A Letter To Investors
The sharemarket can be both a wonderful and a frustrating place to invest or trade. Indeed we suspect that many who entrust their capital to professional managers must struggle with the logic of what is being done on their behalf. Why buy when markets are falling? Why sit back when markets are rallying hard? Why raise cash and why trade out that position? These are some of the many questions we field in our dialogue with clients.
At Clime we approach the task of investing our client’s capital differently to most other managers. There are three key themes to our approach, the way we conduct our business and provide our services. We colloquially call it ITC and you will see us refer to this a lot more in the future.
Firstly, there is Integrity in what we do. We believe that a manager must be true to label; must do what they say and be responsible for their actions. Clime is a public company with responsibilities to clients, staff and shareholders. We balance these responsibilities in a fair and open manner. We are passionate about education and believe that clients should have the resources to question what we do.
Secondly, there is Transparency in what we do. We keep investors informed of our thought process and our clients have access to their portfolio 24/7. We know of no other manager who publicly value investments and who share their base assumptions for their valuation. Most of our peers rely excessively on the research of commission agents and we believe this is a way of both obfuscating responsibility and staying close to the index.
Thirdly, there is Conviction in what we do. We believe that an investor should expect to make a real return from the sharemarket in most years. Our conviction is shown in stock and security selection – for we do not widely spread investments. Our aim is to generate consistent returns through the cycle and we do this by constantly reviewing our valuation of investments and the market. Compounding positive returns is the key to successful wealth creation over the longer term.
So that is Clime and that is important background for this February 2013 letter to our investors and clients.
The market in 2013
We refer to a letter I penned in September 2011. At the time, investor and market confidence was being rocked by serious financial disruptions in Europe. We argued that, whilst the short term was difficult to predict, the longer term was much more certain. We believed at that time that much of the bad news had already been priced into markets. (View article – ‘The further you look, the better it gets’)
Today we are still convinced that the longer term future is more predictable than what will occur over the next 12 months. Further, we doubt that the recent market moves have anything to do with this longer term outlook. Whilst the rally in the equity market has some vestiges of logic, there is also the constant pressure coming from impatience, greed and plain stupidity. The immense liquidity pressure from international quantitative easing (QE) is also playing a role to inflate investment assets. Unfortunately nothing will change these perverting influences on the market. Our view is that these characteristics are and will remain constant forces in the pricing and mispricing of securities for the foreseeable future. There continues to be much that can go wrong and the risks are actually rising for investors as prices indiscriminately rise. That is certain.
The ASX over the last 3 years – “Is it going anywhere?”
Figure 1. ASX All Ordinaries Index XAO 3 year Chart (Feb 2013)
Having made those background comments, let’s now share with you our view of the longer term.
Given our transparency, a lot of what this letter contains is a reiteration of our weekly comments but it is important that we constantly review our thought processes and consider them against factual events.
Firstly, we are certain that China and therefore Australia will have bigger economies in three and five years than they have today. China’s economy will likely grow by the size of Australia’s economy ($1.6 trillion) in the next 5 years. The Australian economy will grow through its engagement with China and through its population. Australia will have 1.5 million more people in 5 years then it does today. This type of growth is good for our equity markets because it should translate into higher profits and dividends. Whether it is good for equity prices will be determined by what is happening in the bond market and the outlook for inflation (see below).
Secondly, whilst the US economy will also be larger in 5 years’ time, we have no confidence to forecast the same for the United Kingdom, Eurozone or Japanese economies. This is because those countries are in financial distress and actually have no means or capacity to repay their massive government debt. This debt will need to be subject to compromise and the terms of compromise have not even been discussed at this point. So they are a long way from a solution and their low growth outlook is compounded by the lack of growth support coming from low birth rates and low immigration.
Thirdly, there is an ageing demographic wealth problem in the developed western world. The poor distribution of wealth is starkly seen in the aggregation of wealth in the population that is over 50 years of age – the burgeoning baby boomers. In contrast, those under 40 years old have too much debt to support a lifestyle that has come too quickly and too easily. The fiscal imperative of governments to withdraw from aged income support has led to the increase in private savings and a curtailment of debt funded consumption. The consumption led growth cycle of pre 2007 is unlikely to return to developed countries but we may see it in the burgeoning middle classes of Asia and South America in about ten years’ time.
