Foresight Capital Partners

Until recently, the fall out from the collapsing US real estate sector has been limited to parties directly involved in this sector, namely mortgage lenders and builders. This column’s focus on the credit markets is now paying off in that third party effects are now appearing.

This month the aptly named “Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund” fell into difficulty after losing 23 per cent of its value in the first four months of the year. A fire sale of assets was adverted when Bear Stearns offered to place its own capital on the line to support the fund. These events illustrated that there is no liquidity for this type of Asset Backed Securities and Collateralized Debt Obligations (CDOs) during market stress. Even with numerous other hedge funds, holding similar assets in this instance there were few buyers at prices close to the assets face value. Lombard Street Research said, “We heard buyers were lobbing bids at just 30% [of face value].” Hence, the liquidity assumptions embedded within the pricing and risk management models of such assets are questionable to say the least.

Collateralized Debt Obligations (CDOs) are similar in structure to split-cap investment trusts where differing ‘tranches’ having different rights over the underlying assets. With CDOs, you typical start with a portfolio of mortgage-backed securities, which roughly speaking are pools of similar mortgages, and other loans. The first tranche of the CDO will typically own 5 percent of the portfolio and absorb the first 5 percent of the default loses. The second tranche will own 10 per cent of the portfolio and absorb the next 10 per cent of loses. The third tranche will own 10 per cent of the portfolio and absorb the next 10 percent of loses, and the fourth tranche will own 75 percent of the portfolio and absorbs the residual default loses. The fourth tranche will usually receive a triple A rating by rating agencies and pay a yield corresponding to similarly rated high-grade bonds or highly covered split-cap investment trust zeros.

In a typical CDO transaction, the bank who arranges the loans will retain the first tranche and a very high proportion of the default risk, and sell on the other tranches transferring only the extreme losses to other market participants. The size and yield of the first tranches is largely driven by the average default probability of the securitized assets. These default probabilities in the Bear Sterns case and across the US mortgage backed securities sector appears to have been greatly underestimated. Re-pricing these assets with respect to higher default probabilities, which now seems inevitable, will lead to a mark down of all similar instruments leading to large paper loses.

Web resource:

Queen’s Walk Investment Limited is a LSE listed closed-end fund which invests within the CDO market. Their web site (http://www.queenswalkinv.com/) contains presentations and reports detailing how the fall out from the mortgage markets during Q1 2007 has affected their portfolio.

BP and Shell account for over 15 percent of the FT100 market capitalization and yet obtaining detailed and reliable data on the oil industry is near impossible. One of the best sources we have is BP’s recently published annual Statistical Review of World Energy covering 2006. By analyzing such fundamental data allows a better understand of the various underlying factors effecting the oil sector.

The report stated, “World oil consumption rose by just under 650K barrels/day, about half the 10-year average. OECD consumption fell by 400K barrels/day, the biggest decline since 1983. Oil consumption growth was above average in China and oil-exporting countries.”

BP also lowered its estimate of world proven oil reserves, for the first time in more than a decade, with proven reserves equating to 40 years of consumption at present rates. Data reveled that 75 per cent of oil producing fields are more than 20 years old, offering support to the peak oil theory.

US Gulf Coast refining margins averaged 13 USD per barrel during 2006, more than three times to average between 1996 and 2004. Refinery utilization rates where 89 per cent comparable with the average 92 per cent utilization rates, from 1996 to 2005. The persistent high prices of petroleum imply a refinery capacity bottleneck. With is not surprising once you observe that the US has not built a refinery for more than 20 years.

This week I met up with Cato Brahde, Managing Director of Tufton Oceanic who manages from Douglas more that 1.3B USD within hedge funds focusing on the energy, shipping and oil service sectors. With more than 18 year’s experience of deploying capital within the energy sector Cato has developed a comprehensive and consistent framework for analyzing the industries various supply and demand characteristics using public and proprietary data. Cato following the BP report commented that, “The energy universe is still at the beginning of a long upturn; oil demand is increasing as the world industrialises, and if China is to continue on its current trend of development it will reach the kind of per capita oil consumption in 25 years time that South Korean enjoys today. This would lead to a near doubling of the world’s oil consumption by 2030.”

He continued, “Given the lack of cheaply available supplies, this kind of growth is simply not possible today, and it will be a major challenge for the world economy to replace the aging oil fields currently being depleted and at the same time cater for Asian demand growth. The portion of the world’s GDP which will need to be allocated to meet its energy needs to increase dramatically and there is little risk of general investors becoming over allocated in energy in the foreseeable future.”

