Performance review 2017 – Comment: “Keep an Eye on Interest Rates and Credit Spreads”
In 2017, the Value & Opportunity portfolio gained +21,7%* (including dividends, no taxes) against 15.6 % for the Benchmark (Eurostoxx50 (Perf.Ind) (25%), Eurostoxx small 200 (25%), DAX (30%), MDAX (20%)).
Some other funds that I follow have performed as follows in 2017:
Partners Fund TGV: +19,97%
Squad European Convictions +29.72%
Ennismore European Smaller Cos +9,32% (in EUR)
Frankfurter Aktienfonds für Stiftungen +13,7%%
Evermore Global Value +4.6%
Greiff Special Situation +11,1%
Squad Aguja Special Situation +14,2%
Since inception (01.01.2011), this translates into +186,7% or +16,2% p.a. vs. 95,3% or 10,1% p.a. for the benchmark. Graphically this looks like this:
The full details can be seen as always on the performance page.
Current portfolio / Portfolio transactions
Compared to last year, Aggreko, Ashmore, Pfandbriefbank, Coface, Romgaz, Kuka, Lloyds Banking, Gagfah, Sapec and Kuka have been sold. New positions bought in 2017 are Record Plc, Cars.com, Kanam Grundinvest and Metro AG. 3 positions (Actelion, HPE and Whole Foods) went in and out in 2017.
Of the 2017 year-end positions, IGE & XAO will leave the portfolio in 2018 as the company will be taken over by Schneider SA.
From a portfolio strategy point of view, I achieved a few important improvements:
- overall average holding period of the portfolio is now 2,9 years (excluding the shorter term Special situations, the average holding period is 3,6 years on average)
- the number of positions is within my “sweet spot” of 20-25 compared to 28 last year
- The top 10 positions have a weight of > 50 % (53,2%)
So for the time being I am quite happy with the structural aspect of the portfolio but I still try to work hard on extending my average holding period. Although working hard is maybe the wrong expression as this is a KPI which I can improve by doing just nothing. But doing nothing is the hard part.
Performance Analysis 2017
2017 was an interesting year. Some sub sectors did extremely well (FAANGs, European small caps) as did risky “lower quality” stocks. Looking at the Dax for instance, the 5 best performing stocks were:
DEUTSCHE LUFTHANSA-REG 150.37%
COMMERZBANK AG 72.58%
RWE AG 43.88%
INFINEON TECHNOLOGIES AG 38.31%
E.ON SE 35.24%
These are all stocks which I would consider “mediocre” at best with below average management and significant structural risks. But the looked “cheap” and once momentum takes hold it looks like that little can stop the “momentum train”.
Normally, as I mentioned several times in the past, I would expect to underperform significantly in such a market. However in 2017 I was “saved” by 2 main aspects:
My significant exposure to European small caps (France around 28% etc.) and some really well performing special situations (Stada, Sapec). This was clearly luck (again).
On the other hand I missed a much better performance because I made a couple major mistakes:
– I should have bought Italian small caps end of last year
– I should have loaded up even more French stocks after Macron’s victory
– I should have kept (some of) my financial stocks longer
– I should have seen that GoCompare, a stock I had reviewed would gain significantly by the UK Ogden Insurance rate issue
– I didn’t manage to analyze a company that I wanted to research and that was was in my “sweet spot” but was the best sector performer in 2017 (ASRNL)
On the other hand, 3 or 4 years ago I would have most likely sold my best performing stocks like TFF and IGE long ago because i would have become nervous after a strong increase.
Top 10 positive contributors
|Weight 12/16||Perf 2017||% Contribution|
|Tonnellerie Frere Paris||7.4%||61.9%||4.6%|
|IGE & XAO||2.6%||54.8%||1.4%|
|Weight 12/16||Perf 2017||% Contribution|
|Drägerwerk Genüsse D||4.5%||-11.1%||-0.5%|
It is relatively easy to see that TFF Group was the main contributor to the performance. It was the largest position and the best performer. To be honest, I was of the opinion that TFF Group was fully valued at the end of 2016 but again the stock surprised me. Similar surprises were IGE & XAO and Bouvet. In total, 50% of the performance was made by my French stocks which had a very good year and now account to around 28,5% of the portfolio although I had reduced them before the French election.
Comment: “Keep an Eye on Interest Rates & Credit Spreads”
In European markets, this has been now the 6th consecutive year of positive benchmark performance after the “Euro crisis” in 2011. Political headlines are bad, however many fundamental indicators look quite healthy (World GDP growth etc.).
