Sunday, December 15, 2013

On the menu: selected highlights for the week

Monday: EU - PMIs for December
  • PMIs for Germany and France should show modest expansion
  • Contrast between both should remain stark, with FR still below 50 on both measures and Germany around 53 and 55 in manufacturing and services respectively
Wednesday: EU - Finance Ministers meet...
  • ... to finalize the much awaited Single Resolution Mechanism
  • Objectives: define the rules to address the failure of a European bank
    • Who decides to shut down a bank?
    • Who will pay for its bailout?
    • Which banks are to be ruled by this new system?
  • The proposed draft is full of compromises to accommodate a reluctant Germany
  • It is a complex system that would require the participation of numerous EU bodies and deal with a lot of voting before any resolution is carried out
  • Not the kind of tools you need when a bank blows up during a week-end, but still better than nothing for future crises
Wednesday: US - FOMC meeting
  • Members could be influenced by the recent series of positive political and economic news
    • US mini-fiscal deal last week lifted some political risks and reduces the probability of another debt-ceiling crisis
    • Stronger ISM, good payroll numbers, unemployment rate at 7%, Q3 GDP revised upwards indicate that the US economy could have reached escape velocity
  • Many observers think that tapering could be announced now or between the lines for January
  • "US Monetary normalization should not cause general asset price deflation as it should come with better growth" - JP Morgan
  • Could it be a trigger to stop the market consolidation of the past two weeks? Wait and see. The markets could well remain directionless until year end.

Monday, November 18, 2013

Value Investing: Prepare for the deep dive with Jeroen Bos

Today Michael is sharing his first thoughts on the recently published "Deep Value Investing: Finding bargain shares with big potential" by Jeroen Bos. 

The strategy detailed by the author is not for the faint-hearted and requires discipline, patience, attention to details and a certain degree of comfort with unloved stocks. All the ingredients one would expect from value investing in one of its purest form. Enjoy the read and get inspired.


Value investing is more art than science, and there are a number of important books that describe the principles underpinning the art. This year alone, at least 3 such books have been published. In contrast, there are relatively few detailed and recent case studies on value investments.

Deep Value Investing by Jeroen Bos fills the gap. It deals with a particular species of the value school. Target investments typically trade below the value of their current assets less all liabilities (so-called "net-nets" à la Ben Graham). No wonder these stocks are ugly, unloved, under-researched, ... and hence exciting!

The author, a former stockbroker turned investment manager in 2003, specializes in UK small caps with a penchant for asset-light businesses. He describes himself as "cheap and stubborn" and seems to possess the right mindset for deep value investing.

Each of the 15 case studies presented in the book is covered with a consistent approach (company background / investment case / outcome). The fact-based analysis starts with the balance sheet and continues with highlights from company results and announcements. Very helpfully, the book is accompanied by an appendix with 586 pages full of detailed disclosures about the analysed companies.

The results are spectacular: the average return of the 15 investments is 1.9x, including 2 failures (RAB Capital and Abbeycrest). The holding periods vary but were generally short (half of the investments were sold within a year). One investment (ArmorGroup) was sold after 4 months for 3x.

Throughout the case examples, the reader is exposed to a number of key value tenets:
  • Stay within your circle of competence: for Jeroen Bos this clearly means small, UK services companies, including recruitment companies (Spring Group), defense contractors (ArmorGroup International, Morson Group), engineering companies (Velosi, Norcom), financial specialists (RAB Capital, Record).
  • Focus on the balance sheet: Jeroen Bos first looks at the balance sheet, more specifically at net-net working capital. Earnings are secondary.
  • Buy discipline: virtually each of the 15 companies was bought below its net-net value.
  • Sell discipline: interestingly, unlike most value investors, Jeroen Bos does not necessarily sell when his investments reach fair value. He prefers to wait even more until some earnings momentum develops and the investments moves from an asset play to an earnings play (for instance, homebuilders Barratt Developments and MJ Gleeson, which had a fantastic run lately, are still the top 2 holdings of The Deep Value Investments Fund managed by Mr. Bos).
  • Catalyst? It strikes me that the notion of a catlayst is absent in Deep Value Investing. Buy cheap enough and good things will happen. And indeed: a number of investments became (accidentally?) M&A targets, sometimes shortly after Mr. Bos invested. 
The last six chapters of the book are devoted to companies Mr. Bos still owns. Two of them are still net-nets today (French Connection, Norcom). Another one seems very interesting to further explore (Record).
At a time when bargains are so difficult to find, Deep Value Investing provides great inspiration to hunt for low risk / high return investments.


