February 3rd, 2016
We are now one month into the new year and - following the significant volatility across markets in recent weeks - we believe that this is an appropriate time to give you an update on how the Fund is positioned and share some of our views on the markets. The picture so far in 2016 is not pretty. As you will see from the below table, the moves across global equity markets have been steep and painful and no major index has been spared the brunt of the selling pressure. Avance Global FI has also fallen during 2016, dropping approximately -3.4% through the end of January.
Such market moves or negative returns are not foreign to us. In the 13+ years that we have been managing the Fund’s investment programme, we have faced numerous challenges in the form of extended periods of weaker markets and/or soft fund performance. At times like these, we need to reflect back on our long-term performance. The below table illustrates our performance during January 2016, the full year 2015, and since inception against a number of comparable indices and asset classes:
THE GREATEST RISK
“To maintain a truly long-term view, investors must be willing to experience significant short term losses; without the possibility of near-term pain, there can be no long-term gain. The ability to remain an investor (and not become a day trader or a bystander) confers an almost unprecedented advantage [to investors]…” – Seth Klarman
The greatest challenge for investors in the current market environment is not the sharp correction across equity markets in recent weeks. It is neither the threat of a meaningful economic slowdown in China nor the 75% fall in oil prices (peak to trough) prices during the last 19 months. The greatest threat lies in allowing one’s investment process to break down as a result of fear or other emotional biases. In a world where time horizons have shortened, the key to long-term investment success rests on not allowing the volatility of our thinking to match the volatility of markets.
We recognize that fear makes it difficult to remain optimistic about investments whose prices are falling. Our process, however, rests on drowning out the noise and taking advantage of volatile investor psychology as opposed to being victims of short term emotions. Ultimately, we aim to use such emotions – and the resulting volatility - as a tool to deliver superior long-term returns. As we have discussed in prior letters, volatility – in the form of fearful overreaction - is generally an important pre-condition for achieving superior performance. As a result, whist we do not like the impact (and anxiety!) of periods in which we deliver negative performance, we welcome the volatility that markets are experiencing. We do so because we strongly believe that such price action sets the basis and creates the opportunities that we seek for our long-term strategy.
With the above in mind, we are actively positioning the Fund in the current environment to be able to achieve the highest potential risk-adjusted returns in the future. In particular, we are allocating funds aggressively to our fixed income holdings where, we believe, a significant valuation opportunity exists.
THE OPPORTUNITY IN CREDIT
Two significant (and not unrelated) events have occurred in the fixed income markets during the last 6-12 months. Firstly, regulation of banks and insurance companies has resulted in an environment of impaired liquidity for bonds, particularly those of sub-investment grade issuers. Secondly, and resulting partly from the first factor, credit markets have cheapened (=fallen) substantially.
Efforts by banking regulators aimed to ensure that banks do not take on excess leverage and risk insolvency have resulted in materially reduced bond dealer inventories. The high regulatory costs of holding corporate bonds on a bank’s balance sheet, whether it’s as a result of capital consumption or due to the rising costs of hedging, means that the market has moved towards a trading environment where both sides of a bond transaction must be found prior to trading. This enables banks not to carry inventory and avoids risk-taking by dealers. Over recent months, dealer inventories of corporate bonds have reached their lowest levels in almost 10 years and have even turned negative at certain points in recent weeks. FINRA TRACE data indicates that it would now take approximately 315 days to trade the entire corporate bond market, whereas 10 years ago it would only take approximately 186 days.
Another factor having an impact on credit markets is the gradual investor shift from cash products (direct investment in single name bonds) to synthetics (ETFs). Ironically, part of this shift is again a result of bank leverage controls. Of note, ETFs favour issuers with more debt outstanding vs. smaller, less indebted, issuers - in absolute terms. This, incidentally, leads to the conclusion that if one prefers to allocate to ETF bond funds, they are making a decision to lend money to the most indebted issuers. That is hardly the smartest way to invest in fixed income.
The magnitude of the correction in corporate bonds is not to be ignored. During 2015 spreads on high yield bonds widened to 720 bps (from 504 bps), and have more than doubled since the summer of 2014. These spreads are at their highest levels since the Euro-zone correction of 2011-2012. According to a recent study by Goldman Sachs, high yield spreads have only been wider than they are today 10% of the time during the last 30 years. Meanwhile, investment grade spreads widened by 30bps to 174bps during 2015 and have only been less expensive 18% of the time over the last 30 years. In the US for example, high yield bond indices returned -4.6% in 2015, the third worst return in almost 30 years, surpassed only by the negative returns of 2008 (-26.1%) and 1990 (-4.4%). For what it’s worth, the two best years for high yield over the same period were in the years immediately following those corrections: 2009 (+58.1%) and 1991 (+39.2%). Edgy investors aren’t helping: over the last 18 months, high yield bond funds, for example, have seen cumulative redemptions of over USD 32.5 Billion, and have posted negative outflows in 13 out of those 18 months.
