Thursday, November 15, 2018

Why I Shorted the S&P500

The S&P 500 now has returned around 0% this year-to-date. This is Trump's second year in office and the euphoria from his economic policy changes has worn off. As I mentioned throughout much of the year I have had a significant short position on the S&P 500 index. So I have luckily come out slightly ahead in this position. So effectively I am running a long-short portfolio. Counting only my long positions, I am very much at less than 100% invested in stocks. And counting the short position, I am at even less exposed to the market. So, the purpose of the short is to remove my exposure to stocks since my primary market, the S&P 500, is way way overpriced. In this way I can still play the stock picking game while at the same time shield myself from the correction that I feel is just around the corner.

I have seen two major US corrections and I have come to realize, by living in the US, that the euphoria for the markets is bound to come once or even twice every generation. I am seeing another case now. The US is simply at an unsustainable level. My reason for this is grounded on the principle that a stock investment should be based on the value of the company. And this value is the present value of all future cash flows. This is a basic value investing principle.

So the S&P500 index should be priced at the present value of the cash flows from of its constituent companies. The latest TTM earnings of the S&P 500 is only 122 whereas the index is at around 2700 today. That means the entire index is trading at PE of 22! This is way over the normal traditional range of 15. And 15 is being very generous. I want to use this latter PE multiple to help get an estimate of the potential return of the S&P500 over the near future, say 10 years.

The future cash flows of a stock, which reflects the value, is somewhat reflected by the earnings of that stock. If the earnings grow by a certain percentage every year, then the value of the stock should grow by that amount also. I will be generous and say that the S&P500 will grow earnings by 5%. I will also be generous and say that the S&P500 will yield 2%. Therefore, from just this data, we can see that the S&P500 will return around 7%. Not bad but not great either considering I keep hearing returns have traditionally been around 10-12%.

But there is still a flip side to the investing reality: the index is at a very high PE multiple now. It must return to more normal levels. Say it returns to a more traditional, albeit still elevated, level of 15. That means for the same earnings, the stock prices will have to drop to 68% of the elevated level! If this happens in 10yrs that is an annual drop of 2.5%. That is a lot considering that the return I just derived was only 7%.

And wait, it gets worse.

All investors will constantly face three impediments: inflation, taxes and fees. So far, I have not mentioned them in calculating returns. Firstly, there is inflation. Inflation is a fact of life and is often ignored when talking about returns. The reason for this is that inflation varies from year to year and to simplify discussion, we talk in terms of nominal returns. Nominal returns are the opposite of real returns which factor in inflation. The 10-12% return commonly touted is always the nominal amount.

The second impediment is taxes. We can avoid this temporarily by investing in tax-sheltered retirement accounts, but there is a limit to how much we can put in such accounts. We can also reduce it by holding stocks for a long time, if not forever. And there must be many other creative ways of avoiding it, for example by cheating on taxes. Because of this variability, I will only look at dividends, which is forcibly taxed. Suppose the tax rate on dividends is 30% and suppose that half of one's portfolio is not tax sheltered. Then using the 2% dividend number, we will pay 0.3% of our portfolio into taxes.

Earnings growth +5%
Dividend yield +2%
PE shrinkage -2.5%
Taxes on dividends -0.3%
Net return 4%
10 yr net return 48%

Thirdly, there is the fees. This is the most manageable impediment. How much one saves depends on how much effort one expends. I depend on myself for all my financial decisions, I hardly own any funds or ETFs. Therefore, the only fees I pay are transaction fees, currency exchange fees and travel costs to visit companies. All this I estimate is only 0.2% of my portfolio. And subtracting all this up gives me a net return of 4% per annum or 48% per decade. See table. I bet this will be an incredibly low number compared to the average retail investor's expectations. In the long term, stock prices will be grounded by the PE ratio. When the current euphoria subsides and reality sets in, the mood of the market will probably cause prices to fall significantly below the 4% estimate, maybe it could even turn negative at the end of ten years! In the given calculations, I said that the PE shrinkage from 22 to 15 would reduce returns by 2.5%. If the PE goes from 22 to 11.5, the nominal return would not be 4% but 0%!

It is easy to see why I shorted the S&P500.

Sunday, July 1, 2018

Portfolio Update

This blog is so devoid of recent entries that I felt compelled recently to post something, anything. Fortunately I have a lot of odds and ends I can update on my portfolio and the market in general.

After riding high under Trump for a year, I am convinced the US market cannot go any higher. The Shiller PE ratio is at a mind boggling 32.3! That is higher than anytime before the great depression and is only surpassed by the dot-com bubble in 2000. On the other hand, I have holdings that are still reasonably valued overseas and even some in the US. Plus I hate paying capital gains taxes. So, instead of selling a lot I settled on hedging the US market. After all, this is a perfect time to short the US market if I am convinced it cannot go any higher.

I hedged the US market by shorting the S&P500 mini futures. Each of these futures is a contract to buy or sell a contract that will pay out $50 times the S&P 500 index on the delivery date. So suppose on the contract expiry the S&P500 is 2700. Then the contract would conceptually pay out $135,000. In reality the contract settles financially everyday, so the original purchase amount and the settlement payout do not happen but instead the delta in the value of the contract is debited or credited at the close of each trading day. So far I am turning a profit shorting the mini futures. However, I really prefer that were not the case, as each gain means an overall downward bias in my portfolio. But it only confirms my belief that the market cannot go any higher.

