My very unaudited portfolio performance in the second quarter of 2014, the three months ended June 30, 2014 is approximately -3%. My year-to-date performance for the six months ended June 30, 2014 is +1%.
At June 30, 2014:
3% Equity Options
17% Corporate Debt
USD exposure as a total of the portfolio: 49%
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With the S&P 500 up 5%, this quarter’s performance clearly underperformed. The same performance as the equity indices could have been achieved holding long-term government bonds. Holdings in US currency also accounted for some of the negative performance.
The primary reason for the negative result is due to the concentration of the portfolio in a specific yet-to-be-mentioned on this site company’s equity. There is regulatory risk in this particular title which has the valuation clearly depressed relative to where it should be, but it is just a matter of waiting for the risk to be removed. Due to the depressed valuation, the company is engaging in a share buyback and this will inevitably increase value for shareholders whenever the regulatory risk resolves itself. It is a matter of time. It almost reminds me of what happened when tobacco giant Philip Morris was being persecuted from all fronts earlier last decade and they were doing massive share buybacks when they were trading at price to earnings of 6 to 8 (in addition to giving out 5%+ dividend yields). It ended very, very well for those shareholders.
The major changes to the portfolio this quarter includes the exercise of equity options that were purchased in the previous year (and in the previous year they were purchased out-of-the-money and were a significant contributor to 2013′s relatively good performance). I did purchase some additional out-of-the-money equity options in a lottery ticket-type play, but so far this trade has not panned out. As purchasing out-of-the-money options at low prices typically implies, these may indeed go to zero. They may also go to the roof. We will see, but in any respect, the risk-reward ratio is better than when you have the Lotto MAX at $50 million.
During the quarter, I sold just over half of my holdings of Genworth MI (TSX: MIC) at an average price just north of CAD$39 a share, a couple bucks higher than current market prices. There is nothing wrong with the company fundamentally – they are very profitable, the market environment is nearly perfect for them, and the scale-back of their regulatory competitor (CMHC) will benefit them greatly. That said, the market is giving them the appropriate premium, so any appreciation in equity will be due to the earnings they generate (not a trivial amount – will be around the $3.80 range, or about a 10% earnings yield at present). I am also factoring in a medium probability of them declaring a special dividend (about $1.50 to $2.00 per share) before the end of the year as they have an excessive amount of capital on their balance sheet and this is cutting into their return on equity statistics. At present prices, I am comfortable with my exposure to this company.
I have also increased my exposure to US currency, mainly to maintain my general policy of keeping a balance of the two currencies in the portfolio (whether it is in raw cash or equities/debt denominated in such currency). I do not have a strict 50/50 policy, but I start to rebalance if things go beyond 30/70. I generally have no strong feelings on currency other than that given my geography, I will be using Canadian and US dollars for the rest of my life and there is little reason to consider the Euro, Yen, Bitcoins, etc. If Gold goes below CAD$1,000 an ounce I might buy one or two just so I can hold it in my hand and stare at it before burying the bars in my backyard.
The quarter was characterized more with what did not happen rather than what did happen. The portfolio is quite boring at present other than the one concentrated bet that I have alluded to above. I may decide to reveal the trade at a future date.
My crystal ball continues to be quite clouded. There is a lot of conflicting information out there, probably because using means and medians on aggregate economic data does not tell the completely picture of the very bifurcated world we are entering. Absent of the relatively large concentrated pick (where I believe there is the potential of a relatively good risk/reward of about 5:1), I have literally nothing on the immediate radar that is worth picking up (or at least worth picking up in the anticipation of significant gains – there are a few incremental type picks out there which are better than average on the risk/reward spectrum).
Macroeconomically, the US Federal Reserve is signalling to the world that their special market operations are going to cease by year’s end and after that they will probably go to some sort of rate normalization regime, but in a way that will attempt not to crash the stock market. Until then, borrowing money is cheap and as long as short money is cheap, you will have lots of players trying to leverage their money into lower and lower quality financial products until the whole system goes boom again. My gut feeling is that we’re about half way there.
Much has been mentioned about liquid ETFs holding illiquid products and this is the financial equivalent of lighting cigarettes near gasoline station pumps. Even though you save a few pennies a litre on your gasoline at these safety-deficient stations, eventually your car will catch on fire and generate losses. Keeping your cash (and car!) away from these future fires should prove worthwhile. Investing in the best parts of the smothered remains will produce outsized gains. I do not see things occurring like they did in 2009-2011 when you had glorious opportunities to seize gains, but a miniature version of this should be on the horizon. Perhaps not this year, but maybe the next. I would just be on the lookout for anything the usual pundits would consider to be highly toxic.
