Altus Insight - May, 2013
The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Date: May 31, 2013
FR: Forrest Jinks
RE: With Eyes Wide Open…
I am constantly amazed by the amount of volatility currently in the investing world. There have certainly been such volatile periods in the past, but it is always the most recent experience that seems to provide the most sensitivity to our psyche. While volatility isn’t always bad, it does have a strong correlation to risk since high volatility indicates high levels of risk and vice versa. Two methods of dealing with volatility, both of which have been discussed ad nauseam in previous Altus Insights, are to invest for yield and to invest in long time horizon investments. We also believe in keeping our eyes wide open to what is happening in the geo political and economic world, as those events are the basis for changes in the rate and strength of market volatility, and can often be a direct cause for volatility. Before discussing events and how they might affect an investment, it is first important to know if a position is a “trade” or an “investment”.
Trading vs. Investing – Many participants in various security or real asset markets have no idea of the difference between investing and trading, and in reality most investment professionals, though they could give a technical definition of the difference between the two, rarely make a distinction between the two when placing money into different “investment” positions. I believe a clear understanding of whether a money placement is an “investment” or a “trade” is critical for me to determine on which factors I need to focus during the term of the investment. As a simplified definition, I view a trade as a purchase of a security or real asset with the idea the asset will appreciate enough in value that asset can be resold in a short amount of time (less than a year or two for instance) for equity appreciation. On the flip side, an investment is made by purchasing assets with the understanding those assets are to be held and will produce returns for multiple years into the future. The purchase of a single family house to fix and flip is definitely a trade, while the purchase of a company that buys and sells many flips over a longer period of time is an investment. Placing money with a long/short hedge fund is likely an investment (there is probably a lock up period) but the purchase and sale of stocks/bonds within that fund will often be trades. At Altus we have a bias toward investing but definitely have involvement in trades, sometimes owning properties less than a month. I am much more concerned about our exposure to volatility in our trades than our investments. Where the water gets a little muddier is towards the stated end of a fund life (which was definitely an investment) because volatility in the market will have a direct impact on the liquidation value of the underlying assets. Our nearest fund liquidation date is still 3 years away but we have multiple trades currently in progress for which I keep a close eye on the events of the world. We will discuss Japan below, but as an example of the current volatility, the Nikkei dropped over 7% in a single day this past week. Only once since the massive crash in 1987 has the Dow dropped an equivalent amount. The following is a summary of some of the bigger items of which to pay attention.
In Search of Yield – As mentioned above, yield bearing investments are a way to ride out volatility storms since they continue to produce returns regardless of the price of the underlying asset. They are also the investment everyone wants when they wish to spend a portion of what their investment earns. But what if there is no yield to be found? Or what if yields are available, but only with an outsized risk profile? Welcome to the effects of never ending quantitative easing where federal debt (t-bills) is producing negative real returns and where most corporate debt is now priced at a higher PE level than the stock market at the high of the late 90’s tech bubble. So what is a person to do? As a biased observer and participant in the alternative investment space, I believe certain real asset investments are the place to be. The problem with alternative investments is usually their lack of liquidity, but if a person truly needs yield or desires yield over a long time period, then the liquidity restriction is less of a problem. In addition to secured investments in debt, additional opportunities exist in funds or investments paying a preferred return. Sometimes these preferred returns are even structured with the principal backing up the preferred return offered with a large chunk of their own investment capital as a buffer. I am happy to answer any questions readers may have about how to get involved in alternative world and what to be aware of before making an investment.