 A Prussian general once said that "No battle plan survives first contact with the enemy". I feel that way looking back at my first merger arbitrage situation , between Anthem and Cigna. As it turned out, all the forecasts about its chances of success were too optimistic. The merger fell apart after various state governments voiced objections and sued to block it. Despite this, I fell into the golden period for managed care organizations and both companies rose handsomely. I have since sold my Cigna shares. So the moral of this story is that with careful thought and due diligence, even if I am wrong in my predictions, I can still come out ahead. The S&P 500 hedge is another play from this same playbook.

In addition to the hedge I have also reduced my exposure to US companies whenever he opportunity arose. This was the case with IEHC and Senvest.

While the S&P 500 and my US holdings have done wonderfully since Trump's presidency. My international holdings are a mixed bag There have been laggards such as Lewis Group of South Africa. And there are some wonderful stocks, such as Installux, European Reliance, Tachibana Eletech and Riken Keiki. I have listed the basic metrics of some of my international holdings below.

Tachibana Riken EUPIC Installux Lewis CMH
Price ¥ 2028.00 ¥ 2504.00 € 3.47 € 415.00 R 31.20 R 27.50
¥ 51105.60
($ 461.66)
¥ 58092.80
($ 524.78)
€ 95.43
($ 110.79)
€ 125.83
($ 146.09)
R 2602.08
($ 190)
R 2057.00
($ 150.2 )
ROE % 6.4 11.2 13.8 9.7 4.8 35.6
PE 13.1 14.1 6 14.5 9.9 8.3
PTBV 0.84 1.67 0.94 1.39 0.49 2.97
Yield %
1.97 1.2 3.46 1.93 6.41 5.85

Note that all these companies, with the exception of CMH of South Africa, all have very little debt. The companies whose stock appreciated significantly did so with a combination of increased profits and multiple expansion. I am still waiting for that to happen in my South African stocks. I have not wavered in my belief that the long term future of world economy is in the emerging markets. But in the meantime while I wait, they are yielding 6%.

Thursday, March 1, 2018

Why I Bought Adrenna Properties

Once in a while a company a catches my eye because of its performance relative to price. But the company ownership structure makes it not feasible to buy. I remember one German company I saw once with very attractive returns relative to stock price, but it is 99% owned by a single entity. So I didn't want to buy because the price does not reflect the fundamentals but whatever a few small retailers value.

Recently I found Adrenna Property Group (ANA:JSE). Adrenna is a South African Property investment company. Its properties are business and residential held for rent buildings in the Cape Town area. Cape Town is the capital of South Africa and is a relatively affluent city in South Africa.

The whole Adrenna story started in 1999 when the Quyn Group first listed on the Johannesburg Stock Exchange in 1999. At first it was a recruitment and outsourcing company. Then Quyn acquired the Colliers group of companies in South Africa and changed its name to Colliers South Africa Holdings Limited. Initially the combined company struggled and decided to delist in 2004. Later, after some major restructuring and some decent results, the company changed its name to Adrenna Property Group Limited in February 2012, and it relisted on the JSE.

From that time onwards, the Adrenna has steadily improved its results. And that caught my eye. The following shows the results in the years following the relisting. All monies are in units of millions. Note that the company has consistently reduced debt while increasing equity through fair value appreciation. The capitalization rate is the net operating income before interest and revaluation divided by the property value.

TTM 2017 2016 2015 2014 2013
Price R 1.00 R 1.55 R 0.65 R 1.45 R 0.80 R 0.40
Shares 55.9 55.9 55.9 55.9 55.9 55.9
Equity 151.1 146.5 125.4 117.6 110.1 98.2
Earnings TTM 19.5 21.1 7.9 7.8 12.2 10.5
Marketcap R 55.90 ($ 4.58) R 86.64 ($ 7.10) R 36.34 ($ 2.98) R 81.05 ($ 6.64) R 44.72 ($ 3.67) R 22.36 ($ 1.83)
ROE 12.9 14.4 6.3 6.6 11.1 10.7
PE 2.9 4.1 4.6 10.4 3.7 2.1
PTBV 0.39 0.62 0.3 0.73 0.43 0.24
Div Yield 0 0 0 0 0 0
BVPS 2.7 2.62 2.24 2.1 1.97 1.76
Debt 0.4 0.37 0.52 0.53 0.63 0.84
Cap Rate (%) 8.2 7 6.7 4.8 6 6.4

The company actually has high earnings through fair value reappraisal. So beware when looking at the incredible PE numbers!

The company's cash flow mostly pays for expenses and interest on debt.  South Africa is a country with high inflation and therefore interest rates are also high. The company's operating income is 2.5 times interest expense. This ratio is a bit lower than I'd like but it is still acceptable.

So Adrenna looks very cheap, but is there a catch? And indeed, there is a problem when investing in Adrenna. That problem is the company's market cap. The company's five largest shareholders own 72% of the company. They include two board member and affiliated entities. This is encouraging in that the board has aligned interests with the average shareholder but it also means there is very little float, possibly much less than USD $1 million. Still I have built as large a position as possible without excessively moving the stock price. Hence, I regard my position in Adrenna as only a trial run of my investment approach because this is not a stock I can buy in size.