value and opportunity

Performance May

May was a strong month for the Benchmark (Eurostoxx50 (Perf.Ind) (25%), Eurostoxx small 200 (25%), DAX (30%), MDAX (20%)) with a gain of 3,2%. The Portfolio made 0,8%, an underperformance of -2.4% in May. YTD, the portfolio is up 9,2% against 5,3% for the benchmark. Interestingly, the portfolio was up every single month this year whereas the benchmark only was positive in February and May.

Best performer in May were the 2 Russian stocks (Sberbank +21,2%, Sistem +20,4%), Koc Holding (+8,6%) and Cranswick (+5,6%), loosers were Portugal Telecom (-12% without dividend), IGE & XAO (-5,4%) and TGS Nopec (-5%).

Portfolio transactions May

Major transactions in May were:

– Sale of second half of the Sias Position at 8,75 EUR (and missing the 5% rally in the last 2 days…..)
– Purchase of TRY 2020 Depfa Zerobond
– Increase of LT2 Depfa 2015

Cash is now at ~10% plus the 5% in the LT2 Depfa 2015 which I consider “cash equivalent”. The portfolio as of May 31st can be seen as always under the “Current Portfolio” page.

Comment: “Leave the driver in the bag”

Anyone who plays golf (yes, I play as well but badly….) likes to swing with the biggest club, the driver. If you hit the ball right, you hear a satisfying sound like “Ziiiinggg” and the ball goes really far. The problem ist the following: For most golfers it is quite difficult to control the direction. On the other hand, especially for players with high (bad..) Handicaps, you need the distance in order to have a fair chance for a good score.

More often than not, especially if you play on older golf courses, you are faced with a similar view from the tee-off:

Trees to the left, trees to the right and only a very narrow fairway and you cannot see the flag. If you hit the ball into the trees, you might not be able to find it and you get a penalty, destroying your chances on a decent score. Or you find the ball, but you need several strokes to get out of the trees again.

The much more reasonable strategy for an average golf player is to use a shorter club where the distance is much shorter but you have better control on the direction. Yes, if you hit the driver straight, you will be much better off than with the iron, but ane iron gives you a much higher probability to stay on the fairway. For professional players, this is a quite common problem. Especially if you play tournaments over 4 days where every stroke counts, one bad hole (out of 72) can kill the whole tournament. So professional golf players have to be pretty good in probablilities. They have to assess constantly what club gives them the overalll probability to get the best total score from any situation.

So why do I tell this “golf stories” ? The answer is easy, an investor is facing the almost same problems than a professional golf players. You can make really risky investments, like for instance a concentrated position in an expensive growth stock which would be the stock equivalent of a driver. Or a super cheap “deep value stock” with management problems and a high debtload. Great upside potential but also big risk the end up in the “trees”. As in golf, the investment environment plays a big role in deciding what amount of risk to take. When markets are cheap in general, then taking risk makes more sense as you are facing a nice and wide fairway.

If valuations are high and a lot of strange things are going on, you might want to leave your driver in the bag and use the investment equivalents of short woods or irons, like smaller positions and more defensive stocks.

The current market environment, especially in the “developed” markets with low yields to me looks very similar to the narrow fairway from above. Relatively high valuations, experiments from central bankers etc etc. in my opinion is faced best with a more “controlled” game, like smaller position more diversification, a prudent cash position and uncorrelated risks. Otherwise the risk of permanent loss of capital and missing the “Cut” is real.

What we actually see in the markets is currently the opposite. Especially pension funds, insurance companies and sovereign wealth funds are “taking out the big clubs” by increasing the risk of their portfolios to compensate for low yields. Suddenly real estate, private equity, high yield corporate bonds and illiquid infrastructure loans are considered perfect investments for conservative pension funds and life insurance companies. Those investors are betting fully on being able to “Control the driver” whereas in reality they might not even had a practice swing before. In my opinion there is a high risk that many or most of those investors will find themselves “in the trees” at some point in the future and cursing themselves for not being prudent before.

So my advice for anyone would be: Now is not the time to “swing for the fences”. Try to stay in the middle of the investment fairway with controlled (and known) risk taking. Don’t take badly priced illiquidity risk and/or credit risk. Don’t buy badly managed companies or troubled business models with concentrated position. On the other hand, don’t stop “the game” completely but play patiently and wait for the “wide fairways” i.e. low valuation environments in order to bring out the driver again.

