Tuesday, February 19, 2013

Ten Principles of Value Investing

"Buying a Dollar for 50 cents". I love the idea, but find it rather difficult to do in real life. Offering such a trade to someone resembles nothing more than an offense and trying to make a living of such an activity would probably put you at the limit of legality.

In the investing world however, a group of people are dedicating their lives at doing only that; they do not buy assets unless they are offered for significantly less than their fair price. Those Value Investors, as they are known, have produced inspiring examples of investment success like Benjamin Graham, Warren Buffett and Seth Klarman, to name but a few.

These legendary investors often adhere to a strict discipline in their approach (even if the Oracle of Omaha seemed to have taken a sidestep with Heinz recently); and having guidelines surely helps as value investing is not a quiet journey. 

In today's post, my colleague Michael Wassermann is sharing the top 10 principles he is following in order to be consistent in this difficult art. Michael has been financial analyst and strategy consultant prior to entering the world of Private Banking three years ago. I like his approach and discussing with him always spurs further thinking on my side. He was kind enough to write this piece summarizing the way he approaches stock investing.

This blog entry is the first in what I hope is going to be a rich "Be My Guest" series where writers other than me will contribute and share their views. This will hopefully help in making this blog diverse in opinions and topics explored.

I am still working on "Hunting for European Smaller Companies- Part II". What Michael exposes here will certainly help in screening for stocks.

Enjoy the read and see you around soon,


My Ten Principles of Value Investing

By guest writer Michael Wassermann

Investing can take different shapes and forms. Let me share some thoughts on an investment style that works for me – Value Investing.

Rather than dwelling on definitions of Value Investing, here are 10 principles that I follow, inspired by legendary investors (Graham, Buffett, Klarman etc.).

1. Never invest without a Margin of Safety. Investing involves a lot of uncertainty. To account for human mistakes, complexity, and bad luck, securities should always be purchased at prices sufficiently below intrinsic value (at least 30% discount compared to a conservative company valuation; see here for fundamental valuation techniques). Such a Margin of Safety is best achieved by buying securities that are "Safe and Cheap".

2. Do your own homework. Unfortunately, successful investing requires a lot of homework, including research and analysis. You can look at what other investors you respect do as a source of inspiration – copying is okay in investing – but you'll only have the confidence required to take sound decisions (and stick to them) if you do your own analysis. If you don't want to invest the time and effort, best would be to delegate your investments to professional managers.

3. Be contrarian. The most lucrative investing opportunities can often be found in out of favour, boring, odd, small, disappointing stocks (for instance, stocks trading at multi-year lows). If everybody loves a stock, it is likely to be quite expensive. As a contrarian investor, I prefer for instance Apple at $450 than at $700.

4. Be flexible. To capture value opportunities, you need to be flexible, agile and unconstrained. This is the great advantage of the small private investor over large institutions – use it. The only relevant constraint should be: avoid what you don't understand, put it in the "too hard" pile.

5. Be patient. Good things happen to cheap stocks – but the timing is unpredictable. Patience is critical to deal with the (inevitable) curse of being too early, and to be able to "wait for the fat pitch". I like to keep a substantial amount of cash as dry powder to be used when extraordinary opportunities arise (they often do eventually).

6. Buy and sell. This is possibly somewhat controversial (many value investors adopt a buy-and-hold approach) and could be perceived as contradictory to the "Be patient" principle. However, whilst I believe that you should always invest with a long-term perspective in mind, I also like to take advantage of market movements to buy more of stocks that have sold off, and trim positions that have appreciated.

7. Make volatility your friend. Too many investors are afraid of stock price volatility and assimilate volatility to risk. From my perspective, risk is the permanent loss of capital, not a number nor a Greek symbol. Volatility creates opportunities and as such is the value investor's friend.

8. Beware of debt. A rock solid balance sheet takes part of the financial risk of investing away. As a rule of thumb, I try to avoid non-financial companies with a debt to equity ratio above 1.

9. Don't over-diversify. You want to focus on your best ideas rather than overly diversify your portfolio. Buffett is right again: "Diversification is protection against ignorance".

