Winter is coming

Winter is coming

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Performance in 2015 was as much a function of investments that haven’t worked out (yet, we hope) as much as it was the result of a conscious choice to reduce or eliminate our stakes in companies that we viewed as expensive. As it happens, the companies we sold outperformed, on average, the investments we purchased. This is far from unusual in value investing. Buying and selling early has always been the bane of the value investor, who must have the fortitude to live through periods of being out of favour. What was a good value at one price is presumably a better value when it has declined 20%, assuming one’s analysis was correct at the outset. We believe that’s the case with the majority of the companies in our portfolio; cheaper on average than they were a few months ago but not yet at prices we’d call ‘no brainers’.

This is a challenging time, and we maintain a more riskaverse portfolio. Interest rates remain near historic lows, and the Fed has begun tightening for the first time since 2006. The global economy is muddling along at best, with the China growth engine sputtering. And stocks aren’t particularly cheap. We fear, as is oft intoned in television’s Game of Thrones that “winter is coming.” We wish we knew when the weather would change. Since we don’t, we want to make sure we always have a heavy coat on hand to keep us warm. Although the Nedgroup Investments Global Flexible Fund’s risk exposure1 has increased somewhat as markets have declined, it remains just 57%, which offers us plenty of room to deploy capital should asset prices fall to more attractive levels of risk and reward.

We are, as always, conscientious about matching assets and liabilities. We appreciate that our fund shareholders have daily liquidity and therefore consider, in turn, the liquidity of the investments we make. Selling an illiquid position is of greater concern today given this more volatile market. If a security owner is forced to sell a position, the negotiating leverage shifts to the buyer, possibly causing the seller to take a low price in order to convert the investment to cash. We like to be the ones taking advantage of forced selling rather than the other way around. We have two paths that afford some protection. First, we have 43% cash that can be drawn down. Second, our average market capitalisation of our equity positions is more than 100 billion dollars, offering us tremendous flexibility.

We’ve been arguing for some time that the market isn’t cheap and, even with the broad stock market averages having declined in 2015, it’s not like businesses are being given away. Take the US (represented by S&P 500 table below), for example, and compare the trailing median Price/ Earnings (P/E), Price/Sales (P/S), and Price/Book (P/B) ratios on 31 December 2015 to the month-end of the two prior market peaks. The P/E and P/B ratios are in line with past peaks while the P/S is as high as it has ever been. No bargains here. Investment discipline has given way to complacency even for the normally resolute. The only explanation we can find for a fully-invested portfolio is that some managers seek to protect their businesses while others feel the siren call of low interest rates that make everything seem cheaper than it might otherwise.

Although we have no idea what comes next, we haven’t been nor are we currently particularly enamoured of stock valuations. This doesn’t mean the stock market won’t continue to rise. We don’t feel we’re being adequately compensated to be more fully invested. We’re a lot more excited about troughs than peaks and also note that the S&P 500 declined in the subsequent period following the prior two valuation peaks.

High yield 
We don’t see junk bond investing as a business. It’s like a holiday home. We go when the weather’s nice, although in this case we mean stormy. Your corporate debt portfolio is effectively equity, albeit in a more secured form but with many of the associated risks. Meanwhile, we are spending our time trying to determine which vacation spot we’d like to visit.

The fund’s high-yield exposure is small, albeit off its lows. That can be explained by the still relatively low yield of these more speculative corporate bonds. Although spreads have widened to 7.1% and are slightly above average, they are joined at the hip with historically low interest rates2.

We prefer to focus on yield since one can’t subsist on spread alone (see table below). When yields are high, even when spreads are below average, we can be comfortable with high-yield exposure, as was the case in 1997-98. Index yields are currently 8.9%, 1.5% below average3. We require a higher yield to get a good return, particularly one that compensates for the risk investment.

In waiting, we think we are being appropriately prudent rather than greedy. We have seen spreads and yields in excess of 20%. We don’t know if they’ll blow out as much in the future, but we aren’t going to get that aggressive until they at least move in that direction. We cannot surmise how the market will unfold, but we hope for a better point of entry. Yields could rise further if the economy weakens or a company missteps or faces a lack of capital available when existing debt matures. Any of those scenarios could provide us with an effective place to deploy capital in the not-toodistant future. Until such time, there’s good reason for us to tread cautiously.

Should markets continue to rise, those more aggressively postured will perform better than us, but it does beg the question how one separates skill from excessive risk-taking. Distinguishing between the two isn’t easy and may even prove impossible. It’s easy to look smart in a rising market. ‘Smart’ are those who leverage a fully-invested portfolio. ‘Smarter’ still are those who invest in the most financiallyleveraged entities. It’s not until the temperature drops in an overheated market that one realises that the ‘smart’ managers may not be dressed appropriately. We try not to lose our shirts and have historically been defensive in weaker market environments, but we haven’t forgotten about the upside, having performed well over market cycles. We hope that’s some indication of capability more than just assuming undue risk and relying on luck.

We can look really smart or really stupid over the short term. We should be defined not by that, however, but by what happens over the long term. We think our strength is time arbitrage. What isn’t attractive today will be so in the future as long as you have both the patience and the staying power to stick around.

1 Risk exposure is defined as non-cash and cash-equivalent assets as at 31 March 2016.
2 A U.S. corporate bond “spread” is the bond yield in excess of a U.S. Treasury of a comparable maturity.
3 BofA Merrill Lynch US High Yield Master II Index. Data from 1/31/1989 to 12/31/2015.
4 J.P. Morgan. As of December 31, 2015.