Japan, A Bug in Search of a Windshield – This term was coined by John Mauldin several years ago as he reviewed the Japanese government’s debt structure, its ongoing spending obligations, and the demographics of its populations. Earlier this year he opined that 2013 would be the year the bug found the windshield. As most of you know, the Japanese government has teamed up with the Japanese central bank on a quantitative easing program so massive that it dwarves even the Federal Reserve’s actions in relative size. Prime Minister Abe has set a target of two percent inflation per year (after 20 + years of zero inflation). I will spare you the math (email me if you want a full explanation) but according to Felix Zulauf of Zulauf Asset Management AG (and corroborated by others), the Yen would have to lose 20% in value against a weighted basket of currencies to create 2% inflation. Yes, it is true that the yen has depreciated against the dollar by over 30%, but the dollar is only a portion of the basket of currencies. Even more importantly, to maintain the 2% inflation the Yen would have to continue to slide that same 20% each and every year going forward. The slide in the Yen makes Japanese exports cheaper to the rest of the world and by comparison makes the goods of the rest of the world more expensive relative to the Japanese goods. Are China, South Korea, Australia or Germany going to sit by and do nothing while their own businesses lose sales to Japanese competitors due to the falling currency? Lost sales means reduced profitability. Reduced profitability means reduced tax revenue and often a reduction of headcount. Japan most likely doesn’t have a choice, having backed themselves so far into a corner they are out of options, but the choice they made and the action they are taking will create currency wars. World leaders continue to talk publicly of cooperation but their actions are already showing otherwise. The question isn’t whether or not we will have currency wars, but rather how big they will be. This is something to keep an eye on as both traders and investors. For instance, actions of the central banks often have an immediate impact on the markets (affecting traders) and changes in exchange rates affect multinational blue chip companies (affecting investors). In the alternative world, even for domestic focused investors, currency wars will affect the cost of financing, the cost of inputs, and the viability of customers/tenants. As a final point of reference as to how bad the Japanese economy has been for the past few decades, in January of 1990 the Nikkei (the Japanese stock market) measured in at 40,000. In January of this year, 23 years later, the Nikkei was less than 15,000. We need to hope that the actions of Japan don’t create massive economic and political upheaval (the last large currency war ended in real war) and that the US doesn’t end up in the same economic quagmire in which Japan has been stuck for so long.
Gold Collapse – In Paper Only – Last month (April) gold prices took a dive of close to 20% (how is that for volatility?). The common analysis was gold bugs finally realized their fear of inflation was overblown and people were exiting their positions. The softening demand led to a swift and brutal drop in prices. I don’t know all the details around the drop (such as only a massive owner of gold, like the Federal Reserve, could have sold that much gold) but one thing seems to be evident - there is no shortage of demand for physical gold. Even as the papers were quoting the experts saying gold had fallen out of favor, lay people around the globe were waiting in lines in major cities to buy whatever gold they could get their hands on. In Asia, many gold traders ran out of gold and had to close their shops until they were able to bring in more supply. This leads one to believe the drop in gold prices was due not to a lack of buyers with an interest in physical gold, but rather to traders trying to take advantage of a weakness in the system. It obviously worked very well for anyone on the short side of the equation.
France – A Softening into Mush – Europe has stayed off the front page of the paper enough lately so that many people are starting to believe the worst is behind them. Fundamentally I don’t know how that can be so, and there is certainly evidence to the contrary coming out of France where the economic numbers continue to soften. Hope for France? Not without a change in leadership. In the early 1980s the French government headed up by President Francois Mitterrand, nationalized the banks and tried to drag the economy further along the Socialist path. When the economy tanked Mitterrand had to reverse course (though he later gained respect for his work in further integrating France into the greater European economy). Mitterrand’s economic advisor at the time of the nationalization? None other than Francois Hollande, the current President of France and the leading character in the government’s efforts to institute a tax rate of 75% (that is not a typo) on income over $1 mil euros per year among other things. It would seem that now would be as good a time as any to stay away from all investments French in nature but with the recognition there will opportunity in the future once the dust settles.