10. Be disciplined. Investing is a highly emotional activity. Maintaining a disciplined approach (for example, by using a checklist) helps avoiding many traps like spending too much time on macro noise, getting seduced by the latest fads, falling in love with a stock, and panicking.

Further reading. The value investing literature is very rich and contains a wealth of wisdom. Below is a selection of 3 timeless generalist books that I find insightful and that I often re-read. For updated intelligence, I also highlight the investor letters of 3 investing gurus.

3 books:
The Intelligent Investor, by Benjamin Graham.
Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, by Seth Klarman.
The Little Book of Behavioral Investing: How Not To Be Your Own Worst Enemy, by James Montier.

3 investor letters:
Warren Buffet's Berkshire Hathaway shareholder letters: http://www.berkshirehathaway.com/letters/letters.html

Howard Marks' Oaktree memo's: http://www.oaktreecapital.com/memo.aspx

Jeremy Grantham's GMO quarterly letters: http://www.gmo.com

Wednesday, February 13, 2013

Hunting for European Smaller Companies- Part I

After a good start of the year, boosted as they were by the Draghi-Rally since July and by the vanishing threat of a fiscal cliff-led recession in the US, European markets kind of lost stamina. They were even severely hit last week because of political turmoil in Italy and Spain that reignited fears over the sovereign debt crisis. The setback was a good reminder that there is still no end-game in sight and that caution remains warranted, especially with a sluggish economic backdrop.

Yet equity valuations are (still) attractive and cautious long term investors could benefit from future corrections to make opportunistic additions to their portfolios. This implies that they know what they are looking for. If not, reading this article (and the next) might help. The objective here will be to focus on European companies with a market capitalization under €7.5 billion and to identify some that have the potential to be future winners.

A rich universe

Before looking at single companies in details, let's familiarize with the universe we will be working with. For the purpose of the analysis, I will slice the Russell Developped Europe Index and create subgroups according to market capitalizations as follows:

  • Mega Caps: above €75bn
  • Large Caps: above €7.5bn
  • Mid Caps: above €1.5bn
  • Small Caps: above €200m
  • Micro Caps: below €200m

This is arbitrary but somehow fits the commonly accepted definitions in USD terms. For simplicity I will also use the term 'larger caps/companies' to designate the companies that are above €7.5bn and 'smaller caps/companies' for the others.

The smaller cap universe is rich. Even if it only represent 25% of the total European market by size, this subset makes up 86% of the stock count with 1624 individual names. Furthermore, smaller companies are active in 147 different GICS sub-industries, which is more than double the 71 that can be claimed by Mega and Large combined. These figures clearly tell that we are by no means restricting ourselves by going down the size ladder. On the contrary, we are broadening the perspectives.

Based on Russell Developed Europe constituents - Source: Bloomberg (as of 10th of Feb 2013)

Very decent risk/return pattern

I have taken the three Stoxx Europe 200 indices (Large, Mid and Small) to compare the annualized total returns (price + dividends) of different segments over time and the results speak in favor of smaller companies. Mid caps did a better job than large ones for investors on 1, 3, 5, 10 and 20 years periods back from now. Small caps outshined the middle sized ones on 3y and 5y time windows. Adjusting for risk (dividing the annualized total returns by the annualized volatilities), the results stay in favour of smaller companies with the exception of last year.

Periods ending on the 31st of January 2013 - Source: Bloomberg

This analysis is fine but too dependent on the reference point we are selecting (the 31st of January 2013). Looking at rolling annualized returns will give us more insight and a feel of how benchmarks behaved over different market cycles. 

The graph below looks at 5-year risk adjusted returns for holding periods starting on the first of January in year 1 until the 31st of December of year 5. We will start in 1993 to have a 20 years span as in the previous analysis.

Source: Bloomberg

Even if it was good to hold big companies in the 90's, it seems that going smaller was an advantage in periods beginning after 2002. Smaller caps had a better recession and a better recovery than larger ones. The most recent data points show that large caps are still losing on the 2008-2012 period, whereas small and mid managed to recoup the losses of the financial crisis. Bigger doesn't really mean stronger, at least in aggregate benchmark terms.