Web resource:
The BP Statistical Review of World Energy 2007 is available at:

http://www.bp.com/productlanding.do?contentId=7033471

The yield curve plots the yield of government securities against their respective maturities. Studying the evolution and shape of a currencies yield curve not only details the price of credit available in that currency but also the aggregate interest rate expectations going forward. In the classical Austrian school of economics, one assumes that credit is only available from governments and banks. At present credit is available from just about everywhere, including foreign governments, hedge funds and multinationals. For example, General Motors over recent years has generated more revenue from selling loans to buy its cars than the cars themselves. Such secondary credit markets and their associated curves such as LIBOR/Swap rates are highly relevant to present credit conditions. However, the principle influence in all these markets will still be the underlying currency yield curve with the US Treasury market being by far the most influential and important such market.

Over the past two weeks global equity and bond markets have been over shadowed by a marked and abrupt shift in the level and shape of the US yield curve. The benchmark ten year US Treasury bond has moved from a yield of 4.6 percent, to over 5.25 per cent. With the yield curve evolving from being ‘flat’ and pricing in a cut in US interest rates in the next year, to being ‘normal’ where further interest rate increases are deemed possible than an imminent cut be been completely discounted. Quantitatively driven relative trading strategies ensured that this shift in the USD curve dragged the Uk Gilt and Euro curve higher resulting in immediate loses for global bond portfolios, with an associated sell-off in global equity markets where the DOW has fallen more than 3 per cent from its recent peak.

Higher interest rates will undoubtedly squeeze the real estate sector, reduce the prices offered in private equity buy-outs and ultimately act as a drag on corporate profitability. Pension fund so called liability matching could also see further selling of bonds, as higher yields equates to less bond holdings needed to ensure a given future cash flow. Market prices reflected these developments with obviously targets such as UK mortgage lenders Bradford and Bingley and HBOS in the UK; and house builders and REITs in the US being hardest hit. Regulated utilities where also marked lower as bonds became a more competitive source of stable cash flows.

However you slice it, higher interest rates are not good for equities. One would prefer such moves to result from stronger than expected growth as opposed to inflation expectations, but I for one are not sure that this in the case.

Web Resources:
GBP/USD Yield Curves: http://www.yieldcurve.com/marketyieldcurve.asp
Dow vs USD Yield Curve: http://stockcharts.com/charts/YieldCurve.html
LIBOR/Swap Rates: http://www.swaprates.co.uk

Last week, we detailed how a dividend investing strategy provides a generous “margin of safety”. Here we detail a worked example of ‘dividend investing’ using the example of an investment in BT Group I recently exited.

Dividend investing candidates within the FTSE 100, display some or all of the following characteristics:

1. Dividend yield is at least 150 per cent of the average.
2. PE ratio at least 20 per cent less, than the average.
3. Dividend payout ratio less than 50 per cent of earnings.
4. Investment grade debt, with cash growth on the balance sheet.
5. Stable dividends going forward, backed by a predictable and sustainable business.

By systematically sifting through the FTSE 100 using, the objective criteria (1-3), will provide a manageable list. The more subjective criteria of (4) will require further detailed study of the companies through their annual reports, announcements and investor presentations. Criteria 5 demands research into not only the company but also the business environment.

In spring 2005, such analysis identified BT Group with a PE under 10, and yielding 5 per cent. Though the headline growth figures where not inspiring from 2000 to 2005, the firm had undergone a transformation at the balance sheet, valuation and shop-floor level. In 2000, BT traded on a PE of over 40, had no dividend to speak of and had debts of £30 billion. By 2005, the debt had been reduced to £10 billion, the speculative growth stock valuation requiring many “ifs” to justify had be replaced with a utility like valuation, and the firm took the bold move to turn itself into a ‘platform business’.

In 2002, the firm re-organized itself around the belief that revenue from calls where going to zero and future growth would come from services (media, broadband, corporate data service) offered over its platform. Resulting in BT building its 21st Century Network platform.

Such developments though enhancing BT’s position where not reflected in its share price until they started to feed through to the bottom line. On 26 April 2006, when this feed through was imminent I purchasing BT at 220.62p (including costs/tax), under 10 times historical earnings and 9 times my estimate of future earnings.

This position went against the consensus with City firms Bear Stearns (14 Nov 05), and Goldman Sachs (13 July 05) both subsequently downgrading BT. As Ben Graham would say, “it is the quality of your analysis that makes you right as a stock picker, not whether the market happens to agree with you”. On 8 May 2007, I sold BT at a price of 318.75p, at which point the earnings had moved forward 20 per cent, paid 6 per cent in dividends and the rating had moved forward to 13 times earnings, provided a return over the year of over 50 per cent.

John McGuinness who holds the current TT lap record at an average speed of over 129mph, reported to the BBC. “On Bray Hill, you go from 0-180mph down a straight. On a normal road elsewhere, you would immediately go to jail or kill yourself. It looks ridiculously fast and mental and insane, 200mph on a road looks like absolute madness. But I leave a little bit, my safety buffer.”