Wednesday, April 24, 2013

Stock Focus: Apple's mini QE

Tim Cook and Co are beating on revenues, earnings and sales for the March quarter. Revenues grew but earnings slowed, in a nutshell:
  • Revenues $43.6bn vs. Est. $42.3bn, and 11% growth YoY
  • 2Q EPS at $10.09 vs Est. $9.98, and 18% decrease YoY
  • Gross margins at 37.5% vs 47.4% a year earlier
  • 37.4m iphones vs. 34m consensus,+7% YoY
  • 19.5m iPads vs. 18.5m consensus, +65% growth YoY
Guidance for the 3Q is not exiting:
  • Revenues mid point is 11% below consensus. ($33.5bn-$35.5bn compared to $38.9bn)
  • Gross margins expected to fall in the 36%-37% range

Decreasing margins, still

This disappointing guidance means that we should not expect any product launch this quarter as Tim Cook somehow confirmed during Q&A when he was hinting at great stuff coming into fall this year and more in 2014. This is clearly a negative when compared to competitors like Samsung that are busier on this front and can be frustrating for those nostalgic of 2012 that was all about shelf revamping. Compound that with the average selling price of iPhones going down because of incentives on the 4 to attract first time buyers and the same phenomenon on iPad due to the tremendous success of the mini and you have some of the ingredients explaining lower revenues ahead. The PC market is also continuing its slide, impacting Mac, but they do better than the competition in the quarter with -2% vs a -14% industry average.

Cash party

On the capital structure side, news were more encouraging. The long awaited cash distribution boost is finally unveiled and the figures are staggering. The strategy is built on three pillars:
  1. The board is accelerating the share repurchase program by $50 billions to $60 billions until the end of 2015. This is the largest authorization for shares buyback in history.
  2. The quarterly dividend payment is increased by 15% to $3.05 a share to further attract investor looking for yield. The dividend policy is to be reviewed annually. With annual paiment of around 11bn, Apple is one of the largest dividend payer in the world.
  3. The intent is to tap the debt market in order to finance this program and avoid repatriating offshore cash subject to taxation. Microsoft already used that trick in the past. The future dividends will also be funded by US generated revenues.

Under this accelerated scheme, the total cash that will be returned to shareholder in the 40 months timeframe spanning from Aug12 to Dec15 will be $100 billions or $2.5 billions a month. This is huge, almost qualifying as a mini QE in the tech space.

Apple is confident that it earns cash in excess of what is needed to invest in growth and feels comfortable about the scheme considering the $144.7bn cash pile it was sitting on at the end of March.


There was a lot of figure dropping as well as stats and facts bombarding during the call, but the part relating to the iOS ecosystem was particularly interesting. Indeed, if Apple is to make it in the long run, their hardware needs to be solidly complemented by content, software and services. This is how they will be able to keep barriers to entry and secure steady cash flow generation.

Here are some key stats for the March quarter, just days ahead of iTunes' 10th anniversary on Sunday:

  • $4bn billing on digital content were generated, translating in $2.4bn revenues for Apple and $1bn for developers
  • Apple has the largest digital offering
  • 74% apps sales worldwide were made on the iOS platform, YoY apps revenues doubled
  • 800 apps were downloaded per second
  • There are 850k apps out there, of which 350k optimized for the iPad
  • 300 million people use iCloud. Great pipeline ahead
  • Customer satisfaction results beat competition and the secure environment attract corporate clients (77% of activations, excluding BlackBerry)

Final comments

How should we feel about all this? I think okay given the gloomy mood around the stock lately. Apple management's bold move on the capital structure shows that they care about shareholders, which is a good sign. The scheme is likely to attract new investors and hopefully give some support to the stock price as we walk through the quarter that separates us from the suggested product launch period.

Hold on to the stock and see you around soon,


Wednesday, March 27, 2013

Stock Focus: Hyundai Motor Company

I find it hard to get excited by carmakers, even with the motor shows season going on. European producers' woes and the gloomy guidance they're giving after years of negative growth is one reason. Another one is the fading momentum in the US after three years of pent up demand and a full industry overhaul. Overlooking the sector would however be a mistake with the current consensus centering on a 3% to 6% increase in global auto sales for 2013. Not bad and above the 3% world GDP growth forecast of the World Bank.
With the European car market most probably continuing its downtrend in search of a bottom and the US losing pace, a reasonable conclusion is that something is at works in some other region. It appears that the variable balancing out the equation is, not a real surprise, Asia-Pacific:

New car sales in Asia rose 10% through 3Q, compared with 0.1% growth for the same nine-month period in 2011. Consensus real GDP forecasts in Asia call for 6.8% growth in 2013, the highest of any region, and 6.9% in 2014. Economic expansion at these levels is conducive to wealth creation and new car demand growth - Bloomberg
I did not perform a top-down macro analysis to uncover those facts. I started looking at the auto industry story because Hyundai Motor Company (HMC) caught my attention while I was screening stocks in emerging markets and Asia. It turns out that in addition to nice valuations metrics and appealing financial ratios, the company is well positioned to ride supportive market dynamics in its home region and beyond.