As you can see from the below table (and as you will have seen from our recent performance), our fixed income holdings have also been hurt by sell-off in fixed income over the last 6 months. The table shows a representative cross-section of some of the bonds that we own in the fund, their recent performance, and their yield to maturity based on today’s pricing.
Combine the shift in demand towards bond ETFs, add the traditionally illiquid fixed income markets, compound it with stringent bank capital regulation, and top it off with the threat of interest rate increases in the U.S. and the most risk-averse investment environment since 2011, and – voilà! – we have deep market sell-off that gives way to a material buying opportunity in corporate bonds. Against this environment of worsening technical factors and the rapid decline in prices, we have been aggressively buying fixed income in Avance Global, with an emphasis on (a) high yield debt and (b) distressed issues. In doing so, we have increased exposure to some of our highest conviction names and added some new positions that exhibit very attractive risk/reward trade-offs. Following our recent purchases, we now have a weighting in fixed income of 55.1% of the fund. This is our highest exposure in some time, as can be seen from the below table.
Within the above allocation, we hold 35% of our fixed income weighting (=19% of the fund) in subordinated bank and insurance debt. This is a long-term theme for our fund, as we have had significant exposure to this sub-asset class since early 2009. Financial hybrids remain one of the most compelling investments in the credit space, offering high absolute yields, adjustable coupons that allow us to contain interest-rate risk, and strong and improving credit fundamentals. Their perceived complexity combined with a reduced investor universe have led these bonds to trade at levels (~7.25% yields) commensurate with US high yield debt (~8% yield), and at considerably higher yields than emerging market corporate bonds (~6%). Since the end of the financial crisis bank capital ratios have risen sharply and reliance on bond markets and inter-bank funding has decreased. Tier 1 ratios across developed nations have risen from an average of 7.5% in the years preceding the financial crisis to over 12.5% today (13.75% if we exclude Japan). Meanwhile, loan-to-deposit ratios have fallen by approximately 20% in Europe and the U.S. over the last 6 years. The risk of capital triggers based on substantial losses would now require a credit event considerably larger than that of the 2008 financial crisis.
Our degree of conviction around our exposure to credit (with an emphasis on high yield and subordinated bonds) is high and we will continue to purchase more bonds as long as prices remain depressed - providing that our investment thesis is intact. We hold over 18% of the fund’s assets in cash, which gives us ample “dry powder” to continue to add more to our holdings if prices contract further or hover around current levels. We recognize that if equity markets should rally in a substantial fashion, our credit positions may underperform. However, the certainty of a redemption/maturity price for each bond (absent an insolvency or restructuring), the coupon cushions and the attractive price entry levels provide a margin of safety that equities simply can’t offer at this time. In this respect, according to a JP Morgan study, in the last 15 years U.S. high yield bonds have outperformed equities over a 12-month period 86% of the time when high yield spreads were higher than 500bps. This data is particularly skewed in periods where economic growth was under 2.0% - as it seems we may be heading towards in the developed world.
Finally, in allocating to high yield and subordinated debt we have placing our emphasis on issuers with ratings of BB- or higher, which account for over 80% of our fixed income exposure. We believe that the sweet spot (certainly the most neglected) for fixed income today lies precisely in bonds with ratings ranging between BB- and BBB, not only because of the jump in yields as one moves into this rating band, but also because the higher-than-perceived risk of insolvency of issuers in that band.
THE EQUITY CONUNDRUM
“One of the most significant factors keeping investors from reaching appropriate conclusions is their tendency to assess the world with emotionalism rather than objectivity. Their failings take two primary forms: selective perception and skewed interpretation. In other words, sometimes they take note of only positive events and ignore the negative ones, and sometimes the opposite is true. And sometimes they view events in a positive light, and sometimes its negative. But rarely are their perceptions balanced and neutral.” – Howard Marks
The above is an appropriate evaluation of the current environment for equity markets. As can be seen form the below table, equities across the globe have adjusted in a meaningful way since their 2015 highs.
