keeps on giving for a long time to come…

US:  I previously fingered the US as the market facing the most near/medium term resistance. Which might seem bloody obvious now, based on the S&P’s non-existent performance YTD. [I should highlight my portfolio was intentionally void of all US exposure ’til now! Except that wasn’t such a smart strategy last year…] And I don’t think that’s gonna change ’til one or two Fed rate hikes are actually out of the way (finally..!?), and investors get to digest, rationalise it & buy the fact…

Meanwhile, we’ll see the reverse currency impact filter through – for globally-oriented US companies, the strong dollar’s obviously going to be a significant hit to their top & bottom lines. We can rely on management to emphasise constant currency results, but the painful drip-feed of negative news headlines and the lack (or even reversal) of sales & earnings progress is still likely to present good/better opportunities to average in to some attractive large caps. Again, this should hopefully offer a welcome chance to access emerging/frontier market growth & benefit from increasing developed market valuations.

That being said, do your own research – US companies’ global exposure is often wildly over-stated by the media (aren’t you sick of those ’10 Safe Plays on China’ articles?!). Inevitably, much of this exposure is European, so emerging/frontier market exposure is often far less meaningful than the journos cite/imply – this can be particularly true of consumer plays (a case of hacks & readers deserving each other). But on the other hand, the global exposure of technology companies often seems to be under-estimated. And it’s worth remembering my earlier warning – there’s a pervasive financial media focus on a select bunch of marquee US names, so be extra careful of any exclusive bias towards such stocks (and yes, I feel this bias myself, every single day) at the expense of a more global Nifty Fifty.

Japan:  Japan’s an appalling & entirely unintentional exception from my portfolio. Again, where to start…identifying the Japanese contingent for a global Nifty Fifty is far more of a challenge than with Europe, for example. I mean, it’s amazing how many large Japanese companies today still make zero/minimal English language IR resources available to investors, and even getting fully comfortable with the format & accounting of annual and interim accounts/updates can also take practice!

Which I think is another explanation for the increasing popularity of using a Ben Graham approach…many investors simply prefer to stick with the numbers. But judging by historic capital allocation, poor returns on equity, and generally intransigent management, on average the pricing & risk/reward of Graham-type bargains isn’t really much of a free lunch. And trying to assume/decipher any supposed sea-change in management’s (lack of) commitment to shareholder value is mostly a fool’s game. Then again, hope springs eternal again re Japan, in terms of governance/IR reforms & potential activist success – so gaining exposure to some genuine value-enhancement (and/or activism) might actually offer that free lunch after all…as long as it comes at the right price.

There’s also a trend towards currency-hedged ETFs. But over time, equities tend to incorporate/offset most significant currency impacts, so I wouldn’t prioritise buying such a fund unless it was one of your first choices anyway. And Japanese large caps are generally the most export-focused companies, so (further) yen weakness is more likely to benefit them anyway. I also suspect Japanese property could be a potentially decent currency hedge (& even a hedge against a run-away fiscal/inflation scenario), and it’s a pretty compelling property market in its own right – so it might be an attractive alternative to other large cap sectors. Residential property values, for example, remain at the same level as 30 years ago – while yields are now about 4.0%+ (down from 5.0-6.0%), which is incredibly favourable vs. the bond market (10 year JGB’s now at 0.44%).

Natural Resources:  I mean, where do I even start…let’s not even ask!? Natural resource companies & stock valuations obviously reflect real world demand. But seven years later, they still can’t seem to bid farewell to all those fond memories of the good ol’ days… How else do you explain, for example, the majors maintaining & even increasing production in the face of a (self-reinforcing) iron ore price collapse. How rational is that..?! But that’s nothing, look at US shale companies – they’re in such dire financial straits, they’re forced to squeeze every last drop of oil/gas from the ground, even if it only yields an incremental dollar of net cash. I’m not convinced a $51 WTI price adequately reflects that yet, nor am I convinced Iran (& the implications for other Middle East production) is fully priced into $57 Brent either.

Companies which might actually benefit from another leg down in the oil price seems like the only attractive play right now. Particularly US airlines, because I really do think ‘it’s different this time…’ (!?): They’re a government endorsed (despite recent complaints) oligopoly (the top 4 airlines control over 80% of the domestic market), their balance sheets & labour benefits have been restructured, and their current pricing power was unheard of little more than a decade ago. [Basic ticket prices are just the beginning now – how much in additional fees/income (at mostly an 80-100% gross margin) do they regularly extract from you today? And those fees are never going away…]. Why agonise whether Ryanair (RYA:ID) is really worth its estimated 17.2 P/E, for example, when Delta (DAL:US), United Continental (UAL:US) & American (AAL:US) trade on an average 6.6 P/E?!

[Also, see here & here. And here.]

Agri-Business:  And somewhat coincidentally, agri-commodities are mostly in bear markets too. They also appear to be in the self-reinforcing phase where producers aren’t prepared to switch crops, or they basically have nowhere else to go. Which leaves a lot of softs/livestock trading at an inflection point – they now look very cheap vs. their more recent price history, but still not unreasonably valued in terms of longer term price charts, so the jury’s still out on their future price trajectory.

So while there’s always idiosyncratic agri opportunities on offer, a watch & wait strategy seems generally prudent – sugar, palm oil, grains & hogs will likely deserve the closest attention. [And if farmers prefer to watch & wait also, then the share valuation & price chart of Deere (DE:US) (for example) is all the more puzzling…] The aquaculture sector remains compelling, but obviously suffers from a unique & recurring cycle all of its own.

