Performance review 2017 – Comment: “Keep an Eye on Interest Rates and Credit Spreads”

Performance 2017:

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% 
Profitlich/Schmidlin: +8,07%
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

The current portfolio can be seen as always on the portfolio page. I have already mentioned the 2017 transactions in the “My 21 stocks for 2018” post.

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.

Portfolio strategy

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%
SAPEC 7.0% 24.0% 1.7%
Stada 5.0% 33.5% 1.7%
IGE & XAO 2.6% 54.8% 1.4%
Bouvet 3.2% 42.6% 1.4%
G. Perrier 4.3% 32.0% 1.4%
Thermador 2.9% 40.7% 1.2%
Majestic Wine 2.5% 39.2% 1.0%
Van Lanschot 2.2% 42.3% 0.9%
Partners Fund 5.2% 18.1% 0.9%

Negative contributors

Weight 12/16 Perf 2017 % Contribution
Wholefoods 3.0% -4.6% -0.1%
TGS Nopec 3.8% -3.8% -0.1%
Svenska Handelsbanken 3.1% -10.1% -0.3%
Silver Chef 2.5% -15.7% -0.4%
Electrica 4.1% -12.1% -0.5%
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:

swap

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”. 

Credit Spreads:

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):

itraxx

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:

  1. There is no empirical evidence of a direct link between equity prices and interest rates
  2. “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.

37 comments

  • Metro crashing… :-s ! (looks like they react to last weeks’ crash with some delay?)

  • For the record: Since I wrote that post, the 30 Year US Swap rate is up plus 40 bps, the 30 Y EUR swap only 12 bps. Nothing huge but still worth watching.

  • Value Investigator

    Your continuous and pronounced outperformance is really astonishing. Congratulations. Especially considering that this is a „hobby portfolio“ – or is there a considerable overlap with professional worklife if I may ask?

    While probably not enough data to testify statistically significant outperformance from an academic perspective, the investing rationales you provide in this blog clearly speak against „luck“. Overall, this is not really consistent with a very efficient market.

    Would you like to share to what factors you attribute your outperformance in general? E.g. willingness to hold a rather concentrated portfolio; experience; focus on less efficient areas of the market; connections (i.e. „Tipps“ the right sources); experience, minimization of errors vs making big „bets“…

    May the large macro-trend towards passive investment vehicles or quant-driven short-term oriented strategies have made it easier to outperform the market if the investment horizon is at least a few years?

  • Thank you for the interesting article. In your example you choose a risk premium of 7 percent. I have not a deep knowledge in fundamental numbers and would like to know, what is the base of that number? Why 7 percent and not 6 or 8 for example?
    Thank you.

  • Happy new year to you and the V&O community !

    Your concerns on the effects of potential reversal of interest-rates [1], combined with some bearish sentiment (Buffet article) [2], and the mainstream view [3] that western equity markets in are either overpriced (US) or almost fully-priced (EU, after a come-back in 2017), with wome Asian economies seem also hot (India)… bring me to the following question:

    Wouldn’t you consider exposition to low-PE (or CAPE) equity markets via ETF, namely East-Europe ?

    We DO know your choice is to concentrate in value opportunities in EU stocks, but when their equity markets are expensive it may make sense to move beyond them.

    PS. Luckily I did not miss on ASR:NL, and I stayed on Idorsia (~ +100% in less than 1Y !! ) 😉

    • You’re the man !!!

      But no, I don’t want to “diworsify” in “low PE / CAPE” markets. I do look at Eastern European stocks but I miss the quality.

      • Diworsify could also be holding to good quality at very high , unreasonable prices… Then it comes to a question of taste !

        Btw, Germany’s CAPE seems better than others, and AUT is even better (probably for their exposure to east & to ‘diworsify’).

      • A similar (under)valuation as the ASRNL case seems to be Vittoria Assicurazione….
        But for some hidden reason they persist to stay undervalued… which is suspicious… Are their financials reliable?

      • Seems ASRNL kept goign up. I am wondering if I should switch to Protector/Fairfax, (that’s my non-Buffet portion of portfolio, “special situations” in your words
        )

  • Congrats with a fine year and beating your benchmark.

    2 quick comments regarding interest rates and DCFs.
    i) In my opinion you would be wrong if you i) adjust your WACC down because of a low risk free rate without lowering the growth rate in you model or ii) up the WACC without upping the growth.
    ii) Alternatively, a low risk free rate means that the economy isn’t doing well, thus the equity premium should be higher.

    Either way, the NPV shouldn’t vary too much as I see it.

  • Value Investigator

    I think the threat or higher interest rates is very relevant for equity markets.

    On the other hand, interest rates should be primarily driven by inflationary concerns.