The company

HMC, together with his affiliate Kia (36% stake), belongs to the top 5 car producers worldwide with a 5% global market share. This South Korean chaebol benefits from a strong domestic franchise and is ideally located in the in the buoyant Asian region that makes up 44% of their volumes. Western countries are also important, but less so, with the US and Europe representing 16% and 11% of their order book respectively (2011).

The company offers all types of vehicles from city cars to SUVs and sedans. A lean business model, competitive pricing and the attractiveness of their cars re-designed by the former Audi/VW wizard Peter Schreyer, have enabled them to gain market shares from other players in key markets they serve over the past few years. In H2 2012 for example, Hyundai and Kia were the only brands gaining pace in Europe (+12% and +24%) while German, French, US and Japanese competitors suffered declining demand ranging from -1% for BMW to -17% for Fiat and Renault.

In the second half of 2012, the situation got more difficult. Like any Korean producer, Hyundai faced stiff headwinds from a strengthening Korean Won (+8% vs. USD and +11% vs. JPY for the whole of 2012). These forex movements eroded their competitiveness at home and abroad and lowered the profits recorded from overseas operations. On top of those currency swings, claims about Kia's advertised mileage consumption in the US cost the company USD 220m to settle and caused a sharp drop in Q4 2012 profits.

So here we are; the stock suffered for the most of 2012 and is now attractively valued. More favorable FX trends and good execution on a business strategy focused on increased profitability should be triggers for re-rating. The following are some pros and cons to the investment case.

Pros and Cons

  • (+) Good valuation With a PE 2013 estimated at 6.12, the stock is at a discount to its global peers (Volkswagen 6.83, GM 8.63, BMW 8.75, Fiat 10.12...)
  • (+) Sound balance sheet with a Debt/Capital ratio of 7.5% vs. the global industry average high above at 43%. And that's without considering cash and other short-term investments that amount to 24% of their balance sheet. Solid war chest I'd say.
  • (+) Efficiency In the beginning of March, Hyundai and Kia demonstrated their flexibility by digesting weekday working hours reduction from 20 to 17 in their South Korean factories. They just boosted units production per hour by 8%, swiftly. Globally, they run with the lowest inventory level at 3% of their assets when other first class players like BMW and GM are at 7.4% and 9.8% respectively.
  • (+) Growth Hyundai and Kia have had above average sales growth over the past 5 years at 7% and 12% respectively. Further avenues for expansion are tackled by establishing a strategy to be better positioned on the fleet market and through a global strategic alliance with Santander to compete on the financing side with groups that have their in-house banks like VW, BMW, GM,...
  • (+) Profitability 10% operating margins, slightly above BMW despite lower priced cars. The current strategy of HMC is to further improve this figure by shifting to a more profitable product mix tilted to mid and large-size sedans and SUVs and lowering incentives and marketing costs.
  • (-) Corporate governance Family-led South Korean conglomerates, or chaebol, are not particularly famous for fair handling of minority shareholders. Dividend policies, strategic alliances, M&A decisions, etc. have not always been very transparent. The Korean discount is as a consequence around 20% in average to Asian peers.
  • (-) Exchange rates The aggressive monetary policy engineered by the Bank of Japan has massively weakened the Yen and favored Japanese car producers like Toyota and Honda in in the big next-door market, China. This trend already caused a big drop in fourth quarter profits and could still go on for a while.
  • (-) Slow model cycle and lack of new products to create the buzz and support sales in 2013
  • (-) Capacity constraint in the US last year impacted HMC that grew at a slower pace than the industry. That's a 'good' problem to have but it needs to be addressed


Overall, the risks are outweighed by the opportunities for HMC. I like what I've seen and read about this company and will definitely keep an eye on it. Fundamentals, market evolutions, current stock price behavior and the support level around KRW 200k make it a buy, in my view.

See you around soon,


Monday, March 11, 2013

Stock Focus: Danieli S.p.A.

Michael, who already contributed on this blog (I strongly recommend his post on value investing available here), took a close look at the European Smaller Companies screen and has made some research on a stock he found appealing. Here it is.

