In a number of posts (Last section here, and here) I have concluded a desire to tilt my portfolio more towards Value. Particular in Europe where Value stocks have been hammered. So a few months ago I started by asking myself, what stocks in Europe are actually considered Value? At the time I had access to an advanced Value ranking which blends simple metrics like Book to Price with more advanced ones. I ran the Stoxx 600 members through the scoring and the top 5 stocks in that ranking were:
Marks & Spencer
Casino Guichard Perrachon
They say Value should feel hard to invest in.. ..well they were right, that is not a list of stocks I find particularly attractive. In the future I intend to build a model which rank stocks on a blend of my own Value-metrics, but that will take some time to get in place. So I will use the advanced Value model (which I trust) and start with the list above. I don’t think I will analyse them all, but Ericsson looks interesting to me, so at least I start there.
Ericsson is a huge company with 110 000 employees spread out over the world. Ericsson was one of the companies that was hyped during the dot-com bubble and thereafter crashed terribly and was saved thanks to strong owners (Investor and Industrivärlden) through a huge rights issue in 2002. A lot has happened since then (business model changed from phones to networks) but the company has failed to create meaningful shareholder value over the past 15 years:
As I want to merge Value investing with Momentum, this price graph is not ideal, given the sharp negative trend Ericsson is in, but let’s look further anyway.
It’s current business model is fairly simple to understand – they build mobile networks and everything that comes with it. The company divides its business into three parts: 1. Networks, 2. Global Services and 3. Support Solutions. Below follows more details on the units.
My holding Coslight Technology (1043 HK – listed in Hong Kong), a batter producer in China did what is commonly called a turn-around by presenting very strong first half 2016 results. They actually issued an pre-announcement that the results would be significantly better, but the market did not react much on the news. Anyhow the results for H1 2016 was an EPS of about 0.36 HKD per share and at the time the stock traded at about 3.8 HKD. Multiplying the result with 2 gives a forward P/E of about 5, so I think you can understand why the stock soared 30% the next day. Since then the stock has continued to trade very strongly and in a wobbly market closed today at 6.7 HKD up +76% since the result announcements. Since we bought our position in the stock at 2.87 HKD we are now up +133% and our first stock price doubling since the blog started! This also means that the holding is close to my holding guidelines of max 15% position size. I am therefore forced to reduce my position size somewhat, the question is how much and does the stock still have room for more upside?
Analysis of Coslight
The outstanding results were partly thanks to subsidies by the Chinese government on EVs. And also that the subsidies where design in such a way that it favored EVs who bought batteries produced in China. I bought this stock because it is one of the most pure play Lithium battery producers that is listed anywhere in the world. And even this company is by heritage involved in production of lead acid batteries (which they are currently losing money on) and also doing something as bizarre as mobile games for the Chinese markets. It happens so that the mobile gaming unit is actually very profitable and not at all something to laugh away, it has very high margins and I see it as a free option for launching a new hit game (you never know).
A move from lead acid to Lithium battery production
The figures in the Semi-annual reports tell a story. The story told is that lead acid battery sales used to be a terrific product, with healthy margins. Coslight made great money on their products and the stock traded in the 10 HKD range in its glory days. Then something must have happened in the industry, because margins deteriorated to the point were Coslight was losing money on its lead acid battery business. At the same the shift started towards Lithium battery production, which has similar healthy margins as the lead acid batteries used to have.
As the graph above shows, net and gross profit margins were healthy back in 2007-2009 and then slumped sharply. Lastly we can see a shift in the trend, where the latest report which created the surge in share price, indicates that the companies sales are back in the healthy area of gross and net profit margin. The reasons for this is because Lithium battery sales has totally taken over and lead acid battery sales has been scaled down significantly. See graph below.
The red line shows how Lithium battery sales has gone from around 30% of total sales in 2012 to around 90% of sales in the last years (although with some volatility). And the blue line also with some significantly volatility shows that lithium battery sales is profitable business. So now we have a transformed company, which stopped producing loss making lead acid batteries and focus on profitable lithium ion batteries. They recently also announced they are going to double production volume (with a 400m USD investment), meaning if they can keep margins at these levels, they will be able to generate a forward EPS of around 1 HKD per share, justifying a price of Coslight of around 10 HKD. The big if is if Lithium battery margins can keep at these levels. I would argue that there is a lot in the pipeline that suggests it will. The demand for batteries is huge among Chinese EV makers and listening to Coslight themselves it sounds like this:
“Power Batteries benefited from Chinese government policies on new energy, the sales volume of China’s new energy vehicles surged to 170,000 in the first half of 2016. The demand for our power batteries grew dramatically for the corresponding period. We have delivered 11,127 sets (2015: 3,061 sets) of all types of electric vehicles batteries, representing an increase of 264% over same period last year. We continued to collaborate with domestic and foreign auto makers to provide battery system solutions for electric vehicles. Our customers include wellknown brands of domestic new energy vehicles manufacturers. Our products include lithium ferrite phosphate batteries and ternary power batteries which are applicable to different types of electric vehicles, including buses, commercial vehicles and sedans. We expect the amount for delivery will rise substantially for the whole year.”