Performance review:

In February, the portfolio performed +2,7%, which is -2,5% lower than the Benchmark (25% Eurostoxx 50, 25% Eurostoxx small, 30% DAX and 20% MDAX). YTD, the portfolio is up +6,5% vs. 3,2% for the Benchmark.

Main contributors for February were G. Perrier with +22,5%, TGS Nopec with +16,9%, SIAS with +10,4% and IGE & XAO +7,1%. Major looser was Cranswick with -5% (in EUR) and Vetropack (-2,8%).

Portfolio transactions

If I look at my transactions in February, I almost feel like a high frequency trader: I sold the final Rhoen Klinikum position as well as EMAK and SOL. I increased positions in MIKO and TGS Nopec and finally I invested in 3 (!!!!) new stocks: Energiedienst, Koc Holding and Ashmore. Cash is now at 13,5%.

The current portfolio can be found here.

Comment: “Is small still beautiful ?”

2014 again showed the usual pattern in the past few years: Small and Midcaps outperform everything else by a wide margin. This is how the constituents of my own benchmark performed YTD:

So European small caps seem to be THE hot asset class. A long time ago, when I went to university (early nineties), I still remember when the finance professor talked about efficient markets. He didn’t believe in them and one of the example quoted was the famous “small cap” effect, the “fact” that small caps over the long run perform better than large caps.

Looking at most markets today, the history speaks for itself. Just look at the Charts:

S&P 500 vs. Russel 2000

or even more drastic: Dax vs. MDAX

Back to the “old times”: When I started to work for a financial institution in the mid nineties, one of my job was to monitor and explain the performance of a German small/mid cap fund. Every Quarter or so, I had to explain why again the fund had underperformed the DAX by a wide margin and the fund was finally closed end of 1999. Just to give an indication how badly Midcaps performed in this period: From the end of 1994 until end of 1999, the DAX performed ~26,4% p.a. against the MDAX with 10,6%, an underperformance of -16,4% p.a., or in absolute terms +221,96% against 65,55%. No matter what academia would say, the decision makers were tired of looking stupid and pulled the plug.

Consensus at that time was that in the age of globalization, the big international companies would be the stars and the small companies would be crushed. We all know how this story ended.

Let’s look at some more recent numbers: Since the end of 2009, the MDAX has performed 21,5% p.a. vs. 12,4% p.a. for the Dax. The French Small&Mid Cap index has performed 13,9% p.a. vs. 5,95% for the CAC in the same period. So again, many “asset allocators” are faced with a situation, where the logical thing to do is to allocate as much as possible into the much better performing asset class.

However, this past performance is only one side of the medal. Let’s again look back and look at something else this time: Valuation

When my employer at the end of the nineties decided to pull the plug of the small/midcap fund, the DAX was trading at a P/E of 32 vs. the MDAX at 16. Interstingly enough, the situation now is just the inverse: The MDAX now trades at 28 times earnings against the DAX at around 16 times. The situation looks similar in other markets. The Russel 22000 for instance trades at ~50 times 2013 earnings against 17x for the S&P 500. Of course, profits in small and midcaps could continue to grow much faster than in large caps, but at current valuation levels they have to grow much faster than for large caps in order to justify their valuation.

There seems to be so much money flowing into small caps at the moment that even the weak companies enjoy their day in the sun. So what to do now ? Chase the few remaining “cheap” small caps and hope that they get pushed up by the momentum ? Or exit completely ? I don’t know, but for instance European small caps have almost completely disappeared in my BOSS score database from the “attractive” bucket. The few remaining ones are rather “deep value” cases.

In any case, one should be very careful with small caps going forward. Based on current valuations, profits at most small cap companies (Europe and US) would have to increase really strongly in order to be able to produce additional outperformance in the next few years. There might be a few remaining opportunities, but overall “the air is getting thinner”. We will see how this plays out, but experience shows that multiple expanions will stop at some level and then usually reverse quite drastically and for long time periods. So be careful with small caps. Maybe “big is beautiful” might come again….