Investing though certainly not implying any of the physical risks of the TT does by its very nature carry financial risk. Actively managing the downside risk against various return expectations is vital. Just as John McGuinness leaves a “safety buffer” when riding in the TT, in the words of Benjamin Graham the founder of value investing, an investor should build in a “margin of safety” when seeking investment opportunities.

A “margin of safety” in the context of value investing refers to the difference between the price a security can be purchased and its intrinsic value. Where the intrinsic value is a value assigned to a security in accordance with your analysis. Value based investors will use a variety of indicators such as the PE ratio, price-to-book, replacement value or dividend yield, in order to ascertain a securities intrinsic value. However, the application of these metrics is only a reliable approach if the metrics you base your model are at worst stable, where ideally the move in your direction.

Dividends offer such a metric and as a source of return are historically much more predictable than capital growth. Capital growth depends on the behavior of other market participants, but dividends depend solely on cash flow and company policy. Executives will generally lean on the side of caution when deciding on the dividend level to ensure that they can be reliably paid and reliably increased. The most likely reason for this is that any dividend cut generally results in senior management being relieved of their posts.

In the main dividends are reliable and consistently increased but even in the most difficult operating environments the exhibit exceptional defensive qualities. For example, in the 2000-2003 bear market when earnings collapsed, the FTSE All-Share index dropped around 50 per cent the aggregate dividend yield only dropped 7 per cent.

For these reasons, the valuation metric of dividend yield and the associated dividend investing strategy where one buys into stocks with a high and sustainable dividend yield is an approach offers a generous “margin of safety”.

Just as John McGuinness’s “safety buffer” does not prevent him from setting lap records, dividend investing with its “margin of safety” does not exclude the possibility of obtaining exceptional returns. Which leads us to next weeks column where I will detail a ‘dividend investment’ I have just exited which provided a return over the one year holding period of almost exactly 50 per cent.

John McGuinness quote originally appeared on the BBC News site at:

http://news.bbc.co.uk/1/hi/magazine/6670313.stm

Ben Graham’s principle of “margin of safety” is detail within his text ‘The Intelligent Investor’ originally published in the 1950s, and is still in print today. The full text of ‘The Intelligent Investor’ is available online at:

http://www.investinvalue.com/0/value.php#intelligentinvestor

The Wikipedia page:

http://en.wikipedia.org/wiki/Margin_of_safety_%28financial%29

also offers further explanation of the investment principle of “margin of safety” and its application.

China’s monetary growth of over 17%, results directly from its managed exchange rate policy. By adopting a managed exchange rate, China forces it exporters to exchange trade surplus dollars for the local Yuan currency. With capital controls, a key component of any managed exchange rate system the Yuan received flows directly back into the local economy. Whereas the dollars received by the State have until this week been recycled into US Treasuries and Bonds.

China’s inflation in March accelerated to 3.3 percent, above the central bank’s target of 3 percent. With the benchmark one-year deposit rate only providing a negative real return of 2.79 percent, households have rushed into the stock market. This has resulted in the benchmark CSI 300 stock market index jumping 81 percent since the start of the year leaving it trading at the lofty valuation of more than 30 times next years earnings. In short, the combination of high levels of monetary growth with limited out-lets for this money, has created a pressure cooker in financial assets in China.

The tight capital controls have also led to mainland listed A-Shares trading as much as 2.5 times higher than there Hong Kong-listed H-shares with the same nominal value and dividend payout ratios. The Chinese authorities, prompted by the US are now seeking to address such market dislocations and will soon allow Qualified domestic institutional investors to get their first taste of overseas markets. Allowing some steam out from the pressure cooker. But the political pressure is only likely to increase over such dislocations with the leader of this weeks U.S. delegation with China, Treasury Secretary Henry Paulson, said Chinese action on the Yuan — rather than market opening, anti-piracy or other areas — is the benchmark by which he would measure Beijing‘s progress.

As mentioned, the bulk of China’s rapidly growing 1,200+ B USD reserves have been invested in low yielding USD denominated Treasuries. With petro-dollar recycling this has created large pools of cheap financing which has lead to a private equity boom. This week China decided to buy into this boom by buying a 10% stake in Blackstone for 3 B USD, which is around 95% of the imminent proposed IPO price. This represents the first investment outside of fixed income securities and though this investment is not that significant in itself it does illustrate that China wishes to take active steps to increase the level of returns on its huge foreign reserves. In particular, the era of cheap financing via China must be nigh.

The present policies followed by China are encouraging rampant speculation. Only time will tell whether any resulting loses which will occur at some time will be socialized as has been the case in Western market in recent years through the ‘Greenspan put’.