Why Going For That Big Short May Not Be So Smart

The economist John Maynard Keynes said it best with his immortal words about financial markets being able to stay irrational longer than one can stay solvent. I think it was Keynes who said those words yet it doesn’t matter. What matters is how important and powerful those words are. I personally think these are some of the most important words of advice for any investor whether they are a novice or seasoned. One may have complete confidence and conviction in a security they are investing in yet there is always the chance that things don’t go according to plan regardless of how much due diligence they may have done on it.

The Big Short is a well known book by Michael Lewis, which was later made into a successful film. The book is about an investor and fund manager named Michael Burry who places an enormous bet against subprime mortgage bonds. He was one of a small handful of investors who at the time discovered how rotten those bonds were and how they had the power to create an enormous financial crisis, which they eventually did in 2007-8. He placed his bet relatively early in around 2005. At the time, it was seen as a rather contrarian thing to do as the majority of people in the financial world were amazingly unaware of how toxic those bonds were.

Although Burry would eventually be vindicated and handsomely rewarded for his bet, I personally think that the way he went about it wasn’t so smart. To be clear, I am not for one moment knocking his deep research and analysis. In fact, I applaud his diligence and ability to discover serious flaws in that corner of the market whilst everyone else it seemed was asleep at the wheel. Yet I don’t think it was a smart move for the following reasons. Firstly, his move to short those bonds represented a very high percentage of his total fund, which made a lot of investors very nervous. If you are a fund manager or work for a fund, it is quite common for an individual security to not represent more than 10% of the total fund. Anything higher than that percentage has the potential to create a lot more risk and volatility to the fund. What’s more, it was expensive to hold such a large short position as large payments to service it were due every month. It was understandable why those investors and others at his fund were nervous and had very little patience. Secondly, and more importantly, I don’t think Burry ever familiarised himself with Keynes’ quote. Although it took about two years for his bet to come good it could have taken much much longer. It is entirely plausible that had his fund had to wait even longer for his bet to come good there would have been so much pressure on Burry to finally close his short and thus cut the loses the fund was making by holding it.

You see it doesn’t matter whether Burry was fundamentally right in his analysis. He was completely correct. These bonds were a train wreck waiting to happen. But that’s not the point. The point is that timing the markets is very very difficult. Alternatively, Burry could have done the following. He could have still made his bet yet it wouldn’t have represented more than 10% of his total fund for example. That way, there would be less tension and pressure on Burry to close his position in the event that it was going to take so long to come good. What’s more, it would have still made him and the investors in his fund a lot of money when that day would eventually arrive.

This brings me to another well worn adage in the investment world of never having all your eggs in one basket. Although this may be a cliché it is so very true. Although enormous fortunes are made by putting all one’s huevos in one single basket, it is also the fastest way to blow up a portfolio. Burry’s enormous bet came good and he was rewarded, but he could also have been fooled by randomness by some unusual twist of fate.

Over the last few years many investors, including some well known names, lost a lot of money shorting Tesla. Although the rationale behind their decision to short the company was completely understandable, namely that the market capitalisation of the company was not reflective of it’s fundamentals, the share price has nonetheless continued to climb even higher. This right there should be a warning in the perils of going for that ‘big short’. As I already stated, it is ok if such a position is not so great that it poses a serious risk to an entire portfolio. But one can only imagine those legions of investors having a Michael Burry style moment with Elon Musk’s company.

Interestingly, it seems that Burry himself has now thrown his hat in the Tesla Short ring. I may be wrong, but it appears that his fund is betting against Tesla to the tune of 40% of the entire weighting of the fund. I wish him luck. Will his bet come good again? Or will he join the scores of other investors who got badly burnt betting against Elon?

By Nicholas Peart

10th August 2021

(c)All Rights Reserved

Image: thewrap.com

START-UPS: The Perils Of Growth At All Costs

Start-ups are an important part of the business landscape. More crucially, the best start-ups provide much needed solutions to long standing problems. They provide real value to consumers. However, one thing I have observed over the years with certain start-ups is this mantra of ‘growth at all costs’.

If you are the founder of a start-up that provides a product or service that people really need and for a reasonable price, it is fair to say that this start-up has a bright future with a large potential for sizable growth over the coming months and years. That is all well. Yet, it does concern me when I observe the ones that have this ‘growth at all costs’ mindset.

No matter how driven or ambitious a founder may be, it is absolutely paramount that there is a healthy working environment amongst all the people who work at the company. There is currently a huge scandal with the UK craft beer company BrewDog over the maltreatment of many of its workers. BrewDog has been a huge success story. Ever since it’s founding a little over a decade ago, it has grown exponentially and is now the largest craft beer company in the country. It’s become a ubiquitous brand with it’s beers sold in all major supermarkets.