Coslight produces batteries for many purposes, it’s not just EVs that are interesting, but also mobiles, laptops, drones and other wearable devices. One big are of sales for Coslight is laptops. I’m impressed with how advanced Coslights battery technology is for the latest generation of laptops. If you haven’t noticed all Laptop brands are coming out with new ultra slim, around 1 cm thick laptops. And I after some serious digging found out that the HP Spectre laptop comes with a Coslight battery. I find this very impressive, the laptop has good battery life although it is so slim. This gives me confidence that Coslight knows what they are doing and are up fighting with the best battery-producers.
I will reduce my position because I want to follow my investment guidelines, but only by 25%, I want to keep this as a large position in my portfolio, since this is somewhat of a breakthrough and turn-around in the company. I will hold on to my stocks at least until I see prices around 10 HKD per share, somewhat aggressive to expect the stock surge to continue short-term, but reasonable in the next 1-2 years I think.
NetEase Slicing position
I already reduced my position once in this stock, now I again sell half my position, since the stocks keeps defying gravity. I’m super happy with the return I got in this stock, but it reached my target price and I see better opportunities elsewhere at these valuation levels.
When I evaluated fund managers, I often asked them to describe their full investment process. Most fund managers present this as some sort of funnel, where you start with your whole investable universe at one end, and the stocks in your portfolio in the other and in between the steps how you got there. Just as an example it could look something like this:
This is my first post where I start defining my own funnel, which in essence is a filter process to get a huge universe down to something manageable. This process is currently rather unclear even to myself. An important part of starting this blog has been to force me to define a funnel, or at least something similar. I need a strategy both for which companies I should look closer at and what to focus on when valuing the company. This may sounds easy, but currently I have a huge lack of consistency on what parameters I evaluate a company on. In a similar way I do not have a process for finding what company is most worthwhile to research.
1. The Universe – Global
As the name of my blog implies my universe is global and also not restricted at the moment to any minimum liquidity cap. Meaning I more or less have the full world universe at my disposal. Minimal constraints in theory gives most room for out-performance, but looking at it practically a small one man show as mine has no possible chance in a lifetime to evaluate all existing companies, so something clearly needs to be done to narrow this down.
2. Filtering the Universe
I henceforth put a minimum cap on liquidity of average 3 month volume at 100 000 USD. This is very low and I probably will revise this in the future, but I currently have one holding which has poor liquidity and that is Highpower International. Given that I just invest my own money I don’t have a need for high liqudity at the moment. In the future I intend to make my process scalable for investing larger amounts and then I want to already have the same process in place. My thoughts for future minimum liquidity is around 1 million USD average daily volume. This will be my first step in narrowing down the universe.
2.2 Investable countries
Currently I don’t have brokerage accounts to invest in every single country in the world (few professional investors do either). My investable markets can be summarized as follows: North America, Western Europe, Turkey, Japan, Hong Kong, China, Philippines, Korea, Taiwan, Thailand, Indonesia, Malaysia, Singapore and Australia.
3. Generating Investment Ideas
Mainly I use what I see, read and experience around me to find interesting prospective investments. I try to think far ahead, what the world will look like in 10 years. I travel quite a lot, that helps for being able to invest globally and to understand consumer around the world. For example I never visited South America and I’m much less confident to invest in that region just for that sole reason. I also spend a lot of time online reading forums and news. This is close to the core of why I love investing. I’m curious about what people think and I like to learn and understand new things. My investment ideas are seldom totally unique, it’s hard to be in a world full of investors, so I steal ideas without shame from all possible sources: fund managers, sell side research, investment blogs, podcast, news articles etc.
4. Specific Screening
Here all types of screens could be applied that is relevant for the current Investment Ideas. Something that makes sense in most cases is screening down to Sector/Sub-sector/Industry for a specific country or region. This comes in handy later when doing peer valuations or just comparing which company is most interesting to look further into. As examples one could try to screen for companies involved in battery production all around the world or consumer staples in China.
5. Factor/Style Screening
I’m a big believer that its favorable to invest along with some well known factor risk premia. When analyzing famous fund managers that have fantastic track records of generating alpha, their out-performance can often be explained in large part through their investment process. Knowing or unknowingly they have built their investment process tilted towards a risk premia that over time has generated some or all of their funds out-performance. One famous example is Warren Buffet’s value investment-style, in combination with a company structure which has enabled him to take on some leverage to the Beta he has been exposed to. Other famous fund managers have exploited Low Vol strategies or more recently Quality and High Dividend tilts.