It would appear that there is very little to be cheerful about these days. A rapid slowdown in China is evident, if not from official data, certainly either from the sale of Apple products or from the falling demand for iron ore. Brazil is crumbling under the weight of corruption and falling commodity prices. The price of oil has plunged 75% in 19 months, rendering high-spending investors (sovereign wealth funds, royal families, corrupt dictators) across oil producing nations more constrained. Currency movements are wreaking havoc on many economies. ISIS has emerged as a powerful and merciless terrorist group. And maybe, just maybe (unless Hillary Clinton can remedy the situation), the US presidential election may pit a pompous buffoon (Donald Trump) or Ted Cruz, darling of the Tea Party, against a socialist egalitarian (Bernie Sanders), exemplifying the continued decline in the political landscape not only in the United States, but across the world. As Spaniards, we would be amiss in failing to mention another example of this in Pablo Iglesias, the man leading Spain’s third most voted political party. Iglesias’ political party, Podemos, which sits ideologically somewhere between communism and anarchism (and which received almost 20% of the vote in the December general election), may hold the key to the formation of the next general government. As it stands, there is a reasonable chance that Pablo Iglesias will be Spain’s next vice-president. If he does, at least he will have ample support and mentoring from the two countries that have been financing his party in recent years: Iran and Venezuela. Allegedly, of course. In any case, it is difficult to find any silver linings in the current environment.
Beyond the investor despair and the overall market numbers, however, what truly defines the recent correction is the dispersion in returns across sectors, countries and, most importantly, investment styles. What the numbers fail to show is the bifurcation in valuations as well as the true magnitude of the recent falls.
Indeed, the pain across equity markets is much deeper than stock indices tend to reveal. The S&P 500 fell by 1% in 2015 and has dropped a further 5.1% in the first month of 2016. This would appear as a minor correction. As of mid-January, however, over 57% of stocks in the S&P 500 were trading off by more than 20% from their highs over the past 12 months. That is bear market territory. Almost 20% of S&P 500 constituents have fallen 40% from their 12-month highs. Much of the market, it appears, has already suffered a major sell-off and is discounting a recession.
Globally, value stocks have underperformed growth stocks by 12%, and “momentum” stocks by 19% over the last 15 months. The current cycle of value underperformance is the longest stretch on record, according to a recent study by Franklin Templeton. The best index performers in the S&P 500 during 2015 were Netflix (+134%) and Amazon (+118%). Companies in the S&P 500 with negative earnings outperformed companies that made money by over 20% during 2015.
We concede that all signs point to a slowdown in Chinese growth. Official numbers are sketchy, but corporate earnings confirm the pain. Chinese equity markets however, have already been discounting this for the last 10 years. In fact, the Shanghai Composite Index has delivered a total return of 0% since 2007. In that period, the Chinese economy has grown by 120% and equity valuations have dropped from 38x forward earnings to 11x. With regards to oil, how much is in the price? Consider this: large cap energy stocks globally are trading at their cheapest levels relative to the overall market (on a price to book value basis) in the last 90 years, according to Empirical Research Partners. More importantly, lower oil prices are a positive for consumers and for the US economy as a whole, a factor which seems to be lost on most market participants engulfed in the anxiety of the rapid fall in the commodity. As we write this, oil has rallied by over 20% from its January lows. It is possible that we may have already hit bottom.
Brazil is also suffering, but its stock market has already fallen by 75% in US Dollars terms from its 2010 peak. Emerging markets as a group have not traded this cheaply since 1998. That was 18 years ago, during the Asian financial crisis. As far as Europe goes, its economies exhibit an evident failure-to-launch, despite a deliberately weakened currency and incessant monetary stimulus. Again, the markets may have already discounted this: the Euro Stoxx 50, the index of Europe’s leading blue-chip companies, is currently 45% lower than it was 16 years ago. In the United States, the ratio of bearish investors to bullish ones is at its highest since the financial crisis, a classic contrarian indicator. As far as the Federal Reserve raising rates, the projected tightening cycle is expected to be the weakest in recorded history. Not exactly a restrictive environment. In the face of this, we can state with conviction that many bargains exist in today’s markets. For patient investors willing to accept volatility.
The below table shows our largest holdings in the equity space, some of which we have held for some time and many of which have made their way to our portfolio recently. As can be seen form the below, these stocks have fallen significantly from their recent highs, reflecting the market’s current risk-off mentality as opposed to these company’s ability to generate cash over the long term. The valuations on these holdings are at multi year lows and reflect the market’s current preference for exciting momentum stories (biotechnology, technology, etc.) as opposed to solid, lower-growth companies at historically low valuations.