I could be wrong, but I am guessing that during those years when BrewDog was growing at such a fast pace, there was very much a ‘if you can’t stand the heat..’ atmosphere in the organisation. Even though BrewDog do make very good beers, the craft brewery industry is very competitive. There are many players and the way that BrewDog has been able to get to the position it is currently at today has been by scaling very fast in a relatively short period of time. By growing at such a rapid pace, it has now got to a size that gives it a clear edge over it’s competitors. If it had not embarked on this journey of aggressive growth it likely would have lost out to another competitor in the space.

Yet a big consequence of adopting an aggressive growth strategy is that it can create a toxic environment in the workplace. It suddenly becomes very easy for founders/chief executives to forget to care about the wellbeing of the other workers in the organisation as, in an almost single minded fashion, they have their eyes set on reaching their lofty targets they have set themselves out to achieve. They fail to understand that the workers are an integral part of the growth/success of their business. Without those workers, it is unlikely that their company would have been able to grow so spectacularly. This is especially true of those founders with very large egos and a lack of empathy for others.

A more extreme example of a growth at all costs business that makes Brewdog look like a plain vanilla enterprise is the rise and fall of office rental space company WeWork under the leadership of it’s colourful founder Adam Neumann. Unlike Brewdog, WeWork never made a profit and simply haemorrhaged cash. Billions of dollars of venture capital money was thrown at the company, most notably by Softbank whose founder and CEO, Masayoshi Son, really believed in the company. At one point WeWork had a valuation of over $40 billion. An eye watering valuation when one takes into account the fundamentals of the business.

WeWork also suffered from a toxic workplace culture. Those Brewdog workers, who via the Twitter group Punks With Purpose are bringing to light the less than perfect behind the scenes picture of the business, accuse the company of being ‘built on a cult of personality’. They take aim at how the company and it’s founders cultivated an image of the company as authentic (applying a ‘punk ethos’), caring about the environment, being forward thinking and progressive, and an amazing and cutting edge place to work at. Yet the irony is that it was anything but rosy. In their own words they scathingly say that “The true culture of Brewdog is and seemingly always has been, fear”.

Yet compared with WeWork this is small beer (no pun intended). The larger than life WeWork founder Adam Naumann would make make Brewdog co-founders James Watt and Martin Dickie blush. He took the term ‘cult of personality’ to another level. To the point where he was able to get some of the most powerful heavyweights in the venture capital space to invest megabucks in his business. Even though, with just a modicum of due diligence, it would soon seem apparent that WeWork was essentially a start-up with very poor fundamentals. The emperor had no clothes. Those VCs who were smart enough to see beyond the hype and mega personality of Neumann and actually did some stone cold research on the fundamentals of his business, saved themselves a packet.

Sometimes it is not necessary for a start-up to pursue a ‘growth on steroids’ strategy. It may be that you can create a lot of value and provide a unique solution without the need to aggressively grow. Sometimes large growth can happen by default if suddenly there is a massive demand for your products and services. And that is fine. There is nothing wrong with growth. Hell, there is nothing wrong with full on hyper growth. But not when it’s at all costs. Not when workers are not feeling valued and a dysfunctional and toxic workplace environment manifests.

By Nicholas Peart

June 20th 2021

(c)All Rights Reserved

Image: satyatiwari 

One Golden Rule To Heed Before Investing In A High Risk Venture

Before you decide to invest in a company, start-up or venture that is highly risky, there is one very important rule that all investors should heed. We are all aware of the obvious rules such as doing sufficient due diligence and only investing what we can truly afford to lose. However, a less obvious rule, and the one which I am talking about in this article, is focused on having Skin In The Game.

The origin of this phrase is debatable although a quick Wikipedia search tells me that it originates from derby races whereby the owners of the horses taking part in these races have ‘skin’ in ‘the game’. More recently, it has been written about extensively in the works of Nassim Nicholas Taleb. Put simply, it refers to how much ‘skin’ a person has in something or how much personal risk they are willing to take on. For example, in the case of entrepreneurs or founders of businesses, an entrepreneur who has the vast majority of their net wealth tied up in their business has considerable Skin In The Game. Even though they will be handsomely rewarded if the company is successful, they will also go down with the ship and face financial ruin if the company goes belly up. This latter point is crucial.

When I analyse high risk ventures, one thing that is a huge red flag for me is a genuine absence of Skin In The Game. A founder or director of such a company needs to have the majority of their own capital invested. ‘Share options’ do not count. However, ‘director buys’ do.

Another red flag is when founders and directors draw huge salaries, especially if the company is not currently generating any revenues. If a company is not yet making money, a company will be raising money via debt or equity placings (issuing more shares) to keep it a going concern. This is precious cash and should not be eaten up in the form of generous remuneration packages. Alarm bells should be ringing if this is the case.