On the other hand, the ECB is still in full support mode (negative rates, bond buying) whereas the Fed started to tighten already.
2017 also is the year where financial markets got a new asset class in Crypto currencies.
For me the main item to watch in 2018 are long-term interest rates and credit spreads. Betting on rising interest rates in Western economies has been a so-called “widow maker” for three decades now. However if we look at this chart with the 30 swap rates in USD and EUR we can see that interest rates are now where they have been 3 years ago at the endo of 2014:
This is clearly not a trend reversal but at least the tailwind from ever decreasing interest rates seems to be gone for now.
Few stock investors I know of pay high attention to interest rates. That is understandable as for most of us we only know an environment where interest rates went lower and lower.
But for any fundamental investor it might be time to maybe have a look and try to understand how important interest rates are. The direct impact of interest rates is easy to understand: Higher interest expense for indebted companies and higher interest income for companies with financial assets.
However the indirect effects are more important. As fundamental investors we calculate the value of our investments as “Discounted cash flows”. Which means we try to project future cashflows and discount them back to today in order to come to a “net present value” and we then compare this to the current price paid by the market.
The DCF formula consists of 2 components: The “risk free rate of return” and the “risk premium”. There are many ways to derive these components but one thing is clear: An increase in the risk free rate of return (all other things equal) will fundamentally reduce the NPV of each and every investment unless it is positively correlated to increasing interest rates.
There is however another interesting aspect: The more you rely on cash flows in the far future, the more sensitive is the valuation to a change in interest rate.
A simple made up example:
Company 1 is a company in a liquidation phase which will pay out 50 EUR per annum for the next 3 years. If we assume that the risk free rate is 1% and an appropriate risk premium is 7%, we can discount the cash flows by 8% and get an NPV of 128.85 EUR.
Company 2 in contrast is a company which will produce no cash flows for the next 10 years but then 68.5 EUR for year 11-15 p.a. If we use the same discounts rates that gives us an NPV of 128.53 EUR, almost the same value as company 1.
However if we increase now the risk free rate by 1%, things look different. All other things equal, the NPV of company 1 decrease by -1,78% to 126.56 wheres as the NPV of company 2 decreases by -12,4% to 112.55 EUR.
So company 2’s value is much more sensitive to interest rates than company 1 as its assumed cashflows are much farther in the future.
So what does that mean in practice ? Well, if interest rates increase significantly than those companies are most exposed whose cash flows are expected to materialize only in the (far) future which is another description for “growth company with high valuations”.
This is another interesting graph, showing the ITRAXX EUR 5Y which is a proxy for the credit spread of the 125 largest European corporate issuers (5 year maturity):
We can see that corporate spreads are still “tightening” which in my opinion might be the result of the ongoing ECB purchases.
If we look back at the DCF model, corporate spreads are not a direct input into the model, so one could think of just ignoring them. However in my opinion this would be a big mistake. The issue here is the “Equity risk premium” which unfortunately cannot be directly observed in the market. Credit spreads however are a directly observed price for credit risk premium and in my opinion therefore a good proxy for the direction of the implied equity risk premium.
Example of an indirect transmission of interest rates into equity prices: Private Equity
When I discuss the impact of interest rates on equity valuations, I often get two responses:
- There is no empirical evidence of a direct link between equity prices and interest rates
- “Oh, you believe in the Fed Model ?”
To both points I would say: You are missing the point. I am talking about the fundamental value of assets, not the current market price. As value investors we know that value and price can differ a lot for extended periods of time.
But back to the indirect transmission. One major force in today’s markets are Private Equity investors. These investors buy either private or public companies and in most cases they finance their purchase with as much debt as possible.
The limiting factor is almost always a EBITDA/interest multiple. So how many times the company can cover its interest expenses after absorbing the debt which has been issued to finance the purchase. And it is pretty easy to understand that if interest rates go up, the PE guys can push down less debt and are able to pay less for the purchase. However this does not happen over night but usually only with a time lag. A PE shop working on a deal for 2 years will maybe make a compromise instead of just killing the deal, but over time the PE guys will need to lower their bid prices in order to protect their equity returns And this at some point in time will impact valuations especially in the mid and small cap sector if interest rates really go up.
Just to be clear: I am not amking a prediction that interest rates will rise. But if they do i think one should really pay attention to this and try to avoid to be fully exposed to the potentially very negative effects.
On the other hand I will clearly continue my bottom up approach and try to find interesting companies, but clearly I will need to make sure that I will be protected against adverse outcomes.