Fourthly, the QE programs of the US, Japan, Eurozone and the UK will come to an end. It is uncertain how they will come to an end and what the repercussions will be. However, what is certain is that Central Bank asset purchases will result in those authorities owning a massive amount of government debt. For instance, we know that the Federal Reserve of the US already owns about 15% of all US government issued debt and so the question becomes – will they sell it or write it off? If they sell it then who will buy it and at what price? If they write it off then will this event create a new cynical economic paradigm where markets become permanently infected by a perceived Government safety net?
Finally, the end of QE, the continuation of growth in China and the recovery of the US economy will see a recovery in the $US and therefore an uplift in the Chinese yuan. The decision by China to improve the economic lot of the lower middle class worker through higher wages is now a policy. It will result in increasing costs in China and that will result in the exportation of inflation from its manufacturing sector. The inflation will be compounded by a lifting of the Chinese and US currency against the $A. A decade of Chinese export deflation is coming to an end. The developed world and particularly Australia has closed down too much of its manufacturing capacity to stop this likely inflation surge. When this becomes apparent then Governments, Central Banks and markets will react. Based on history the first sign of problems will be observable in bond markets which invariably smell inflation long before equity markets. Given that bond markets are dramatically overpriced now, due to QE, then the bond correction could be severe.
The market over 5 years – “Hasn’t gone anywhere!”
Figure 2. ASX All Ordinaries Index XAO 5 year chart (Feb 2013)
The above is our view of the macroeconomic trajectory in the next few years. Whatever happens, the current economic environment is neither stable nor sustainable. Importantly, we suspect that investors and advisors today are not investing with an eye to the future. Rather, they are reacting to interest rate settings that are neither normal nor derived by a free market. By not understanding the economic cycle and being reactive to price movements, then investors are actually increasing their risk of investment failure.
Yes there are absolutely short term gains to be made over the next year, but the claims of a return to a sustained bull market echo the calls of a distant past that “there is gold in those hills”. We believe there is always gold to be found in the sharemarket. It is called “value” and to find it you must know what “value” looks like.
How to manage capital in this environment
In undertaking our management, at Clime we adopt a rational approach to valuing investment assets. We strongly believe that it is foolhardy to transact in the equity market without a solid base for valuing securities and shares. Our method revolves around a desire to buy shares in companies at below our assessment of value. The companies of interest identify themselves through their audited history of achieving high returns on equity. We value companies using an “intrinsic value” methodology and from these we create model portfolios of stocks and securities that we believe will generate a superior return over a longer time frame.
Intrinsic valuation is not new. It is not a black box or a software programme. Rather it values companies based on their projected return on equity. The valuation is actually a multiple of equity that adds an income value to a growth value. It is fairly logical and simple. It is not as simple as price earnings ratio but it is vastly more logical.
In managing capital in this environment we have two simple rules.
First be realistic about what the equity market can and should return an investor. Over a long term the market index returns about 7% p.a. This is a reasonable benchmark, but using a value based stock selection process then we would expect to achieve 10% p.a. returns.
Importantly, a 10% p.a. return with reinvestment would generate a return of 100% over 7 years. Think about it carefully – would you be happy to double your capital every 7 years?
Second, remain patient and rational. Value can appear at any time and for any reason. As a manager we do not feel compelled to be fully invested because we prefer to buy value and we can only buy when we have liquid capital. There is no rush. Often those who rush up the hill to stake their claims often step over the gems that were slightly hidden.
You may think that this note is full of caution. That is intentional. The market has rallied by over 30% since our letter of September 2011. Let’s remember our targeted investment return, think about 7 years to double your capital and you may want to be as patient as we are.
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John Abernethy is the Chief Investment Officer (CIO), Executive Director of Clime Investment Management (Clime Group) and Chairman of Clime Capital Limited.