We would characterize our current stance on equity markets as a whole as constructive on a medium-term basis and somewhat cautious on a short term basis. When we look at our holdings, however, we are very optimistic on a medium-term basis and neutral on a short term basis. The return on a stock is a function of a company’s ability to generate cash over the medium term and the multiples that markets apply to the company’s financial returns. We believe that the stocks that we own in the Fund (which represent no more than 25% of the Fund’s assets at this time) are trading at very attractive valuations and represent a very compelling long-term investment. It is always tempting to try to time the market and invest at the bottom and we do recognize that markets could fall a further 10%-15% as we approach capitulation. However, our light allocation to equities, should allow us to endure such a move
Our holdings are a perfect illustration that value stocks are enduring a difficult period of underperformance. We strongly believe that this trend will soon reverse. We are not declaring that a rally is just around the corner, but it is true that the shares of many companies have suffered price and valuation declines which far exceed the real deterioration of their businesses.
PERSEVERANCE, RESOLVE, GRIT
As we battle through a challenging and volatile market environment not only for equities but also for fixed income, we must remind ourselves that the value of a security should be a reflection of the underlying company’s ability to generate cash flows over the next 20+ years. Our investment horizon should reflect this and cannot become overly short-term as this can compromise a process. Valuations and earnings drive markets in the long term - that is the ultimate truth in investing. Sentiment, meanwhile, drives markets in the short term. That is what creates volatility. Greed, fear, and panic are the sentiments that drive markets to extremes. Markets require successful investors to demonstrate perseverance and resolve to withstand short term fluctuations. With that in mind, we will seek to strike a balance between cautious investing and clarity of thought to take advantage of emotional extremes.
We would like to thank you for your continued trust and patience during recent months.
If you have any questions, do not hesitate to contact us at email@example.com
The Investment Team
(1) MSCI All country Index. (2) IBEX 35 Index, (3) BarCap Global Aggregated Hedged Index. (4) HFRX Global Hedge Fund Index. (5) Annual volatility in the last 3 years calculated as the standard deviation. The manager has made every effort to ensure the accuracy of the information contained in this report, but accept no liability for any errors that may be contained herein. This report does not constitute or form part of any offer to sell or issue or any solicitation or invitation of any offer to purchase or subscribe for any shares in any investment vehicle, nor shall the report in its entirety, nor any part of it, or the fact of its distribution form the basis of, or be relied upon in connection with any contract therefor. The unauthorised use, disclosure, copying or alteration of any part of this report is strictly prohibited. Investors in any of our investment vehicles are reminded that any application to subscribe may only be made on the basis of the information contained in the prospectus of such investment vehicle, a copy of which is available on request. No reliance may be placed for any purposes whatsoever on the information contained in this report or on its completeness. This report should not be copied or distributed by recipients and in particular should not be distributed to ineligible persons. It is entirely the responsibility of the recipient to ascertain whether they are eligible according to the requirements of their local jurisdiction to invest in any of our investment vehicles. This report and its contents do not constitute any financial or legal advice by the manager or any other investment vehicle or by any other entity. This material serves to provide general information to investors in the Fund and is not meant to be legal or tax advice for any particular investor, which can only be provided by qualified tax and legal counsel. The services and investment funds referenced in this report should not be regarded as an offer of solicitation for such services or investment funds in any jurisdiction where such activity is unlawful. It is not intended for any use which would be contrary to local law or regulations. The promotion of any funds presented in this report is restricted to clients who are experienced investors in these types of investment vehicles and qualified by law to invest in such investment vehicles. This report and its contents are not intended to sell services or products and are prepared for convenience and informational purposes. Every effort has been made to ensure the accuracy of any information presented herein. Past performance is not a guarantee of future performance. It should be remembered that the value of investments may fall as well as rise, investors may not get recover the amount of money invested and that currency movements may have a negative as well as positive influence on returns. All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. Any investment decision should be made solely on the basis of the information and risk warnings contained within the information memorandum and/or prospectus issued by or on behalf of any fund or company concerned. Interested parties should not rely on any information contained herein that is in conflict with the Offering Documents. Any offer of securities may be made only by means of the relevant Offering Documents. Some information contained herein has been obtained from third party sources and has not been independently verified. We make no representations as to the accuracy or the completeness of any of the information herein.