Strategic Investment Framework 2008

I am in the process of writing my strategic investment framework for 2010, but i thought i would fristly repost the strategic investment framework that i posted in Sommersoft somewhere back in late 2008:

With the level of worry on this board about 'bad news' flows i thought i would try to provide a brief framework which i am using to evaluate the global economy and hence the structure of my own investments.

An Evaluative Frame Work Required:
All boom bust processes contain an element of misunderstanding or misconception. The primary reason for this is the belief by market participants that the market is in a state of equilibrium (efficient market hypothesis) rather than my belief that at most points in time the market actually is in a state of unequilibrium (or artificial equilibrium due to interference).

Current accepted practice states that financial markets tend towards equilibrium. This may apply over the long term (and this can mean decades or longer when most investors have a much more short term analytical framework), but in the short to medium term, this is a fallacy when applied to the real world as it assumes perfect knowledge.

Human beings are incapable of having perfect information as they process information through prisms reflecting their own circumstances and inherent biasness.
Human beings biased perceptions thus influence not just market prices, but also the fundamentals that those prices are supposed to reflect. This is because on one hand human beings try to understand their situation, but on the other hand they try to change their situation (for personal advantage or to achieve a better perceived outcome). The two functions work in opposite directions and can interfere with each other.
This can lead to the self reinforcing (through market participants perceived understanding of a situation and then perceived successful application in changing the situation) but eventually self defeating boom-bust processes (as their knowledge base is not perfect, impaired through investment prism bias and their structural deficiencies through the imperfect application of changes to the situation)

In simplistic words this translates as financial trends start from rational causes but are often prolonged to a point where prices swing upwards or downwards into the irrational. In the context of a market, a feedback loop (whether positive or negative) can be understood simply as market priced assets inflating/deflating as underlying funds are reinvested or withdrawn.

I must give due thanks to George Soros’s new book The New Paradigm for Financial Markets for giving me the framework to succinctly present this thought process.

The Current Global Macro Environment:

We are currently witnessing the unwinding of the recent global period excesses. Essentially:
1) currency surpluses used to deflate a country’s currency through international carry trades;
2) financially engineered products that were priced on recent historical data (that was also a period of relative stability, leading to insufficient pricing for risk) and issued to those who weren’t qualified to assess their inherent risk,
3) A period of easy credit terms, a rising housing market that allowed consumers to refinance for current consumption (housing equity as a means of 'income' to support expenditure)
4) A build up of consumer based export industries (exporting nations) and a build up of consumer infrastructure (such as retail shops businesses, retail based warehouses etc, for the importing nations).
5) A period of historically low interest rates relative to the underlying economic conditions due to the fallacy that the global trade system had ‘eliminated inflation’ through the hollowing out of inefficient industries to those countries with lower labour costs and the flow through economic benefits in the establishment of justifiable higher asset prices in higher labour cost countries (the false we will think they will sweat hypothesis). This in turn leading to the desire to achieve ‘reasonable’ rates of return by professional money managers

These factors are all interlinked due to the rise of intermediation within the global economy.

As this process unwinds we are going to see most of the financial pain centred around the catalysts that were built to unsustainable levels during the previous period’s excessiveness (of course there will also be indirect pain through related industries, but the storm of readjustment wont be focussed on these areas as they never benefited from the positive reinforcement of the boom time conditions).

As you watch the GFC unfold through the media, you will see a number of D&G articles. These articles will create the appearance that world capitalism is coming to an end. I beg to differ, if you look through the underlying nature of the storm you will see in nearly all cases it relates to the unwinding of an unsustainable resource build up.

Hence a bit like the 24hr bug, the world is regurgitating all the excesses out of its system.

This has happened numerous times over the course of history and is nothing to be alarmed about. The key is to recognise that time of change is upon us. Industries that were the key to riches in recent history will probably not be in near future years.