[Also, see here.]

Property:  While there’s no real sign yet of expanding bank balance sheets globally, the gears are certainly being lubricated. In terms of property, bad assets continue to be restructured/sold off (or they’ve migrated into public hands), while good assets & projects are being re-financed far more easily now. Which, of course, gets the whole property merry go-round spinning again – as property recovers in value, so does its value as collateral, which frees up fresh loans for property investment & development, which drives up prices & improves collateral values, which frees up more loans…well, you get the idea. Left unchecked, property’s the self-perpetuating virus which (almost inevitably) causes a banking bubble & collapse.

But when I look at the US, UK & European property sectors, I don’t really see a tremendous amount of value vs. the price recovery (to date) & the obvious risks still present at this point in the cycle. [Admittedly, I’m also pretty allergic to the income-driven & potentially unsustainable REIT model that’s become (increasingly) prevalent in these markets]. In fact, Ireland might just offer the best risk/reward, despite the NAV premiums in its newly-listed property sector. [Again, distressed PIGS assets would be a more aggressive bet]. And the sheer wall of money we’re seeing would certainly seem to assure a steady increase in prices – the collective market cap of Irish property IPOs* in the last two years now amounts to EUR 3.4 billion, not to mention all the PE/distressed/other funds out there chasing the same pie. Now consider the additional leverage all this equity can employ…all against a backdrop of declining unemployment & one of the fastest growth rates in Europe.

[*Namely: Dalata Hotel Group (DHG:ID), Green (GRN:ID), Hibernia (HBRN:ID), Irish Residential Properties (IRES:ID) & Cairn Homes (CRN:LN). At a stretch, Applegreen (APGN:ID) might arguably be considered a different kind of property play, while Abbey (ABBY:ID) could even make a wholesale return to the Irish housing market – that’s another EUR 0.7 billion in market cap.]

But as a notable exception to my new & more cynical perspective, I also think emerging & frontier markets still offer a compelling proposition, specifically in terms of luxury residential property investment/development. Some markets are more attractive than others, but the requirements & economics of servicing the rich have become remarkably similar across the globe in the past decade or so. Valuations aren’t actually a huge deterrent – but unfortunately, the real stumbling block has been (& still is) the quality of individual corporate management/governance… London-listed funds/companies have generally disappointed in terms of compensation & related-party transactions, capital allocation & fund-raising, and (most of all) management’s poor quality of execution. Local companies are a likely better bet, but obviously have their own issues & definitely require far more analysis and due diligence! Of course, the rich also buy overseas at ever-escalating prices – London & New York are the obvious wealth magnets – but accessing that specific exposure isn’t so easy either…

[See also some related Japan commentary above. Also, see here.]

Distressed:  Distressed assets are ultimately event-driven, so they’re always a useful & less correlated component of any portfolio. But for many investors, a rising market tends to raise the investment hurdle for these assets…as I’ve said, it demands ‘a far more realistic & cold-blooded evaluation of the likely scale and timing of a potential value-realisation event’. [And available discounts to fair value, in terms of investment vehicles & the assets themselves, are obviously a key factor in that equation]. It probably isn’t an asset class that promises much in the way of (new) supply either (same is true for distressed consumers), at this specific point in the cycle. [So investor attention will be primarily focused on PIGS property assets/loans, the US energy industry, and maybe eventually (ulp!) Chinese non-performing loans].

[Also, see here, here & here.]

Undisclosed:  New & undisclosed asset class.

Hedge Funds:  Not on my radar for the moment. The substantial NAV discounts on offer some years back have essentially been eliminated now, and overall hedge fund performance has consistently lagged the equity markets ever since the tail-end of the crisis. [Not that the industry’s performance during the crisis was inspiring either…] Of course, this reflects the current predominance of long/short equity & credit funds. Activist funds should still be considered: But in terms of sheer size, the larger funds are obviously forced to stick with the standard playbook (M&A, debt & share buybacks) – those tools, and management’s desire to co-operate & implement, are really just another bull market phenomenon.

But if you suspect/agree we’re now in a period that in many ways recalls the early ’70s, hedge funds may ultimately become the most important (& attractive) asset class available to investors. The subsequent volatility & collapse (& even death) of equities, and the unmooring of the hitherto (relatively) fixed price universe of gold, currencies, commodities, and money market & bond rates, allowed the stars of a still nascent hedge fund industry to rack up what should be remembered as the most incredible & consistent investment returns ever (from the ‘mid ’70s & into the ’80s). Of course, these were all macro hedge funds. But obviously the industry itself, and the dynamics & regulation of the markets, are drastically different today. And I’m also not so sure a new generation of macro giants will ever exist again…

[Also, see here.]

Event-Driven/Fixed Income & Cash:  ‘Nuff said already…time for some ‘cold-blooded evaluation’.

[And again, here.]

OK, we’re done!

Just one final post-script:  Actually, I’m mostly focused on analysing & evaluating large cap stocks in just two sectors, specifically – in general, they’re the only obvious sectors which I believe still offer investors a pretty compelling risk/reward.

So, what the hell are they?!

Ah but like I said, that’d be giving away the prospective prospecting work that’s ultimately still to come – for my portfolio & (ideally) the blog – in the weeks, months & even years ahead… Just stick with me, dear reader!  😉