Founders and directors who have a considerable amount of Skin In The Game in a venture is an indication not only that they truly believe in what they are working on and executing, but also that they are motivated and kept under a considerable amount of pressure to ensure that the company succeeds. They believe in the company so much that they are more than willing to match their considerable belief via taking on a considerable amount of personal monetary risk. If the company doesn’t succeed they will be financially ruined. There will be no government or organisation ready to bail them out if they fail.

I have seen so many high risk ventures collapse where the founders and directors have come out of the wreckage mostly unharmed. They always drew big salaries and their equity stakes were mostly in the form of options rather than purchased with their own money. Founders and directors with little to no Skin In The Game are not under any acute pressure to contribute in the best ways they can. They don’t believe in the company they are working for nor is their heart really in it. It is merely a gravy train.

Thus, before deciding to invest in a company, start-up, venture or anything that is highly risky, one should always ask, ‘How much Skin In The Game do the founders and directors have?’

 

By Nicholas Peart

(c)All Rights Reserved

 

Image: valueresearchonline.com

THE FOLLY OF MARKET TIMING: Focusing On Percentages Not Prices

It is natural to get in the habit of trying to buy or sell shares at a particular price. Sometimes we may get lucky and reach our desired entry or exit point. Other times, we may not always get what we want in this respect. I fall into this trap myself a lot of the time, yet, perhaps unwittingly, am I playing a mugs game?

The future is uncertain. Nobody can predict the future and don’t believe anyone who tells you otherwise. I have written articles where I have talked about where I think certain things may be going, but the truth is anything can happen. I know nothing. Even if we have deep and unmatched levels of foresight we can so very easily, in the words of Nassim Nicholas Taleb, be fooled by randomness. We can be knocked off our perch by completely random and unforeseen events way out of our control. This is one reason why it is important to have a diversified and balanced investment portfolio. If one sector or stock is particularly badly hit by some unexpected event, at least your other investments in other stocks and sectors are not affected. That old chestnut of ‘not keeping all your eggs in one basket’, whilst it may sound hackneyed, still rings true.

Whilst we may or may not be able to get our desired buy or sell price for a particular stock, one thing we do have complete control over is how we weigh and structure our investment portfolios. There may be a company you highly rate and want to invest in, but you want to invest in it at the right price. Right now, you consider the current price too high and have lower price in mind that you hope will arrive. But what happens if that price never comes and instead the share price of the company just continues to climb in value? Instead of hoping to get the right price, or worse, the lowest price, why not say to yourself, ‘What percentage of my total investment portfolio do I want this company or security to represent?’. I think dealing in percentages rather than prices can not only help you to be a better investor, as it can take away a lot of the unnecessary stress and anxiety associated with trying to buy or sell a security at ‘the right price’. It can also help you overcome deeply ingrained cognitive biases.

When you focus more on what percentage of your investment portfolio you want a security to represent, rather than chasing a price, that can give you more control and balance. If the investment goes down in value, the percentage weighting it represents in your portfolio also goes down. If the investment goes up in value, it’s percentage weighting also goes up. By this you can then decide whether you want to be more overweight or underweight in the percentage weight of this particular security. If you want to be more overweight, you buy more. If you want to be more underweight, you sell a portion.

The percentage of what a security represents of your total portfolio is in many ways more important than the price you pay for it. Even if you end up overpaying for a stock or security, if it represents a percentage of your portfolio that is not too detrimental to the overall performance than it is not so bad.

 

By Nicholas Peart

(c)All Rights Reserved 

 

Image: datanami.com

 

Money Cannot Buy Happiness, But…

Money can buy you freedom. That’s it. Not as a means for conspicuous consumption, gaining status or power, or indulging in an eternal cornucopia of mindless, decadent pleasure and self-indulgence.

The Twitter account Orange Book (@orangebook_) recently posted the following tweet…

Things money can buy:

-freedom to think
-freedom to travel
-freedom from jerks
-freedom to learn slowly
-freedom from an alarm clock
-freedom from work you dislike
-freedom from financial anxiety
-freedom from low-cost nutrition
-freedom to pursue a creative purpose

I could add more things to this list…

-freedom to create and invest in ventures that make the world a better place
-freedom to be time rich
-freedom to afford better healthcare
-freedom to help others

All of this is very positive, however there are downsides too. For example, I would include the following…

-freedom to run away from problems
-freedom to avoid the unsavoury aspects of life
-freedom to not live in the real world
-freedom not to grow

As much as having money shields us from the unpleasant aspects of life; from jerks, from jobs we hate etc ; if we never have to deal with these unsavoury aspects of life, this can put us in a very vulnerable and fragile situation if, by some random stroke of misfortune, we ended up in a no money situation. The freedom that money provided in the past is gone at the drop of a stone. When previously, money offered a means to be cocooned from the real world, not having any money now throws us back into it.

It is much better to have money, but at the same time, know how to deal with the real world, how to deal with challenging situations, how to deal with difficult people. This is because, if we ever find ourselves back to a situation without money, then life is not a constant struggle.