Emerging market 

A common shortcut argument consist of saying that smaller companies are more dependent of their domestic economies. It is true, but it casts a shadow on the ability with which small and mid caps managed to tap emerging markets growth. The graph below is based on data from companies belonging to the Russell Developed Europe Index that reported revenues per geographic segments (data available for 92% of the Mega caps, and for 78%, 82% and 84% of the large, mid and small caps respectively). If they are in average markedly less exposed to markets outside of Europe, mid/small/micro caps do not lag in terms of Emerging Markets exposure.

Latest yearly revenues per geographic segment - Source: Bloomberg


Under the radar

Mid and Small Caps get less analyst and news coverage than heavier weights, which means that there are potentially more market inefficiencies to be exploited there. In addition to lower level of 'sell-side' implication, there are also less mutual funds active in the space, resulting in less crowded trades.

The graph below shows the average number of sell-side analysts covering a stock in each of the market cap segment: mid and small are less popular which can be an advantage.

Average number of sell-side analysts covering a company per segment
Source: Bloomberg, based on the
Russell Developed Europe Index constituents (as of Feb 10th 2013)

The following table is taken from a MorningStar article on European Mid Cap investing. The analyst looked at the assets managed by funds explicitly focused on Large/Mid/Small Caps and compared them to the market cap of benchmark indices (the Stoxx Europe 200 Large, Mid and Small). The Small and Mid Cap funds represented only 3.9% and 7.1% of their respective benchmarks market cap, well below the 14.5% achieved by those following large caps. The study dates from November 2011 but I doubt that the gap has been closed since then (full article here).

Other arguments

Small caps tend to be focused on their core business, they have less divisions and product lines than bigger companies. This can help in the analysis and in projecting future cash flows and earnings. Moreover, due to their small size and focus, they can be ideal M&A targets of bigger players looking for growth they cannot generate organically. M&A activity has been low in 2011 and 2012, yet cash is abundant on the corporate balance sheets, so there could be an uptick in takeover moves going forward. Identifying potential preys can translate in nice performance boosters.

Mid caps have had the time to prove themselves and still have a lot of potential they can exploit. In other words, it's a universe of well structured companies with a track record you can examine and potential for growth. All mid-caps do not become larger players, but the animal spirits of their owners and managers push a lot of them 'up' that road.

These are arguments that I cannot prove with hard data, however. 

Preliminary conclusion

Up to here we have been looking at the European Smaller Cap segment in very broad and quantitative terms. What we can say is that in aggregate, those companies are performing very well in risk-adjusted terms, they provide broad diversification potential across industries, are well exposed to emerging markets and are doing all this without attracting too much attention. 

In the next post, I will follow a bottom-up approach and screen the smaller cap universe in search of stocks that could be candidates for successful investments.

Until then, have a good time and enjoy everything you do.



Tuesday, February 5, 2013

The case for Emerging Market Debt

I was recently invited by an asset management firm to take part in a conference on emerging market corporate bonds, an asset class that has been particularly popular lately. The manager of the fund in focus shared some insight that would have been difficult to get otherwise, so I did not lose my time. During his speech, he made one observation that I found particularly relevant: emerging market corporate debt is an asset class that is "to large to be ignored". In other words, if you are in the process of building a diversified investment portfolio, you basically have to take a stance: either you incorporate these type of bonds or not. This is an asset allocation decision you have to make, you cannot just overlook that market.

The remark can be extended to the larger Emerging Market Debt (EMD) complex that is  also encompassing sovereign issues. Fund flows indicate that a lot of investors are enthusiastic about this market,  which is understandable given the good issuers that can be found and the attractive yield/risk profile that many bonds exhibit.

Over the past few months however, the interest has turned into some kind of frenzy and several observers are calling a bubble. Recent events do indeed surprise: in October last year, Bolivia issued a $500 million 10 year bond at par with a coupon of 4.87%. This is a low yield for a BB (hence "junk") issuer with a rather poor track record with foreign investors. Still, the bond  managed to be 9x oversubscribed in a sign that market participants are fighting to get their slice - maybe without going through a proper due diligence process.

Emerging Market Debt is neither "good" nor "bad" and all subgroups do not look bubbly at the moment. It is a universe that can produce investment vehicles having a positive impact on a portfolio if they are well understood and added on decent valuations and in the right context. Let's go through the basic features of these markets before looking at the current opportunities and risk to consider.