Employment Numbers – Is inflation in the cards? Since Helicopter Ben Bernacke began his effort to revive the economy through quantitative easing several years ago, the debate has raged as to whether or not inflation (and even massive inflation) was in the cards. One of the major arguments against the onset of inflation was that there had never been an increase in inflation without there first being upward pressure on wages, which was commonly thought to be impossible due to high levels of unemployment. Unemployment levels have dropped from their cyclical highs but improvement seems to have stalled with there even being an uptick in unemployment earlier this month. Additionally, the unemployed are staying unemployed longer than ever before, averaging 37 weeks of unemployment compared to 23 weeks at the end of the most recent recession (after which time things were supposed to be getting better). Simultaneously, job openings have continued to grow and are now equivalent to 2008 numbers and with a steady upward trend. Companies with openings they are unable to fill also continue to move higher. David Rosenberg, the Chief Economist and Strategist for GluskinSheff (and a regular on Bloomberg, CNBC, etc.) expects to see wage inflation begin sooner rather than later. There are two different explanations that make his claim plausible.
The first is that the education and skill set of those unemployed don’t match what is needed in the market place. Part of this divide is due to how fast the world is changing but also how poorly workers, and the US government, are adapting. As has been referenced here before, Joseph Schumpeter made the term creative destruction famous in the middle part of the 1900s. The idea is that a healthy, innovative, and growing economy will have businesses fail and employees laid off as they are replaced by companies with a better value proposition to the consumer. Those laid off employees then go get retrained and reenter the workforce in a more productive role. This works great in theory until an outside force (like the government) disrupts the normal business cycle (such as through QE, the auto bailout, etc.) which in turn creates larger waves of uneducated unemployeds and creates the unemployeds farther in the future than would naturally occur, resulting in them being that much farther behind in their education to be able to re-enter the work force. This says nothing about safety nets that may hinder motivation or an increase in the societal entitlement mentality.
The second is that increasing secondary employment costs for low earning employees increases the likelihood of companies to either invest in tools that can reduce the required workforce or to hire temporary workers. These secondary employment costs include workers comp costs (especially in California), legal exposure for hiring/firing practices, costs associated with Obamacare, etc.
The reasons as to why wage inflation might occur are interesting, but aren’t nearly as important to me as an investor as to what the effect of the wage inflation might be on the greater economy. If Mr. Rosenberg is correct, and the increase in wages leads to an increase in general inflation, those owning real assets, especially on cheap leverage, will be the winners. Those owning bonds or similar investments will be the losers. If inflation was to increase to even 4 or 5% (above the Fed’s stated target but well below a level that would be called high inflation) the yields that buyers of fixed income assets will require will also rise. Increasing yields equates to decreasing prices. Someone owning a 2% T Bill could lose ½ the market value of the bill and then be stuck earning an interest rate on their original investment that is half the rate of inflation.
California Leavin’ –Last weekend I was in a location with several hundred other people for a couple days, many of whom are in the productive period of their life…raising families, trying to grow their businesses, investing for retirement, etc.. Though I don’t see them often, I have known most of these people for many years and inevitably there would be a “catching up” conversation. As a born and bred Californian it was disheartening to hear over and over how these productive members of society (and consistent tax payers, employers, etc) were either in the process of moving their family or business out of California or were starting the research on how to do so. Unfortunately this anecdotal data echoes other anecdotes I am hearing more and more often and some of which have hit pretty close to home. A consultant friend of mine who does a large portion of his consulting outside of California moved his business to Nevada last year where he figures he will save $10,000s/year in income tax alone. Just this past month another good friend and former business partner sold off most of his California business interest and bought a new business in Idaho. Last week I researched a property owned by a business owner who is moving his entire company out of state. He runs an industrial filtration manufacturing company and a large portion of his sales are outside of California. He will save $50,000 on workman’s comp insurance each year, to say nothing of the impact on his income taxes or cost of living. On the flip side, some parts of the state, like the technology hub in the South Bay, are booming. Is this the start of an Altas Shrugged type movement, or just a small recalibration of the population? Personally, I think it is too early to tell, and maybe I am wearing rose colored glasses, but I believe between the weather and topography California has far too much to offer to become a shrinking entity a la’ Michigan; but it could well be that the mix of the population could change drastically. A change in the demography will reduce the viability of certain investments and businesses while opening up opportunities in other areas. Just something else to keep an eye on…
Until next month,
Altus Equity Group, LP