Enjoy the read, don't hesitate to comment and share if you like it!



As a value investor, the European smaller companies screen provides me with a great hunting ground (check the screen here).

One company that caught my attention is Danieli, the Italian steel specialist.
Italy? Steel? No wonder the company is cheap. This must be a value trap, right?

Well, let’s check it out.

Danieli’s origins date back to 1914, when 2 Danieli brothers started a company in Brescia in Northern Italy to use Electric Arc Furnaces in steelmaking. In 1955 Luigi Danieli took over the family business (50 people) and started designing and manufacturing equipment for the steel industry, maximizing the use of automation. The first minimill was installed in Germany in 1964, and spread to Spain, the US and Asia. The company accelerated its growth under the leadership of Cecilia Danieli and her partner Gianpietro Benedetti (the current CEO). Following large investments in research, and M&A activity around the world, Danieli ranks today among the 3 largest suppliers of plants and equipment to the global metals industry (after Siemens VAE and SMS).

The company is still 63% controlled by the Danieli-Benedetti family and has 2 businesses:

  • Plantmaking (~70% of revenues). This is a high margin, high return business. It is driven by the need of more steel capacity in emerging markets. The plantmaking market is characterized by its oligpopolistic nature (the top 3 companies have a 60% market share), high barrier to entry and good pricing power thanks to its diversified client base (ie. steelmkaers such as Posco, Tata Steel). Danieli is a global player with facilities in China, India, Russia, Thailand, Vietnam, amongst others, and over 75% of sales in emerging markets. It has a flexible cost base with fixed costs representing around 10% of total costs.
  • Steelmaking (~30% of revenues). Specialty steel manufacturing business (ABS - Acciaierie Bertoli Safau) making high quality steel for the Italian, German, Austrian construction and engineering sector. Danieli has made significant investment to restructure the business. Stelmaking was loss-making until 2004, and again in 2009-2010, but generated an EBITDA of €112m in 2012; it is currently undergoing a difficult phase. Danieli bought a plant in Croatia (not far from the Italian headquarters) in 2012 to reinforce this business.
Below are the company’s key figures in EURm (the financial year ends in June):
Net Income
Book Value
Net Debt*
Order Backlog
* Note from Strictly Financial: Negative Net Debt means positive cash position

These figures show that:
  • The business has been growing very strongly until 2008 (CAGR > 20%) and has stabilized since then. Note that the order book excludes a €600m contract in Ethiopia and the pipeline looks promising (e.g., Egypt, Abu Dhabi).
  • Profitability has increased, with an EBITDA margin > 10% (despite headwinds from projects in Egypt and Libya resulting from the Arab spring).
  • Return on equity remains high, above 10%.
  • The company is very cash-rich, which is important given its cyclicality. Around €500m of cash come from client prepayments.
So we’re talking about a profitable business with a long track record and strong balance sheet, well-positioned to capture the growth in global infrastructure.
A closer look at valuation indicators confirms that the stock is cheap on all metrics. To illustrate the point, Danieli trades at only 3 times Enterprise Value (EV) on EBITDA (twice less than similar companies).

Enterprise Value calculation:

+ DAN voting shares €840m (40.9m shares @ €20.47 per share)
+ DANR savings shares €540m (40.4m shares @ €13.36 per share)
+ Net financial debt (€500m)
+ Other net liabilities €200m
= 1080m

The company’s savings shares pay a slightly higher dividend than the voting shares (35 cents vs. 33 cents). They currently trade at a 35% discount compared to the voting shares, in line with the historical discount.

Concluding thoughts:

The fundamental value of Danieli is significantly higher than its current market price. The share price has come off recent lows (the voting shares traded at €15 during the height of the European debt crisis; I wish I had looked at the company at that time) but still offers good value.

It seems that Mr. Market heavily penalizes the company because of its cyclicality, Italian roots, complex share structure.

Some analysts view the potential award of large contracts as a catalyst. At current valuations and with a long-term investment horizon, I believe there is a sufficient margin of safety even without major contract wins.

It is always comforting to invest along highly regarded investors (e.g., Bestinver, Alken, Pzena).



Disclaimer 1: I have just bought shares of Danieli. "Put your money where you mouth is", right?
Disclaimer 2: I am working for a Private Bank in Belgium. The views expressed here are mine and not those of my employer.

Wednesday, March 6, 2013

Hunting for European Smaller Companies - Part II

Italian voters made it clear last week that there is no straight way out of the European mess. Markets corrected strongly and fear was back with peripheral bond yields and equity volatility picking up. Things have normalized since then but this type of event could well occur again in the near future and offer opportunities for stock pickers. In this second part of the "Hunting for European Smaller Companies" series (first part accessible here), we will take a deep dive and screen stocks in search for gems that could be offered at a discount due to market turbulences. An Excel file is attached at the end of the post with the list of stocks that passed the test.