Instead of just prophesising D&G, its much more profitable, in my opinion, to look at what are the future needs and wants. Being a capitalist society, profits have always been made by satisfying human needs and wants. The nature of these needs & wants will change during cycles (and there are cycles within cycles), but the profit motive and human greed to satisfy these changing needs & wants is constant

Australia Relative to the USA & Europe:
The major reasons why I don’t see Australia having the same degree of economic pain as the US and UK (and I emphasise same degree) are:
1) This is a financial crisis caused essentially by lending to people who couldn’t afford the asset and had the legal right to hand back the asset and underlying debt. The debt was then passed through to those institutions that believed that diversification eliminated risk, when in actuality those institutions didn’t have the skill base to analyse the underlying semantic risk.
2) Our financial institutions have minimal involvement in the debt securities issued on the basis of point 1. We are more than 18 months into the credit crisis yet our banks are still generating profit, compare this to Iceland, UK and US where their financial institutions are haemorrhaging losses.
3) Australian lending rates where much higher going into this global recession. Hence Australian borrowers have a much higher buffer as interest rates come down. (In the last 6 months compare the huge differential interest cost savings of Australian borrowers compared to their US counterparts). This factor to me is one of the key supports of the Australian economy. We all complained in prior years when our lending rates were much higher than other countries, but at least now those higher interest rates will insulate the pain as interest rates fall, and again I emphasise here the rate of differential fall in the Australian borrowers lending rate compared to their US counterparts. Sure some Australians will loose their jobs and hence find themselves in financial difficulty in repaying the loans. But compare the increase in unemployment rates to reduction in interest rates and the stimulatory effect of the reduction in interest rates will still be greater than the loss from an increase in unemployment. In simplistic terms what was the residential lending rate in early 2008 about 9%. If we see RBA target rates of 3% this should translate into residential lending rates of 5.5%. On an average loan of say $300,000 this translates into cost savings of $10,500 a year. This is a huge 'tax cut'. Sure there will be some recently unemployed for whom this may just act as an insulator before the inevitable, but for those still employed its an extra $200 a week in their pocket. The other key point to note here is that unlike the US or UK, the majority of central bank interest decreases are actually passed down to the consumer level home loan because of Australia’s high proportion of variable home loans.
3) The benefit of the commodity boom was only indirect for most of the Australian population (through the wealth effect from speculation in resource shares, through increased government tax receipts that were then partially redistributed to recipients not benefiting directly from the commodity boom etc). Hence its loss will also only be indirect. For those that were direct beneficiaries it will seem like the world has come to an end for the rest of us that never had a direct involvement the effect will be indirect and more muted (mostly in the form of loss of government revenue).
4) Australia's 'smallness' for want of a better word. Unfortunately the US is regarded as the global lender of last resort, essentially the world central bank (I’m not stating the correctness or otherwise of this, just that this is still the current underlying opinion of the world). Hence even though it is the catalyst of the global financial crisis, it is still regarded as being a global safe haven for cash. The problem here though is its impact on exchange rates. Basic economics suggests that the US currency should be depreciating, unfortunately with demand for its 'safe' currency the opposite is happening (and in my opinion this will lead to an extension in depressed global conditions than would otherwise be the case). Australia doesn’t have this, hence the depreciation of its currency. Essentially this is good for Australia as it will improve the future trade situation (through an increase in exports and increased competitiveness of import replacement industries (however for import replacement industries there is a significant time lag as it takes time for capital to be allocated to it, essentially what Paul Keating referred to as the J-curve effect).
5) Our proximity to Asia. Although Asia will incur a down turn because of its export dependency model to the west, Australia provides many key resources that will still be in demand (resources, foodstuffs, education, immigration), with the AU$ depreciating our industries become more competitive. Sure resourses will not be as attractively priced, but they will be insulated by the falling AU$ (from memory we still managed to survive prior to the resource boom starting 2002 odd ) Asia also has net savings that will insulate them to a degree.