 

By Nicholas Peart

(c)All Rights Reserved 

 

Image: Patheos

The Dangers Of Story Stock Investing

Investing successfully requires a lot of boring fundamental analysis and often the best stocks to invest in are in boring overlooked, but undervalued companies with strong fundamentals and a decent margin of safety. These companies are not prone to hype.

On the other hand you have story stocks. Investing in a story stock does not mean that your investment will go down in value. On the contrary, a stock with a powerful story could make you very rich. Look at Amazon. Then again look at the multitude of other stocks, which had a powerful story behind them, but that was it. Fundamentally they were houses made of cards, which soon collapsed. The Dot.com crash from twenty years ago is littered with such casualties. More recently, the whole WeWork disaster is a prime example of company with an enticing and exciting story (as well as a charismatic and convincing leader), yet with very shaky and fragile financial fundamentals.

The problem with story stocks is that the stock valuation gets to a point where it is propped up much more by the goodwill of the story alone than by the company’s fundamentals. This is very treacherous territory as even a mild downtown or modest bit of bad news can send the share price crashing back down to Earth.

A stock with a unique story behind it is psychologically very alluring. Doing some solid due diligence such as analysing company reports and financial statements requires effort and if you dont have much experience on that front it can seem very daunting. However, with practice and learning you can become better at analysing and understanding all this nitty-gritty stuff, which also enables you to make better investment decisions with a cool head. Knowing exactly what you are investing in and having even just a modest understanding of the full financial health of a company is a very reassuring thing.

I suppose we prefer stories to analysis, because stories have much more of an instant cognitive resonance. Our minds can be lazy and it’s so much easier and more soothing to be swayed by a good story or glowing article in the media on a stock. More succinctly, sometimes a powerful mantra alone is enough to sway us. Software is eating the world or It’s the wave of the future or You are investing in a slice of history or Nobody else is doing what this company is doing are a handful of mantras that can make us overly bullish on a particular stock without questioning it further or taking it apart via some deep research.

The problem with such stories and mantras is that they activate and play to our emotions and making investment decisions based on emotions is never smart. We always have to have a healthy, balanced, critical and analytical mindset to investing without allowing our emotions to hijack and influence our decision making. A cool head always wins.

 

By Nicholas Peart

(c)All Rights Reserved

 

Image: 4.bp.blogspot.com

VALUE OR GROWTH? A Tale Of Two Scottish Funds

There are two Scottish funds listed on the London Stock Exchange, which I would like to focus on in this article. They both have similar names, yet their investment strategies differ considerably. The first of these two funds, The Scottish Investment Trust, is a contrarian value fund. Whilst the second fund, the Scottish Mortgage Investment Trust, is a growth fund.

The Scottish Investment Trust (SCIN) is over 130 years old and was first established in Edinburgh in 1887. Since 2015, the fund has been managed by Alasdair McKinnon with a focus on blue chip dividend paying companies that are out of favour. McKinnon takes a contrarian view to investing avoiding sectors that are hot and investing in companies that are undervalued and where sentiment is poor. The rationale being that when sentiment turns, the value of the companies increase as investors begin to pile in. To be clear, contrarian and value investing don’t mean simply investing in any old company that is down and out and going through a turbulant period. It is important that the company has a margin of safety to ride out any difficult period thus protecting it from having to raise emergency cash and/or ceasing to remain a going concern. It is also equally important that the company has healthy cash flows and a decent track record of this. The amount of cash that a company generates from its operations is a crucial metric and sometimes overlooked. A low P/E (Price To Earnings) ratio is one thing and a significant metric in indicating whether or not a company is overvalued, yet it doesn’t tell the whole story. The level of cashflow generation indicates how much cash a company is generating and the more cash it generates, the more of a financial buffer it has, especially if it’s total operating margins are not very high. It is also important to monitor a company’s total liabilities and how manageable and sustainable they are.

As of 30th April 2020, the largest holdings in SCIN’s portfolio included large gold mining companies such as Barrick Gold and Newmont Mining, large pharmaceutical companies such as Roche, Pfizer and Gilead Sciences and other assorted value blue chips such as United Utilities, Japan Tobacco, BT and Chevron. The gold mining companies have been in the portfolio for sometime. Recently gold has performed very strongly and it’s likely to continue. McKinnon, like myself, is of the view that major fiat currencies run the risk of being debased. Since the last financial crisis in 2008, we have been living through a period of very low interest rates and easy money. The present COVID-19 crisis has only exacerbated this as central banks have reduced interest rates even more and printed unprecedented amounts of money to prop up national economies in the wake of this crisis. Add to this the staggering levels of global government, corporate and household debt and you have a rather fragile situation. McKinnon’s thesis for having exposure to gold is as a form of insurance against this extraordinary macro environment and the real future risks and consequences it carries. He is also no fool by investing only in the biggest and most geographically spread global mining companies with low production costs. Whilst it is true that gold may not currently be unloved, I would still consider it a contrarian investment as it represents, to a degree, a lack of faith and trust in central banks and governments. It is also considered unfashionable. I would argue that newer supply-capped digital cryptocurrencies such a Bitcoin are more fashionable and hotter than gold. Especially amongst younger investors who generally overlook gold and other precious metals as a store of value.