So the first step for me is to understand/decide what risk premias that are worth investing along with. From the research I read and the experience I gained professionally I have decided to initially focus on Value and Momentum. The reasons for this I will need to explain in further detail later, although some explanations have been given in earlier posts.
6. Invest with tailwind
One important aspect of my investment style is finding some sort of future tailwind in my investments. For me these tailwinds can be of very different types, one example would be investing in stocks with Value characteristics. The normal way of thinking about tailwinds would be and industry that has potential for good growth. This type of tailwind that I focused during the last year has been the development of Electric Vehicles (EVs) and the emerging Chinese middle class. Another tailwind I use frequently is just what the market tells me about the price of a stock (price momentum). During the 15 years I invested I always looked at charts and been intrigued by how Technical Analysis (TA) try to capture psychological aspects of investing. My belief is that there predictive power in price momentum and this has also been shown in numerous research papers.
Long term (5-20 years) upwards price trend is also important to me. It tells me that the company has created share holder value over the long-term, surprisingly many large companies have not. Positive price trend over the long term I also call a tailwind.
6.1 Timing / Short term Momentum
Short term price movements I use to try to time the investment and enter at an attractive level. This is less of a tailwind and more of a proven market anomaly (price momentum) and a personal preference that I like to buy on short term weakness (in general I like to buy stocks on days when the market is down). I realize these attempts at timing might be futile, but I do feel over my 15 years investing I developed some type of fingerspitzengefühl. I might need to back that up with some statistics at some point, that I currently don’t have. When I have more time I will analyze as many past trades as possible and see if I entered the stock at a favorable price point.
6.2 Value Investing
This is such a big topic and also something I still have much to learn about, so I will cover this in Future posts separately.
For the stocks that passed my filters and requirements I want to do a deep analysis of the company and it’s peers. This step will also need a separate post to go through in further detail. Here I also have much to learn, since by profession I’m not an equity analyst, although I have been analyzing companies for many many years in my spare time. The CFA also helped with some techniques and account knowledge.
8. Portfolio Construction
Finally portfolio construction. My aim is to have a portfolio diversified over sectors, countries, style/risk premias and sometimes even currencies. A colleague of mine used to say, diversification is the only free lunch. The meaning of that is that diversification gives you a higher sharp ratio and less company specific risk for free. What you possibly pay is if you have one outstanding idea and you still just invest with a small amount in the idea, to not give up diversification. But this to me is nonsense (as long as you don’t have insider information, which I don’t). In my belief there are no such investment cases which warrants you to go “all-in”. Here I also have some work to do, one reason I have not come so far, is that the amount of stocks I have researched is too narrow. I don’t have a pool of 50-60 good investment ideas to chose from and select those that give me good diversification in the way I mention above. So i don’t expect to develop these last stages of my investment process before I have come further in the earlier steps.
So now I have created my first own “Funnel” going from the full investable global universe down to Portfolio construction. All steps are not finalized and I have much more work to do, which will probably take me another year or two to iron out. After that I expect to have a professional investment process to follow. This process will both be built in such a way that it will increase my probability to generate out-performance (by quantitatively filtering out companies with favorable metrics) and suit my investment style and the way I like to invest. Both are equally important to me. I believe that merging quant with stock picking skills is the future and exactly what the most advanced investors are already doing today.
So I have been fairly stressed out lately, struggling to keep my blog updated and more importantly keeping up with the news flow in stocks I own or follow. The reason for this has been a final push at my old job and everything that needs arranging before my move back to Asia. Now being through the worst, I decided it was high time for a vacation. And lucky me, weather is still summer-ish and I had a few nice super-relaxing days. So now with some time on my hands, I’m going to summarize some thoughts I had over the last few months.
Let’s start with the big picture, what’s my view on equity markets in general? In my view we have all the signs of a late stage mature bull market. Of-course this topic can not be discussed without mentioning the low rates worldwide. Yes, this is unchartered territory, yes, we have never experienced this type of environment with virtually global zero rates. But at the same time that is what is said every time the market get’s toppish – This time is different (Reinhart and Rogoffs’ book title released in 2007 just before the crisis started) comes to mind. What I can conclude is that Every time is different – and that is the whole reasons why markets managed to get overvalued. I was sure we were rolling over into a longer bear market about 1 year ago, when the Chinese markets pulled the rest of us with them. Day by day I’m looking to be more and more wrong on that statement. But I did turn more short term bullish on Asia and Europe around April-May, I expressed this view in my post Market Thoughts May. But investing in this market I still have this nagging feeling of running in a dark room picking up glowing pennies wondering if the steam-roller is catching up with me? Markets do climb a wall of worry, but I feel a disconnect here, private investors are happily buying stocks, which can be seen by the silly out-performance of small and micro-cap companies during the last years. At the same time many “professional” (or let us say educated) investors have been more skeptical for quite some time. Let’s take a close look at this phenomena.