A brief history of the asset classes

Emerging Market Debt (EMD) is commonly broken down into three subgroups that exhibit different key characteristics, they are all "asset classes" of their own. 

Hard Currency Sovereign EMD is the most mature of the three categories and covers bonds issued by governments in USD and, marginally, in EUR. In a not so distant past, financing to emerging market countries was essentially provided by developed market banks in the form of loans, mainly USD denominated. Issuing in a "hard currency" rather than in the debtor's own protected lenders against inflation and foreign exchange rate manipulation that were not rare phenomena. This all went rather fine until the 80's, when a series of Latin American countries started defaulting on their debt causing troubles to US banks. In order to help those financial institutions in shoring up their balance sheets, the US Treasury made it possible to convert those bad and illiquid loans into tradable instruments coming with more guarantees from the debtors.  When they started selling these so-called "Brady Bonds", by the name of the Treasury Secretary of the time, banks removed the risk from their books and created a market for hard currency sovereign EMD. 

The second sub-type is the local currency sovereign EMD. It gained pace when the improving fundamentals of emerging countries enabled them to issue debt in their own currencies, making them less vulnerable to adverse foreign exchange markets movements. The trend was reinforced by an increased domestic demand for savings vehicles and the development of financial services and local pension funds looking for places to park money to cover future liabilities. Today, Local Currency EMD is about three times bigger than Hard Currency EMD and has seduced investors wanting to bet on an appreciation of emerging market currencies vs G3 or G10 currencies.

Corporate EMD, the third subgroup, has been booming over the past decade and has grown into a well diversified asset class across countries and industrial sectors. It also comes in both local and hard currency flavors but is mainly accessible in the latter form to foreign  investors. Issuance of hard currency corporate debt has grown rapidly; from a USD 46 billion market in 1998, it reached USD 411 billion in 2010 and almost doubled in two years to get to USD 803 billion at the end of 2012.  Part of the success is due to an increased demand for high yield instruments by international investors and to investor-friendlier corporate and accounting information.

Emerging Market Debt timeline - Source: Russel Research

Issuer profiling

"EMD is big, it is getting bigger and that's great". Try to say that with enthusiasm to a seasoned credit analyst and he will probably think that you are out of your mind (growing debt piles are rarely seen as a sign of health in the profession). After this punch line, try to add a pinch of salt to your statement by putting forward some figures about the current level of indebtedness, the issuers creditworthiness and their dynamics. These are all quite good looking.

The average balance sheet leverage of corporate issuers in emerging markets is lower than those of their western counterparts and sovereign have lower debt-to-GDP ratios than what can be seen in industrialized countries after almost five years of debt crisis. Several Sovereign EMD issuers are also backed by solid economic fundamentals like higher economic growth rates, good demographics, important foreign exchange reserves, current account surpluses and access to strategic resources that are hard to find in the "West”. 

Rating developments are also in favor of EMD that has been enjoying more rating upgrades than downgrades over the past few years, not quite the same as in the industrialized world. Default and recovery rates are also in good standing and do not differ very much than what can be seen in advanced economies High Yield (HY) corporate world.

Source: JPMorgan

Source: Schroders

Primary Source: BoFA Merill Lynch, date from 31Dec06 to 30Jun12
Includes IG and HY issuers
Secondary Source: Pictet

EM Ratings up, DM Ratings down - Source: Pimco

Primary Source: JPMorgan and BoFA Merrill Lynch; Secondary Source: Pictet Asset Management

Benchmark indices

We can take a dive into the composition of the three EMD sub-categories by analyzing the reference indices that track them. Inclusion to these benchmarks requires to pass some tests in terms of issuer quality, issue size, liquidity,... and all the paper out there do not qualify. Even though they are not comprehensive, those indices have the big advantage of being more "investable" than the wider universe, they are thus a better gauge of what the actual market is for investors.