McKinnon deliberately stays away from sectors that are hot and fashionable such as the technology sector. SCIN has absolutely no exposure to FANG (Facebook, Amazon, Netflix, Google) stocks or any other hot tech/startup stocks. The closest thing to tech in the portfolio are it’s holdings in boring and undervalued blue chip communication service companies such as BT, China Mobile, Verizon and Deutsche Telekom. McKinnon believes that the tide will turn regarding the high valuation of many technology companies, as unlikely as this may currently seem, and that value stocks, for a long time overlooked and underperforming compared with their growth counterparts, will prevail in due course.

The Scottish Mortgage Investment Trust (SMT) is currently the most valuable investment trust by market capitalization listed on the London Stock Exchange. As of today, it has a total market cap in excess of £10bn and over the last decade has performed extremely well. The primary reason for its impressive performance has been it’s exposure to all the FANG companies plus a number of other tech investments that have recently done exceptionally well. For example, the fund has a substantial holding in Tesla, whose share price has more than doubled since the beginning of this year. Generally speaking, tech shares have done very well since the COVID-19 induced lockdown measures were put in place over the last few months and the share price of SMT is trading at all time highs.

SMT, like SCIN, is also a very old investment trust with a hundred year plus history having first been established in 1909. It is currently jointly managed by James Anderson and Tom Slater. Anderson has been managing the trust for 20 years with Slater joining him in 2010. Their focus is purely on growth and investing in companies of the future. SMT is everything that SCIN is not. SCIN adopts a Benjamin Graham style value investing strategy. SMT does not embrace this type of strategy and even questions it. This is highlighted in a series of interesting essays written by Anderson and published on the fund’s parent Ballie Gifford website entitled Graham Or Growth?. I highly recommend giving them a read as it provides one with unique insights into Anderson’s way of thinking and by extension the investment philosophy and strategies of SMT.

It is true that growth investing has greatly outperformed value investing since the last financial crisis more than a decade ago. At the very start of 2009 the Russell 1000 Growth Index (RLG) was around 360 points. Today it is almost 1820 points. In this time the RLG index has grown more than 500%. That is highly impressive. By comparison the Russell 1000 Value Index (RLV) was around 446 points on 1st January 2009. Back then the RLV index was higher than the RLG index. The same cannot be said today with the RLV index almost 1,105 points. The RLV index has grown less than 250% during this period. Whilst this is certainly not a poor return, it doesn’t hold a candle to the RLG index’s 500% plus return.

Regardless of which side of the fence I am on regarding value or growth investing, it cannot be denied that both Anderson and Slater are highly skilled and visionary managers with a highly impressive track record for picking winners. It is much harder to quantify growth stocks than value stocks via traditional metrics and methods of fundamental analysis. If one were to just use just those methods when investing, one would have passed on investing in Amazon, Alphabet or Tesla in the early stages of their listings in the public markets. It takes more than just the tried and tested strategies of the past to value these companies and Anderson’s essays make this very clear.

However, it is just simply not the case that all new and exciting tech companies are ‘crushing it’. There have already been some casualties. The one that springs most to my mind has been the downfall of workspace company WeWork. Before the issues of the company came to the fore, it had a valuation of $47bn even though it had vast amounts of debt. Today, it’s worth far less at around $3-4bn. One of the largest investors in the company is SoftBank whose Vision Fund took a massive hit. Fortunately, SMT and its parent company Baillie Gifford, never built up a stake in WeWork over the years, but it could have easily happened here.

The recent WeWork debacle is one of a number reasons that make me nervous about having too much exposure to SMT right now irrespective of its stellar performance. As much as I respect the vision and foresight of Anderson and Slater, I worry that their fund could come a cropper some time down the line if a number of the holdings in the SMT portfolio underwent similar write-offs in value like WeWork. One of the fund’s holdings, Tesla, is probably the most polarised and hyped publicly traded stock in the world today. I have a great respect for its founder Elon Musk, who is a highly driven and exponentially thinking visionary. There is no doubt in my mind that he is special. However, the company could very easily experience a similar WeWork style crisis. No matter how highly I rate Elon, the financial fundamentals of Tesla are fragile and the share price could dive spectacularly in the event of a major existential crisis. This would create a huge dent in the value of SMT, as its Tesla holding currently represents a chunky 10% of the entire portfolio. Together with Amazon (which also represents 10% of the total holdings), it is one of the largest holdings in the SMT portfolio.