European Small/Micro Cap investors feeling great!
Let’s look at the following two graphs.
The first one shows MSCI Europe Small Cap ETF versus Stoxx 50 Europe (very large cap). The out-performance is striking, small cap +14% and large caps down -12.5%. As a large cap investor in Europe you really felt pain and as I already mentioned in May, far from recovering. But as a small cap investor, you are fine, great actually, just shy of all time highs.
The second graph shows a much more extreme example, in Sweden. This shows the performance of the main index OMXS30 versus the wider OMX Small Cap index as well as the Micro Cap index of stocks listed on a venture exchange called AktieTorget. This smallest list is mostly available to local/nordic investors. It’s astounding, since the highs set by most indices in May 2015, this small cap benchmarks have gained another 35% and 55% respectively. No wonder that retail investors focusing at least partly at these smaller companies are feeling great. So I’m just going to say it – This is what a bubble looks like. I will try to actually give some historical proof of why that is the case.
The Small Cap Factor
This graph takes some explaining, so bear with me, because it is has a very important point for the small cap style investing (red line in graph).
This graph is taken from a very recent research piece on factor investing. For those of you not familiar with factor investing, it goes all the way back to Fama French’s (now old) groundbreaking research of how returns can be explained by more than the Beta in the CAPM model. This is today expressed through products like Smart/Enhanced Beta, Risk Premia Investing and such. A complex topic which I’m happy to write more about if somebody reading is interested. Are you new to this, at least read Fama–French three-factor model.
So the three factors created in this test are called Small Minus Big (SMB), Up Minus Down (UMD) and High Minus Low (HML). The UMD factor approximates Momentum investing and HML Value Investing. But what we will focus on this time is SMB – which approximates investing in Small Cap stocks.
What this graph then shows is the out or underperformance versus a benchmark of these 3 factors. The SMB factor is constructed by being long small caps and shorting the benchmark (simplification). Instead of time on the x-axis this graph is constructed to show skewness of returns. They do that by sorting all returns for the whole time period (in this case since 1950). Imagine sorting all returns day by day for this SMB factor, from smallest daily changes first, to the largest (up or down) at the end. Then accumulate the returns starting with the smallest, until you finally added together all returns ending with the largest daily movement (not considering when it happened in time).
How it’s described in the research paper
“Graf showsthe ranked amplitude P&L of the three Fama-French factors in the US since 1950. Clearly, SMB and UMD show the typical humped shape observed for the market ERP in the previous section, therefore corresponding to a negative overall skewness equal, respectively, to _∗= −1.39 and −1.38. For UMD, the 5% largest events contribute to losses that amount to 20% of the gains accumulated by the 95% small to moderate returns, whereas for SMB nearly all the gains are erased by the 5% largest events!”
This clearly shows that investing in small cap stocks works extremely well in normal markets, with great out-performance. BUT, when we start to see larger moves in the factor, it gives it all up again. As we know (also from other research) most of the extreme moves happen when markets fall sharply. So investing in Small Cap stocks really is like picking pennies in front of a steam roller, it works great, until it doesn’t and at least historically it has not added any major outperformance. Saying it in another way, investing in small caps has a cycle of out and underperformance. Both Value and Momentum investing has historically shown both much better outperformance – and skewness results. Which is very attractive if you as me are afraid that we are in the late stage of the bull market. So for all of you out there who made great money in the small cap space – well don’t expect to get out at the peak, get out now. I will also try to minimize my exposure to small caps going forward.
Value investing decent protection and opportunity
So I have previously alluded that it’s been tough going being a Value investor for quite some time. What I mean by that is that the Value factor has been underperforming. Of course Value can be defined in many different ways, the easiest being just ranking companies by Book to Price. Some investment banks have come up with more refined ways of defining it. I chose to present such a way, which is Pure in the sense it’s neutralized for Beta and Sector risk. As can be seen it has been doing very poorly. Keeping in mind the nice properties of Value outperforming in shaky markets that we just learned about in the skewness graph (blue line in graph above). Together with it’s current underperformance, it might be high time to start loading up on those Value stocks. And definitely something I have to spend some effort on since my portfolio is too geared towards high growth companies at the moment.
It should be mentioned that this is mostly conclusions drawn on the European stock markets. The relationships in SMB in the US is at the moment are not the same. Much due to the S&P still at its all time highs, with some seriously large companies performing very well, so we are clearly in different stages of the cycle. I’m of the firm opinion that some larger stocks in the US are also valued too high.
My next post will be about some seriously outstanding results and stock performance of my holding in the battery company Coslight Technology.