The three indices that are commonly used are published by JP Morgan:
  • JPM EMBIG Global Diversified for hard currency  government debt
  • JPM GBI-EM Global Diversified for local currency government debt
  • JPM CEMBI Diversified for corporate debt (hard currency)

The total market value of those indices stood at $1.35 trillion and was broken down as such:

Source: JPMorgan (data as of 31Dec12)

Below is a graph giving you an idea of how these market compare in size with more established ones. These figures are not based on the exact same indices but they also give a valid picture of the markets. (IG stands for Investment Grade credit -> BBB- or above, HY stands for High Yield -> BB+ and below)

Primary Source: BoFA Merrill Lynch
Secondary Source: Pictet

What's in it?

The three indices are somewhat different in the exposure they offer to countries and sectors. The corporate debt index is tilted towards Asia, hard currency EMD gives a big weight to Latin America. Local currency gives similar weights to the two big regions but no exposure to the Middle East.

In terms of number of issuers, the corporate index is the most diversified one with 391 different names as of November 2012. The hard currency index comes second with 44 countries followed by the local currency index with only 14 members. The fact that there are less local currency issuers is logical as you have to meet tougher criteria to be able to borrow in your own currency.

Looking at types of economies, local currency gives more weight to commodity exporters and hard currency sovereign lays more on the side of manufacturing countries.

Risk/Return factors

Risk and return, as measured by yield to maturity, duration and ratings also vary among EMD indices. The highest yield, the shortest duration and the best average rating are all available in local currency EMD. This sounds very attractive but investor are also exposed to currency movements that can induce a lot of volatility, with the potential to offset capital and carry gains. The better credit quality is logical as only those countries with good fundamentals are able to borrow in their own currencies.

Source: Pimco

Here some key factors for each EMD group:

Local currency EMD 
  • Exposure to emerging market currencies
  • Market depth (bigger investable universe)
  • Higher current yield to maturity
  • Shorter duration and hence lower interest rate risk
  • Higher beta (sensitivity) to world equities
  • Concentration (14 issuers)

Hard currency EMD
  • Lower beta to world equities
  • No FX risk
  • Lowest yield
  • High sensitivity to US Treasuries 
  • Diversification (44 issuers)

Corporate EMD
  • Yield pickup to Hard Currency EMD
  • No FX risk
  • Shorter duration and better quality than hard currency sovereign 
  • Cyclical in nature
  • Sensitivity to US Treasuries
  • Big exposure to financials and heavy industries

The following graphs, taken from a report from the excellent M&G Bond Vigilantes blog (here), show the historical relationships between EMD and other key developed markets. They do not tell the whole story, however, as past performance is not a proxy for future returns, as any disclaimer would tell.

Current markets assessment

Hard currency debt appears fairly valued now and its higher sensitivity to US Treasuries doesn't look good with the perspective of higher rates going forward if the US Fed changes its tone or if markets anticipate a shift in policy.

Local currency sovereign bonds give 400bps yield pick-up to the average yield of sovereigns in the developed world with an Investment Grade status. There is also upside in the form of currency gains: emerging countries are not printing money, they sit on important foreign exchange reserves and they have lower debt levels. Interest rates are not expected to change much this year in the absence of a shock to the global financial markets. This is an interesting spot.

Corporate EMD is growing in depth and breadth. Capital flows are supportive and credit dynamics as well. It is also the universe that gives the biggest exposure to Asia which is still the fastest growing region of the world. The current spread to US Treasuries is comfortable and not pricey in historical perspective.

As a conclusion, I think that any allocation to EMD should currently give more weight to Local currency Sovereign and Corporate EMD. The former has a better overall quality and gives upside on the currency side, the latter gives more credit risk but is less sensitive to currency markets and should do better in risk off markets (often causing the USD to rise). Hard currency EMD should have a smaller allocation given its current valuation.

How to invest

Trying to build your portfolio with individual bonds is not reasonable. Efficient diversification cannot be achieved with 10 to 20 bonds and, even if market are improving, they still do not have the liquidity of IG or even HY bonds.

ETFs are proliferating, but these just copy the benchmark blindly and do not take any measure to mitigate risks that could emerge in the market going forward.

These asset classes are ones in which it makes sense to pick up 2-3 good fund managers that could still beat the benchmarks by carefully selecting issuers and bonds instead of buying everything that is issued just because it is out there. EMD funds can provide you the liquidity and diversification that should make you sleep better, so they are worth considering.

That's it for today, see you around soon!