McKinnon is very wary of the present high valuations of tech companies and has citied the WeWork situation as a clear and present danger. In a post from December 2019 entitled Peak Unicorn?, he refers to the overvaluation of these exciting multi-billion dollar valued unicorn story stocks as a ‘disruption’ bubble, which has been propped up by an environment of cheap money and will not end well.

The last ten years have been very good for growth and technology stocks, yet it remains to be seen whether the next ten years will be equally magnanimous.

By Nicholas Peart 

Published on 27th May 2020

(c)All Rights Reserved

CITED ARTICLES:

https://resoluteoptimism.bailliegifford.com/will-the-mean-revert/

Peak Unicorn?

Image: tripsavvy.com

Don’t Fight The Trend…

the trend

But don’t be off your guard either.

A lot of the time, stocks are priced at a value quite debased from their fundamentals. Thus they are either overvalued or undervalued. This is true since markets are, for the most part, driven by sentiment. In the most extreme circumstances, total greed or fear takes over.

I have been rather baffled by the stock market rally over the last few weeks after having witnessed some of the most spectacular series of crashes over the brief one month period from the end of February towards the end of March. This rally far from reflects the economic reality on the ground. Many people have lost their jobs and are struggling financially. Yes, there have been huge stimulus packages to soften the blow, but these are artificial and only increase an already substantial debt load.

Yet markets can behave irrationally for a very long period of time. Far longer than one can stay solvent, to quote the economist John Maynard Keynes. Instead of trying to be right, sometimes it can pay to just go with the trend. That often quoted adage, the trend is your friend, is very true. Rather than fighting it, it can be less painful to simply ride with it in whichever direction it may blow.

But don’t get carried away. Always be on your guard. As the tide can abruptly change without warning.

By Nicholas Peart

(c)All Rights Reserved 

 

Image: Peggy_Marco

Fishing For Bargains In The Market Carnage (UK MARKETS)

deep sea fish

Disclaimer: All financial recommendations in the article are those of the author and should not be taken as financial advice. It is best to do your own research before investing in any security or to speak with a financial advisor. 

The market crash since February has been painful for all long term investors. Yet at the same time it has presented opportunities to buy several good quality stocks and securities at a lower price than normal. In this article I will focus on some of those, which I think may be worth a look at.

Travel Industry

Lots of the big multi billion pound FTSE 100 blue chip companies are currently trading at much lower valuations than before the crash. One of the industries most affected by the current coronavirus pandemic has been the travel industry, which includes airline and cruise ship stocks.

On the FTSE 100, three companies springs to mind; International Airlines (IAG), EasyJet (EZJ) and Carnival (CCL). The share prices of all three companies have been heavily impacted and currently look very cheap. However, as cheap as they may be, they now carry a lot of risk as there’s no guarantee that, despite their size, they will have enough cash to see them through this difficult period before they are back to operating at normal capacity again.

International Airlines group owns multiple airlines in its portfolio including British Airways, Iberia, Aer Lingus and the low cost airline Vueling. Out of the three companies, this one is in my view the safest bet if I had to chose, which one I would invest in. The principle reason for this is, because of the fact that it owns multiple airlines rather than just one. Furthermore, it also employs the greatest number of people (over 60,000) and it is likely, although not guaranteed, that it would be at the receiving end of a government bailout should it really struggle to remain a going concern in the coming weeks and months. Allowing the firm to go bust, would result in a lot of people out of work.

Easyjet carries more risk than International Airlines. Although it has decent cash reserves, it has entered into an agreement with Airbus for £4.5bn to purchase 107 aircrafts. Considering that Easyjet’s current market cap is less than half that amount, such a transaction puts the company in a very difficult situation at a time when precious cash reserves are king. Unless the company scraps the Airbus deal and temporarily suspends it’s dividend, it runs the risk of becoming insolvent in no time and is unlikely to be bailed out either.

But Easyjet is not the riskiest of the three. That prize would go to cruise ship company Carnival. In the wake of all the well publicized coronavirus cases occurring on cruise ships, I cannot see that industry recovering for at least several months. Unlike flights, which are a necessity, it is not a necessity to take a cruise. It’s share price has reacted accordingly falling from a 52 week high of £41.75 in May 2019 to a 52 week low of just £6.06 earlier this month. The share price is currently £8.69. If the company wants to ride out this crisis, it will need to embark on some pretty substantial cost cutting measures going beyond simply cutting the dividend. Earlier this month, the company increased it’s borrowings to give it more financial flexibility, but the consequence of this is that the company has got itself into debt even more.

Personally, I would think very carefully about investing in either company as cheap as the shares may be. The trick is to find high quality blue chip stocks that are beaten down, but fundamentally have a robust enough margin of safety that will see it through the worst of a crisis without having to resort to options such as taking on more debt or any kind of dilutive rights issue.