Right now, most pundits think the stock market and bond markets are highly toxic.
I am reasonably sure the catalyst to start some sort of panic will be something relating to interest rates, and this usually will stem from inflation reporting. It is ironic how the first step to instigating the deflationary bust that Prem Watsa (of Fairfax fame) will be through an inflationary fear period, but it is plausible to see how that can occur. Once the excess inflation fear has been removed with the appropriate increases in rates (short or long term, whatever the case is), you will start seeing the carry trades out there completely unwind, and with that, the unwinding of the incredible amount of financial leverage there is out there – borrowing at 3% to make a 5% return on some crummy asset-backed security product.
Put yourself in the shoes of a typical mortgage bank. How much money is there to be made on 5-year fixed term products at 3% rates? Your spread over risk-free rates is nearly nothing after you deduct costs for marketing, bureaucratic infrastructure, etc, etc. This doesn’t end well when there is some sort of shock that reduces confidence in asset prices and people’s ability to pay.
I remain quite focussed in this part of the market cycle that more and more financial garbage will be pumped out into the system for eager investors that are going to pay anything for yield. This is reminding me of the mid 2000′s when income trusts were going public with very questionable ability to actually pay the distributions promised. Yield games can be played with securities, but when confidence is lost (either through real interest rate increases, or some other crisis of confidence), the underlying asset values can no longer support the yield and that is when you will see a huge domino effect.
This is the reason why I remain very reluctant to invest in yield-bearing products unless if the underlying entity has a clear ability to sustainability generate such funds. Even though there is a pile of cash earning next to nothing, it is quite dangerous to throw it into some low-risk debenture with a 4% yield to maturity (example #1, example #2, example #3, etc.). The liquidity will not be there when it is needed, and when there is a mini-credit crisis, it will very likely cost more than the yield that is currently being given away.
Given the long-term track record of the portfolio (see below, over the past 8.5 years it has achieved 16.7% compounded annual growth), it is quite difficult to produce gains at this level. Mathematically, if I managed to produce an absolute return of 12% for the year (which ordinarily is quite good assuming I don’t take a ridiculous amount of risk to achieve this), I would still be bringing down my long-term return. Psychologically, it is tough to see myself tread water for the first half of the year (producing something that barely would outperform a GIC), but this is part of the investment game – in order to perform better in the long run, I have to accept that I effectively will have to step away from the market and during these times, I will underperform my own long-term averages.
One of the costs of heavy portfolio concentration is that this will occur. With any luck, the second half of the year will be better. I’m guessing it will be.
Divestor Portfolio - 2014-Q2 - Historical Performance
|8.5 Years:||+16.7%||+5.5%||+3.5%||(Jan 2006- Jun 2014) Compounded annual growth rate.
|2006||+3.0%||+13.6%||+14.5%||Performance marked by several "wins" and several "losses" which nearly offset each other.
|2007||+11.7%||+3.5%||+7.2%||One holding was acquired at a moderate premium; nothing otherwise remarkable about this year.
|2008||-9.2%||-38.5%||-35.0%||Avoided market meltdown by holding significant cash; bought heavily discounted corporate debt at and around year-end.
|2009||+104.2%||+23.5%||+30.7%||Most gains this year were in the corporate debt market. Anybody holding anything from February onward would have made money, but I mostly selected securities that were more heavily depreciated. I completely realized the once-in-a-generation opportunity that occurred here and was able to take advantage of it.
|2010||+28.0%||+12.8%||+14.4%||Continued to realize gains and lighten up on corporate debt holdings which were mostly trading at par at year's end.
|2011||-13.4%||+0.0%||-11.1%||Very poor performance, most of which stemmed from poor decisions around the August timeframe, and also completely missing on two targeted trades which completely fizzled. Wounds in this year were completely self-inflicted.
|2012||+2.0%||+13.4%||+4.0%||Spent most of the year in cash, which explains the relative underperformance. Did not feel confident about significantly getting into equity or debt, but did dive into "value" equities at the end of the year.
|2013||+52.9%||+31.8%||+10.6%||Despite making several unforced errors in the year, not to mention having a generally bearish outlook on the marketplace, insurance industry holdings appreciation and one very timely trade contributed for the bulk of performance. Half the year had more than 20% cash in the portfolio.
|2014 (Q1)||+4.2%||+1.3%||+5.2%||Little transaction volume this quarter. Still over 1/4 in cash, trimmed a large position.
|2014 (Q2)||-3.4%||+4.7%||+5.7%||Little action this quarter; continuing to hold onto a significantly concentrated position.