    The inflation rate is 2,2% in the US and 1,5% in Europe.

    Why would the FED or ECB threaten a finally solid economy? GDP growth is still far from extreme. Unemployment in the eurozone is 8,8% and youth unemployment is 18,8%.

    Real income growth is still very weak, so I do not expect inflationary pressure from here.

    I am not sure why inflation rates are so low despite all the quantitative easing we had. There may be something to the story on price pressure due to the „amazonization“ of a lot of goods, increasing efficiency and lower prices due to digitization.

    I think it is still too early to bet on (or explicitly protect against) inflation (and therefore higher rates).

    • Value Investigator

      …and in Japan interest rates did not „recover“ from beeing extremely low since almost three decades.

      • If you read my post carefully, you will not see me mentioning betting on rising interest rates. I just said “watch”.

        • Value Investigator

          Still your post has an alarming tone in general. Why „watch now“?
          Just thought it would be interesting to discuss what may trigger higher rates.

        • What exactly is alarming in the post ? This is what I actually say:

          Just to be clear: I am not making 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.

        • But maybe one more point: I think the artificially low interest rates (-1-2% real yield for instance in Germany) is creating more and more distortions in the economy. From “real estate prices can never go down” to the current Crypto currency boom we can see that people tend to rely on the assumption that interest rates will stay low for ever. Which might be the case or not.

        • Value Investigator

          The potential consequences, on which I fully agree, are alarming.

          But why bother if there is no reason to expect interest rates to rise? At least you hint that that may happen („trend of lower rates appears to be gone; may be worth to have a look now“).

          Good point on the potential economic distortions of low rates. Unaffordable real estate prices are becoming more and more of a concern. And of course it is not a good sign that many „shitcoins“ are getting flooded with money. Combined with the „ok-ish“ inflation in Germany and low unemployment, the Bundesbank would probably already have increased rates.

          If we keep in mind that Draghi makes monetary policy for the whole Eurozone, I think rates will remain low for a while. With very low inflation, higher rates may trigger a deflation, which is too risky given the state of the whole Eurozone.

  • Thanks for another great post.

    On interest rates, one thing I’d add is that your analysis is static, whereas interest rates are a dynamic system. Hence just as important as rates going up (I agree a big static effect) is the speed at which they go up (a dynamic effect). On the latter though, it’s worth noting that the banking sector still has the central banks enslaved – both in US and in Europe. While banks have deleveraged somewhat since the crisis, there still isn’t an equity cushion sufficient to allow Central Banks to raise rates a lot and quickly – if they did they would decimate the fixed income asset side of the banking sector balance sheet and will have to bail the banks out again. So while I agree rising rates are important, I’m pretty confident they cannot rise by a lot quickly.

    • No, we will not need to bail banks out because of an interest rate increase. Banks manage their interest rate exposure by swaping everything into floating which makes them pretty much immune against interest rate rises.

      They might have an issue if defaults go up significantly. Without defaults, rising interest rates are a net positive for banks.

      • Hmmm… this feels like a systemic bezzle – someone somewhere must eat the drop in value of fixed income instruments if rates rise. I struggle to believe that the banking sector is 100% hedged into the non banking sector – but am not smart (or informed) enough to have a better view.

        • UI haven’t said that the banking sector is “100% hedged into the non banking sector”. Defaults are clearly a problem but interest rates as such are a net positive.

  • Congratulations, mmi. You deserve it.

    And thank you for your IGE-XAO analysis. It’s the only idea I picked up from you, but you made an excellent analysis and it worked very well.

  • willbuyyourPIKnotes

    Hey, great post and congrats on your year.

    I’ll just add/highlight that the average PE shop with $1B or more of AUM, 2% management fees and a structure whereby fund vehicle #2 can’t be earned on until fund #1 is fully invested, probably won’t be lowering its bid just because it will affect it’s IRR.

    For that to happen, bankers would need to get less greedy/envious of peers making money from lending on generous terms. That cycle doesn’t end on people’s sensibilities. A counter weight shock to the system is the only thing that lowers that PE price bidding momentum in a big way.

    But yeah, great points all around though. Thx

  • Hey mmi,

    Congratulations on a great year and thanks for all the quality posts you’re putting out on a regular basis! It’s a real pleasure reading your blog.

    If you’re looking into investing in Singapore or Romania, please let me know and I’ll do my best to provide you with info on what I regard as interesting companies in these markets. It’s just a way of saying thank you for all the knowledge you’re sharing with the community.

    Have a great year!
    Lucian

    • And an off-topic question: did you ever consider Disqus for your blog’s comment system? I just wanted to edit the comment (wishing you “Have *another* great year!”), but it doesn’t seem to be possible.

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