Oil and Gas Industry

The other industry that has taken a hammering is the oil and gas (o&g) industry. As the market crash began to develop steam, the price of oil fell a whopping 30% in just one day. Towards the end of March, the two largest UK listed oil and gas companies, Royal Dutch Shell (RDSB) and BP (BP.), were both trading at discounts of more than 50% of their share prices at the start of the year. As I write this, their share prices have recovered a bit off their recent lows, yet they still have a way to go to reach their previous levels from the beginning of the year.

I think o&g prices will be incredibly volatile over the new few years and long after the worst of this current coronavirus pandemic is over. Even though o&g prices may currently be at very low levels, it doesn’t take much for prices to suddenly spike again in very little time. In the coming weeks and possibly months, o&g prices may continue to stay low or go even lower to lows that are unthinkable. When investing in o&g companies, especially when prices are low, it is always important to invest in companies that have very low production costs and/or a large downstream business. Such companies are able to weather lower o&g prices better than those that are either producers with high production costs or worse o&g exploration companies.  The latter are much more vulnerable to lower o&g prices and a prolonged slump in these prices can have a very real existential impact on these businesses as their operations become economically unviable.

For those reasons, I am attracted to the more solid players in this industry who will be able to get through this challenging period the best. I already mentioned the two main players, Shell and BP. Their share price erosion has now meant that both companies now pay even higher dividends. Yet there is always the very real possibility that these dividends get temporarily cut, which I actually think is a good thing in the short run if only to boost essential cash reserves. There is currently a lot of negative sentiment in the o&g industry and its not a popular industry. I have a contrarian mindset towards this industry and believe that in due course there will come a time when o&g prices will be much higher than their current levels.

Consumer brands companies

There are some consumer brands companies that are presently very under-priced. A neglected industry that immediately springs to mind is the tobacco industry. Like the oil and gas industry, it is a very unpopular industry and sentiment continues to be poor. What I find interesting is that whilst sentiment has been poor for some years now, there was a period not so long ago where there was a lot of hype in the nascent cannabis industry. I recall the share prices of exotic hot Canadian pot players such as Tilray ascend to ridiculous valuations that were very debased from their fundamentals. I fortunately stayed well clear of all the hype and I am glad that I did as today the current share price of Tilray is a mere fraction of what it was at the apex of the hype.

Rather than chase these hot pot plays, there was and is far more value to be had investing in some of the large public tobacco companies such as British American Tobacco (BATS) or Imperial Brands (IMB). Both companies have been depressed for some time and currently pay very large dividends. In the case of Imperial, it’s dividend is now more than 10%. In the current economic turmoil we are all experiencing, there is no guarantee that these dividends will not be cut, yet I remain certain that the share price of these companies will recover. Whilst it is true that less people are smoking traditional cigarettes than before, these companies will increasingly become entities where they do not have all their eggs in one basket. Going back to the much hyped cannabis industry; who’s to say that once cannabis becomes increasingly legalised in a growing number of jurisdictions across the world and there is more robust consolidation in this industry, those large players don’t also get a piece of the action?

I am also interested in those large consumer brands companies of essential products. The two biggest ones on the FTSE 100 are Unilever (ULVR) and Reckitt Benckiser (RB.). Both are global, robust and defensive non cyclical companies. Yet there is one smaller company, which I think offers a lot of upside to long term investors. This company is called PZ Cussons (PZC). It has been undervalued for a while now and currently has a total market cap of less than £1bn, which I think is very cheap. What’s more, it is well exposed to emerging markets with high growth potential. It is best known for owning the Imperial Leather soap brand and also the Carex brand too. This is important to know since as this current coronavirus pandemic has escalated there has been an acute shortage of hand sanitiser products. Carex is one of the leading producers of hand sanitisers in the world and whilst it may not have a monopoly, I expect record sales for PZ Cussons’ Carex brand when their next financial report covering the last few months is published.

Index Funds and Investment Trusts

Rather than focus on picking individual company stocks, I also like looking at index funds that track entire stock markets and also well run investment trusts. Investing in index funds is ideal for those who don’t want to invest in individual companies and undertake all the fundamental analysis that goes with it. What’s more, by investing in a small select number of index funds rather than lots of individual stocks, you are also cutting down on your dealing costs, which can eat into precious cash.

In the UK, the two principle stock markets are the FTSE 100 and the FTSE 250. The FTSE 100 contains the largest 100 UK companies by market capitalisation and the FTSE 250 the next round of large UK companies, which are not part of the FTSE 100. The FTSE 250 companies, although smaller than the FTSE 100 ones, have generally more growth potential. Yet what the FTSE 100 companies may lack in the growth potential of the FTSE 250 ones, they make up for by paying generally larger dividends. Both indexes are trading at vast discounts to their levels befor the start of the crash. If you are a long term investor, buying some units in both a FTSE 100 and FTSE 250 index fund at current levels could be a very smart move. One could also slowly drip feed money on a weekly or monthly basis. This may also be a good move if these markets continue to fall before they recover.