Performance:

January was a very good month for the portfolio. The portfolio gained 3.68% vs. -1.86% for the benchmark (New benchmark since 1.1.2014: Eurostoxx 200 Small 25%, Eurostoxx50 25%, Dax 30% MDAX 20%).
Major positive contributors were April SA (+12,8%), Cranswick (+10.2%), Installux (+9.6%), Draeger Genußscheine (+8,0%) and Hornbach (+7.1%). Overall, the portfolio benefited from a January small cap effect more than anything else.

Portfolio transactions:

As discussed, I sold the entire Celesio position. Additionally, I started to sell down a quarter of Rhoen at around 21.95 Eur. On the sell list as well is the remaining stake in EMAK. Unfortunately the January effect did not help the EMAK share a lot.

Cash is currently at 15.6% of the portfolio. The portfolio as of January 31st can be found here.

Comment: Taking responsibility

Currently, two complete former management boards of two infamous German banks are standing trial. In both cases, HypoReal Estate and BayernLB, the boards made large acquisitions just before the financial crisis (Depfa, Hypo Alpe Adria) which turned out to be disastrous and sank both banks.

Of course, both boards and CEOs do not see themselves responsible for what happened. Hypo Real Estate’s former boss Funke blames the former German Finacne Minister Steinbrück for everything, the BayernLB CEO Kemmer blames of course the financial crisis for everything.

Taking credit personally for success and blaming others for failure seems to be common today in most management boards. As an investor however this kind of behaviour is very dangerous in many ways. In order to compound wealth long-term, investors need to avoid mistakes much more than trying to pick the next Apple or Google.

Blaming others for bad investments is in my opinion a sure way NOT to compound well in the long run. Blaming others and not oneself increase the risk that the same mistakes are made over and over again. Clearly, luck plays a big role in investing as well, but in the long run skill and especially the avoidance of “Unforced error” will dominate luck.

A good example is the current Prokon “scandal”. Many people now are blaming the German authorities that they didn’t step in and closed the scheme long ago. No, it was not the fault of the investors, which ignored all the warnings, it was the fault of others. Thinking like this leaves the door wide open for the next Ponzi scheme and then the next and the next etc.

If I make a (big) loss with an investment, my first question always is: What did I do wrong ? What did I miss ? Did I ignore facts or did a fall into a behavioural trap ? Unlike a CEO, the only person I can possibly fool is myself, so no need to blame the financial crisis, incompetent politicians, bad weather etc.

The same goes for greate investments. One should also ask oneself: What part was luck and what was skill ? History is full of failed investors which made one lucky trade and then lost it all because the thought that they actually knew what they were doing. The Celesio trade is a good example. Yes, I made a quick nice profit, but my initial assumptions were wrong. So instead of thinking: Hey, merger arbitrage is easy, I should ask myself if this is really a game I should play in the future as I do not seem to have better insights than anyone else.

So to make the long story short: For long term investment success, it is far better to take the opposite strategy of a typical Bank CEO: Take full personal responsibility for failures and only partial credit for success. I will almost guarantee that this will lead to a much better outcome than the typical “Bank CEO” approach for your personal portfolio.

Performance:

Performance for the month December was +1.2% vs. +1.3% for the benchmark, an underperfomrance of -0.1%. For the year, this resulted in +32.8% vs. +29.0% for the Benchmark (50% Eurstoxx 50, 30% Dax, 20% MDAX), an outperfomance of +3.8%.

Since inception (1.1.2011), the score is now +75.0% for the portfolio (20.5% p.a.) vs. 40.7% (10.4% p.a.) for the Benchmark.
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Performance

September was a very strong month in most markets. The Benchmark (50% Eurostoxx, 30% Dax, 20% MDAX) gained 5.6%, this is the best month for the market since January 2012, where the BM started into the year with an 8.4% gain. Interestingly in September, the Eurostoxx outperformed both, DAX and MDAX.

The portfolio gained 4.9%, an underperformance of -0.7%. As discussed many times, I expect the portfolio to underperform in these markets, especially now when I own around 25% cash.

On a year-to-date basis, the portfolio is still ahead the benchmark with a gain of 26.6% against 17.5%.