Again I stress I don’t think everything is going to be hunkey dorey in 6 months time I just don’t see Australia being effected to the same degree, and hence I am investing accordingly

How to Profit in the Current Climate:

Therefore in my opinion avoid allocating investments (whether its shares or buying underlying property) to
1) Retail shops/shopping centres and discretionary retailers (in regards to REITS there will be periods of profitable arbitrage opportunities based on individual REITS debt financing terms, NTA, movements in capitalisation rates and the application of current accounting standards in regards to debt hedging (hint wait for interest rates to have bottomed which will allow future write backs!!!!, or the reversal of such rules by the international accounting bodies);
2) Office buildings within major financial centres;
3) Export companies that target discretionary consumer spending;
4) Domestic importers that target discretionary consumer spending;
5) Finance companies that use financial engineering as a means of making profit.
6) Companies that rely on high debt
7) Companies that rely on acquisitions to manufacture earnings (This point is not so obvious, but in times of easy credit a company can manufacture earnings by issuing a combination of higher PE company shares and external debt to acquire lower PE companies and hey presto earnings. For recent examples look at ABC Learning (extreme example) and TPI & ALS (less extreme)).

Whilst the market values of such investments are falling, they could very much present value traps. Future losses will be curtailed as such sectors downsize, but even after the losses are curtailed, what will be the catalyst to restore future earnings to previous levels (hence the value trap).

Instead look for Companies:
1) That never benefited from the recent boom (this in itself is not a reason for investment, only that such companies may have less of a value trap);
2) That can both maintain pricing during periods of deflation and increase them during periods of inflation (given the history of politicians all the current liquidity being pumped into the system could be difficult to withdraw once the financial system rebalances itself).
3) Use internally generated free cash flow for expansion, rather than debt or continued issuance of new equity.
4) Keep a close eye on inflation; if underlying inflation starts to rise avoid capital intensive companies.
5) Use the current market fear to buy companies with monopolistic practices that are trading on reasonable PE’s for the first time in 10years+

In regards to residential property, i think performance will be mixed.
I split Australian residential property into 3 sectors: lifestyle, upmarket, generic traditional housing.
Lifestyle property could well be in for a time of future underperformance, as its underlying intrinsic economic usefulness is low (hence lifestyle). This sector will be significantly affected by both reduction in retirees income and net wealth and erosion of wealth amongst the wealthy (2nd properties as beach homes etc).
Upmarket properties could also be in for a time of future underperformance (but I think less so than lifestyle properties, because their intrinsic economic usefulness is higher) because its performance is correlated more to the health of the business sector than to traditional property valuation measures (average incomes, interest rates etc). The level to which Australia goes into a recession will be the most important factor for this asset class, not interest rates. If Australia avoids a deep recession then I think upmarket properties will stabilise very quickly (but maybe not show much in the way of near term future out performance, because business conditions wont return to their former boom time conditions for a number of years).
Finally we have generic medium priced and lower housing in capital cities. I just can’t see why this type of property has a risk of material depreciation. At the end of the day step back and look at the big picture, there is still a structural undersupply (which is building due to the current downturn in new starts). And I cant over emphasise this differentiating factor to between Australia and the US (I don’t have the figures in front of me, but a significant amount of residential property in the US towards the end of the boom was never build even for the purpose of an investment rental property, they were acquired solely for the basis of flipping which was evidenced by the vacant nature of the property, i.e. properties were developed and then left vacant in order to be resold) This underlying demand will create a floor in how low prices can go. If Australia enters a recession some people will loose their jobs and of these a portion are at risk of having bank possessions (But not all, just because someone becomes unemployed doesn’t mean they will automatically loose their house, the correlation won’t be 100%). But underlying this fact will be new buyers who are trying to enter the market (because of the demand surplus). Some of these new buyers will be put off by the GFC, but others who are in safe employment or have adequate savings or other factors will still be happy to buy. So you have to look at the MARGINS effecting supply and demand