I have selected a few LSE listed investment trusts, which I consider sound and well managed. One investment trust which I recommend more for income than growth and is currently trading at quite a discount is the City Of London Investment Trust (CTY). It consists mainly of large multi billion pound FTSE 100 companies paying good dividends and thus the trust pays a decent dividend. Some of these companies have temporarily halted their dividend payouts and that is I feel reflected in their current share prices. I expect this trust though to recover strongly when the markets recover and for the companies in the trust that have cut their dividends to reinstate them. The trust also has one of the lowest fees in the industry.

Another LSE listed investment trust I like which is focused more on smaller FTSE 250 companies is the Henderson Smaller Companies Investment Trust (HSL). This trust also pays a dividend although its smaller than what CTY pays and the trust’s fees are also higher. However it has much more potential for growth, without it being reckless.

Both CTY and HSL are currently trading at discounts of more than 30% of their January highs.

The Templeton Emerging Markets Investment Trust (TEM) is also trading at a large discount and is one of the best trusts invested in some of the largest emerging markets comapnies in the world. I prefer this trust over ones focused on just single emerging market countries and I recommend drip buying on any dips in this current downturn.

Finally, I am always keeping an eye on the largest LSE listed investment trust by market cap, the Scottish Mortgage Investment Trust (SMT). This trust contains many high growth companies in its portfolio from holdings in some of the largest tech companies in the world to several promising unlisted companies. NASDAQ listed tech stocks have been some of the best performing stocks during the ten year plus bull market. However it remains to be seen whether the next ten years will be equally generous to these companies. Like other stocks, SMT has also suffered during the current downturn although its held up better than others. I have included this trust as although I still think it is rather richly valued, it may wobble more over the coming months and could present a very good buying opportunity for the long term.

Precious Metals

I continue to remain very bullish on precious metals. In particular, gold and silver. Rather than typical investments to make money, precious metals for me are a form of insurance in a world simply awash in debt, cheap money and uber low interest rates. One of my biggest fears is the effect all this accumulated debt will eventually have on the world’s major currencies, especially the US dollar. Several economists are predicting many years of deflation and sustained low or even negative interest rates, but I beg to differ and think that all this debt and enormous current stimulus packages to soften the blows inflicted by the current coronavirus pandemic could likely lead to inflation rearing its ugly head. As I explained in my previous articles, this will lead to central banks raising interest rates and all this outstanding global debt becoming more expensive to service.

All these factors considered I think gold will do very well over the coming years and even from its current high levels, I don’t think the price is expensive. Silver, on the other hand, is very cheap compared to gold and perhaps for value investors, there is more upside and an even stronger case for silver. I like silver very much for those reasons and think it could rally much harder than gold.

Regarding investment opportunities for exposure to both metals, I think the best mining companies are the biggest ones, Barrick Gold and Newmont Mining, which are both listed on the Toronto and New York stock exchanges. I am not so keen on the smaller mining companies with high production costs and too much exposure to politically unstable countries. One can of course buy physical gold and silver from a dealer and keep it in a vault. Bear in mind though that storing silver, especially in modest amounts, will be more costly than storing gold. I like very much gold and silver ETFs, which are backed by physical bullion in a vault. It is very important that each unit of such an ETF is directly backed to a portion of the physical metal in a vault. Two precious metal ETF securities I recommend are the Wisdom Tree Physical Gold ETF (PHGP) and the Wisdom Tree Physical Silver ETF (PHSP).

 

By Nicholas Peart

(c)All Rights Reserved 

 

Image: PublicDomainPictures

It’s Only When The Tide Goes Out That You Discover Who’s Been Swimming Naked

low tide

This is probably one of the wisest bits of advice related to the current market turmoil. And it was said by none other than one of the most successful investors of all time, the Sage of Omaha himself, Mr Warren Buffett.

What this present crisis has exposed are those companies that are worst prepared to handle a downtown. A company should always have sufficient emergency cash reserves or at least some margin of safety to protect it in the event of a slump such as the one we are currently experiencing.

The most prudent companies always have this margin of safety. On the other hand, the most ill prepared companies overleverage themselves and take on large piles of debt during the good times. Then when the bad times arrive and the tide goes out, they are the ones who are most vulnerable.

Right now boring old cash is king. Some of the most indebted companies are currently facing a genuine liquidity crisis and the very real possibility of going bust as their cashflows have virtually dried up. However, those companies who have set aside enough cash, have no or at least manageable levels of debt, and don’t have unsustainable overheads (or a low cash burn rate) will survive this downturn period the best and will bounce back the strongest when the markets do eventually recover.

I think this is something we can all learn when we make investment decisions, especially when we buy shares in companies during a bull market. It is always important when doing your own due diligence on a company to figure out how well it would fare when the tide changes. When the tide goes out, will it be sufficiently covered?

 

By Nicholas Peart

(c)All Rights Reserved 

 

Image: TimHill