The September performance was boosted significantly by two special events: The new buy out attempt for Rhoen Klinikum (+8.6%) and the minority buy out of EGIS (+30%). Other outperformers were Sol (+9.1%), Tonnelerie (+9.7%) G. Perrier (+9.5%), IGE (+7.1%). Underperformers were April (-1.3%) and Miko (+1.6%).

Nevertheless it is also important in my opinion to assess the own performance as objectively as possible with regard to skill and luck. Yes, 26.6% YTD sounds like a lot of skill. But in reality, there is a huge percentage of luck (in the form of BM performance) involved as well. European small and mid cap indices are performing like crazy (MDAX +30% YTDT, French mdi/small caps +22%, Italian Small/midcaps +31% and +37)%. As I am investing mostly into those small and midcaps, my performance doesn’t really look so good compared to those benchmarks. Yes, the decision to invest half of the portfolio in French and Italian small and midcaps was a good one, but the stock selection was rather mediocre and the cash allocation so far value destroying.

Portfolio activity

Portfolio activity was rather high with 3 transactions. I sold Pharmstandard after a few days because I overlooked an important aspect (record date). I increased the Rhoen Position and I added Trilogiq as a new “half” position. I am actually considering putting a “hard” limit on portfolio transactions per month in place (maybe 2 or 3)

Portfolio as of 30.09.2013:

Performance

The portfolio lost -0.6% in August, compared with -1.1% in the BM (50% Eurostoxx, 30% Dax, 20% MDAX). YTD the portfolio is up 21.4% against 12.5% for the benchmark.

The major driver was of course the 25% cash allocation in a down month, the single stocks were all within low single digit perfomance in either direction, so nothing special here.

Portfolio transactions

August was a rather active month with 4 relevant transaction:

1. AS Creation was sold out
2. MIKO came in as new “Core Value” investment (half position)
3. A 1% position in Pharmstandard as potential special situation was established
4. In parallel, I am building up a position in a yet undisclosed French company where I did not yet manage to write a post but I include it “anonymously” in the portfolio

Portfolio as of August 31st 2013

Comment: Circle of Competence

For most value investors, Warren Buffet’s concept of “Circle of Competence” is a very important guideline.

Here is a video of the Oracle himself explaining the concept.

Most famously, he avoided the Dotcom bubble by staying within his circle of competence and not investing in tech companies. Many people therefore take this advice as granted and tend to stay in an area which they know best, like German small caps etc.

However I have a serious problem with this concept or at least with the interpretation of it.

First of all, in reality, each of us is born without any circle of competence with regard to investments. So whatever you consider as your CoC now, has been outside your initial CoC. So at one point in time one had to step out this “zero CoC” to build up any kind of competence.

It is also funny to listen to Warren Buffet explaining this concept. His CoC is HUGE. Clearly, his most well-known investments are Coca Cola, Gilette etc. But if your really follow his investment career, you can clearly see that he continuously expanded his circle of competence..

I mean he started with delivering newspapers and putting pinball machines into Barber shops, but then over his career he almost did everything. Starting with buying department stores, newspapers, he invested in commodities (Silver) Chinese companies, Israeli companies, sold CDS, S&P 500 puts, bought reinsurance companies, provided LBO financing etc. etc.

Expanding one’s CoC however only works if you step outside your CoC a least a little bit at one point in time. Clearly, jumping blindly without any knowledge for instance into US listed Chinese stocks normally does not end well.

I think the best way to expand one’s circle of competence is along the following dimensions:

a) Geographically
So if one has a lot of knowledge in one sector like for instance car manufacturers, it is not that difficult to look at those companies in other countries in order to gain experience. Due to the fact that many companies today are very international, this kind of knowledge in my opinion is extremely important anyway. Just looking at the 3 German car manufacturers for instance is a quite useless task. Usually it is easier to look at “familiar” countries first before going to more exotic places. In that way it is easier to learn about specific issues in other countries if you know the sector well.

b) Sector wise
Similar to geographically, it is also relatively easy to move from a sector one knows well to a sector which is in some way connected. So if you are strong in chemicals, to their direct suppliers (Oil companies) or customers should be easier if not necessary. If you know a lot about consumer staples, retailers would be logical next step etc. etc. For me for instance, it was much easier to understand IGE & XAO, the Electro Cad software company after I had analysed what their client G. Perrier is actually doing

c) Along the capital structure
A more unusual way to expand one’s circle of competence is along the capital structure of a company. Usually many people buy stocks and then maybe some bonds. However if you want to more systematically improve your knowledge, start with a company with a more complicated capital structure, including, bonds, loans, Hybrid debt, convertibles and work your way thorough. You will be rewarded with a much better understanding how the financial side of a company works and you might dicover some interesting opportunities along the way.