Screening process

The universe we defined previously consisted of Russell Developed Europe Index constituents with a market capitalization below € 7.5 billions. This is a set of 1624 companies. As we do not have an army of analysts working on this blog, we will first have to use quantitative criteria to set aside the names that are unlikely to be good candidates for investment.

I have looked at the whole universe (smaller and larger caps combined) and concentrated on 6 key measures; 621 smaller caps and 62 larger ones that did not have data on one of those six axis were thrown away. I will call the 1206 stocks that remained the "workable index". In this workable index, quartiles were defined for all ratios. Smaller stocks belonging to the worst quartile on any of the dimensions studied or that did not score well with respect to an arbitrary level were dismissed. Below are the details.

Price multiples

The goal here is to gauge how much we are paying for one unit of money produced or booked somewhere on the firm's financial statement. If a company's earnings power and future expected cash flows (which are supposed to be captured in the share price) are comparatively higher, you will be ready to pay comparatively more for one unit of its assets, cash flows, earnings, etc. Higher multiples mean less margins of safety for buyers if reality doesn't meet expectations.

  • Price to book (PB) First things first. I like the ratio because it is relatively stable and intuitive. With a value greater than one, you would lose money if the company went immediately bankrupt as assets sales would not compensate for the price you paid. Lower than one doesn't mean bargain, there could be good reasons like overvalued intangible assets, unrecognized impaired ones or poor business outlook.

    The highest quartile begins at 3.19 in our workable index, the 242 smaller companies with a ratio beyond that limit were disqualified here. This still leaves us with some quite expensive stuff.

  • Price to Earnings (PE) The star measure. It tells you, among other things, how many years would be required to produce earnings that would equal the price you paid. The problem with the PE is that it is a volatile indicator, I would prefer to use Price-to-5-years-average-earnings-before-extraordinary-items but this was not readily available so I will stick to the good-old trailing 12 months proxy.

    The the fourth quartile begins at 23.14, filtering out 164 names.
  • Free Cash Flow Yield (FCF/P) Cash is king. Free cash flow cleans net income from easy to manipulate non-cash items like depreciation and amortization and gives a fairer picture of profitability after the company has paid for operating expenses. A big difference with EBITDA or Cash From Operations is that Free Cash Flow deducts capital expenditures from Net Income. Capex are necessary to maintain/grow the assets base and can absorb a substantial part of the revenues in some industries. The level of cash is calculated before interest/dividend payments so we can use the ratio to compare companies with different capital structures. The higher the ratio, the cheaper it is to buy the money machine.

    We set the limit at 4.16%, the median of the workable index, below is too low. 276 stocks are out.

Other multiples

  • Net Debt/Equity Leverage is a good way of enhancing returns to shareholders, too much of it can be dangerous and put the company at risk. Net debt subtracts the cash from short term and long term liabilities, as it could be used to pay back creditors if necessary. I often complement this measure with the interest coverage ratio that tells me how many times the company can pay for debt servicing from EBIT. This gives more insight than leverage in absolute terms.

    70% is our top quartile frontier here, I prefer setting the limit at 100% and check the financial structure in more details later. We get rid of 48 additional stocks.

  • Operating Income/Net Sales A.k.a. Operating Margin, it reveals the portion of revenues that is left after the company has paid for the variable costs of production. On top of giving a profitability measure, a high and resilient figure can indicate that a company has a unique technology, brand name or other barrier to entry that prevents competition to enter its market. Low margins can be an indication of a mature business, nothing to be afraid of if this goes with good volumes, strong market position or reasonable valuation.

    Losers' quartile begins at 6.66%, 70 companies follow the exit sign from here.

  • Return on Equity (ROE) ROE is one of the many return ratios available. As we already look at leverage and cash position with Net Debt/Total Capital, we can overlook ROIC at this stage. ROE is simply the Net Income/Shareholder's Equity.

    The lowest quartile begins at 8.18 in our workable index, 22 stocks are out.


We end up with 181 smaller cap stocks, an Excel file giving you an overview of the results can be downloaded here. These names need to be followed, monitored and further analyzed; we'll come back on them in future posts.
As a bonus, you will find a sheet containing the bigger caps that qualified along all criteria. They are of course worth considering too.
That's all for this time, see you around soon.


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:

Howard Marks' Oaktree memo's:

Jeremy Grantham's GMO quarterly letters:

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!