I should however add a word of warning here.
If i am correct about generic medium priced housing remaining roughly stable or even more problematic showing a price rise, this does pose a risk in the longer term as it will give positive reinforcement to the attractiveness of residential property as an investment class.
With the massive capital losses seen in the stock market this may encourage future speculative money into residential property (once the global financial crisis concludes) increasing its supply. If supply increases materially to cover its current short fall, we could be in for a rough time when interest rates increase in the future (because the key underlying demand/supply issue wont be supporting the market, and also the reverse of the current benefits of central bank movements in interest rates come into play, i.e. just as decreases had a disproportional higher impact on home loan repayments due to the high % of variable interest rate loans, so will increases in future interest rate rises have a disproportionately higher effect).

Non-recourse in regards to your post, this is exactly what I was referring to about the world being like a living organism.
Just step back a moment and look at the big picture, consumers in developed nations have effectively spent more than they earned on private consumption. The market being what it is accommodated the increase in demand by increasing supply (more resources allocated to shopping centres, businesses focusing on imports to cater for the demand, retail businesses etc)
Now the increase in debt has been cut off (and worse still consumers are having to pay back that debt), so of course industries that cater directly to private consumption are going to contract.

The problem here is that because of the excesses of private consumption, this proportion of the total economy is unsustainably large and needs to contract to long term sustainable levels.

Because the world is so interlinked (its more like a global village now), those countries that are 'savers' and exporters are also imbalanced in that they have created export industries that are unsustainably large relative to the total size of their GDP.

In my opinion this is why dollar averaging such a successful strategy over the long term.
Most human beings are incapable of selecting perfect buy in and exit points. In some cases they follow a herd mentality (which is inbred into our physiological thinking, as safety lies with the herd), in others they successfully execute a correct buy in/exit point and then incorrectly attempt to extrapolate that decision making process over future transactions.

Dollar averaging removes the temptation to time the market and acts as a natural hedge against mistakes (as each dollar buys more assets during cheaper times and less during expensive times).

This applies equally to shares and to property.
Far out, would hate to know what you do for fun! :eek:
I hope, after all that work, you actually make time to invest......

So don't believe in the good old saying "it's not about timing the market but time in the market" then? I admire your work to try and safeguard your investing but I can't help but think if I did similar it would get in the way of progression.

Far out, would hate to know what you do for fun! :eek:
I hope, after all that work, you actually make time to invest......

So don't believe in the good old saying "it's not about timing the market but time in the market" then? I admire your work to try and safeguard your investing but I can't help but think if I did similar it would get in the way of progression.


haha, actually sometimes it good to put pen to paper so to speak, it helps to clearify the mind, especially in times of uncertainty.

In business you prepare strategic plans, so why not with investments.
During the height of the GFC there was incredible uncertainty, but coupled with huge opportunity, at least for those that invest in shares.

In my opinion 2010 is even more uncertain from a strategic point of view. The immediate risk profile is lower of course, but the margin of safety is also much lower. The margin of saftey is lower because of the recovery in investment assets. Margin of safety is inversely correlated with longer term risk.
haha, actually sometimes it good to put pen to paper so to speak, it helps to clearify the mind, especially in times of uncertainty.

In business you prepare strategic plans, so why not with investments.
During the height of the GFC there was incredible uncertainty, but coupled with huge opportunity, at least for those that invest in shares.

In my opinion 2010 is even more uncertain from a strategic point of view. The immediate risk profile is lower of course, but the margin of safety is also much lower. The margin of saftey is lower because of the recovery in investment assets. Margin of safety is inversely correlated with longer term risk.

Not a bad read. Cheers for that. I usually zzzzzz when i see stuff like that but because of your writing style (slight nudge to the informal) it was ok.

You know its gotta be ok when it comes from a guy who reads *nudge nudge wink wink* RALPH mag