There are clealry many ways to expand one’s circle of competence, but the three mentioned have worked quite well for me. I think it is important to move in relatively small steps and be patient. Whenever you step out, you will most likely experience a set back, but one should consider this as an investment.

So to sum it up: Don’t let you fool you by Uncle Warren. If he would have stayed with delivering newspapers and putting pinball machines into Barber shops, he most likely would not be one of the richest people of the world. Only if you expand your circle of competence continuously, you will reap the reward over time. However make sure not to jump too far…..

Performance:

July was a strong months for equities. The Benchmark (50% Eurostoxx, 30% Dax, 20% MDAX) increased by +5.0%, resulting in a YTD performance of 12.5%. The portfolio in comparison gained “only” 3.1%, YTD it is up 21.4%.

The underperformance in July is to be expected. 25% of the portfolio is now in cash, a further 7% in bonds. Most of the stocks have betas significantly below 1. So underperformance in a strong market should be expected.

Best performers were some of the French stocks, G. Perrier +18.6%, April +16.0%, plus Dart Group at a whopping +25.2%. Losers were AS Creation -8.7% and EGIS -4.6%.

The only 2 transactions in July were the complete sale of Drat Group, with a gain of total +226 and my add ons to the Hornbach position. Due to low trading volume, I only got up to 4% from 3.7%, so I will continue to buy in August.

Portfolio as of July 31st 2013

Comment: “Did you see the Gorilla ?”

There is a classic psychological experiment being done in many seminars which goes the following way:

A video is shown with two 3 person basketball teams, one with white shirts and one with black shirts. Both teams in a somehow chaotic fashion pass the ball to each other. The viewer gets the task to count the passes between the white shirt players over a time period of around 90 seconds.

You can try this yourself for instance here:

http://www.theinvisiblegorilla.com/gorilla_experiment.html

Participants get then asked how many passes were played. Most participants get the number right. The second question then is unexpected: Did you see the gorilla ?

I have to admit that when I did this experiment the first time in a seminar, I didn’t see the gorilla. I had the exact amount of passes, but no, I didn’t really see that a guy in a gorilla costume was walking slowly through the picture.

In my opinion, the current situation in the financial markets is very similar. Everyone (and his grandmother) is looking at Ben Benanke. Every single speech gets analysed down to the last word and market react violently on any interpreted change etc. Every speech, minutes etc. get analyzed over and over. For me, watching every word of Bernake is like counting the passes of the white shirt basketball team.

Yes, the FED does impact certain things but real business activity depends on a lot of other things. If you are a Bavarian “Mittleständler”, you do not build a new production hall because Ben Bernanke is saying this or that. You expand if you expect more orders from China, Brazil, Australia etc.

And this is in my opinion the big gorilla dancing in front of our noses: The slow down of the BRIC (and associated) economies. Despite any faked official numbers it is clear, that the high time of BRIC/EM growth is over. I watch closely many companies which are active in China and all of them are reporting problems. Interestingly, very few people seem concerned about this. One can now read many articles which talk about “soft landing” in China or “decoupling” of the US. Yes, both of those things could happen, but my experience tells me whenever you here “soft landing” and “decoupling” you should actually prepare for the worst case.

So what does that mean for the portfolio and investment strategy ?

For me, it doesn’t mean to get out of the stock market right now. Market timing is an art I do not understand. Nevertheless I will follow (further) some general guidelines:

– be extra careful with companies with EM market exposure
– rather err on the conservative side when analyzing companies. Take less risk, not more.
– focus more on special situations
– do not rely on stock momentum for existing position. Sell when too expensive
– be patient, don’t invest just because cash is piling up
– expect and prepare for significant underperformance in the next few months
– Don’t count the passes, but focus on the Gorilla …..