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Investing

Why Cornerstone Investors Aren’t Justification For Qualifying An Investment

I had a chat with Bill from Snowball Effect a few years ago on the subject of cornerstone investors. It seemed to be his view at the time that having a cornerstone investor gives confidence to small investors that the investment is qualified (i.e. worth investing in on the same terms). I didn’t agree with this at the time, but I didn’t articulate my reasoning. I’ve given some thought to this and thought it might make a good subject for an article for the website.

In short, my logic is that an investment is only worthwhile if it fits in your portfolio. More than that however, the reason for fitting in your portfolio affects the valuation, which affects whether you should buy it or not.

Consider this: A very, very rich man may be more focused on protecting his wealth than amassing more. Therefore an investment that returns exactly the rate of inflation with no growth prospects, no way to get your money out and no way to fail would be the idea investment for such a person. That person may purchase a cornerstone shareholding and be very content with their investment.

Similarly a person saving for a house or trying to grow their savings into an early retirement might find this to be a very, very bad investment.

There are a number of other scenarios such as a cornerstone investor might be buying into an investment for leverage over a company to help one of their other investments. There are a number of other reasons a cornerstone investor might invest in something that is not copacetic to a small investors interests, but put simply, this is a common scenario why a cornerstone investor is not justification for investing, and you should always do your own research, planning and calculating.

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Investing

My Thoughts On GameStop (NYSE.GME)

This is an old article that I started writing years ago, but never finished. I thought I’d wrap up the article and publish it partly to get it out my drafts list, but also because it may provoke some thoughts and ideas, which is rarely a bad thing.

Lewis Hurst

GameStop is massive in the news right now, and the average Joe is fighting back against big fund managers and their shorting. They’re calling it Wall Street vs. Main Street, but who’s the bad guy? I thought I’d share my alternative view of the situation.

What Is Happening?

Fund managers (and others) have taken a “short position” on GameStop (NYSE.GME), which makes money on the gamble that the stock value will go down. Put simply, a “short” is when you ask a broker if you can borrow stocks from them (usually at a fee), which you sell. At a later date, you then buy the stocks back and give them back to the broker. If the stock price went down after you sold, your buy-back price is lower, so you make the difference in money. If the stock went up in price since you sold, you will lose money when you finally buy back the stock to return the stock to the broker.

There is a lot of money to be made while shorting stocks, because you often borrow more than you can afford to buy, so your position is leveraged. The down-side is that you can also lose a lot of money if it goes wrong. The idea being that the difference between a buy and sell is coverable – which dictates how much you can leverage.

Shorting is not an unethical practice in itself, but there can be underhand stock market manipulation to ensure that the price goes down.

A band of Reddit users decided to start a campaign to get the general public to buy lots of GameStop shares to push the price up, so stock shorters lost money.

Who Is Losing?

These Reddit GameStop investors sit on a high horse as though they’re doing a good thing, beating “The Man”, but it’s more complicated than that. What they’re actually doing is stock market manipulation (morally questionable) and screwing over funds whose managers may or may not be unethically manipulating the market to support their shorting.

Unfortunately it’s not “The Man” who loses out here. Fund Managers get paid a lot when they win and less (still lots) when they lose. The real losers are those who invested in the funds that the Fund Managers look after. These can be anyone, which includes retirees, pension schemes of Joe Average (working and retired people) and anyone else who happens to have had their money in those funds.

Therefore, I’m not convinced that there’s anything ethically superior in what the Reddit investors are doing. In fact, I believe that what they are doing is the opposite.

Who Is Winning?

The thing about it is, GameStop are not a good company to invest in. They’re not performing well. Therefore owners of GameStop stock will on average lose money. With this type of manipulation going on, people who sell nearer peak prices will walk away with what is essentially other investors money. This isn’t ethical in my opinion, especially because those in the best position to do that are the people organising these Reddit threads because they’ll be the earlier investors in the manipulation. It’s basically a scam.

Probably the only winners (by group) would be the company (GameStop) itself. With an artificially high share price, it’s possible to do a capital raise (which from memory is what they ended up doing) to get lots of money for other endeavors, prolonging the lifespan of the company and the jobs of those involved and giving it a chance to do something different in the hopes of saving the entity.

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Investing

When Will The Next Bull Start?

I’ve been thinking about when the next bull run could start, given the context of future events and how things could play out.

I should start by saying that I expect that there will be bull runs in different markets (such as the housing market) depending on things like the start of dropping of the OCR relative to the economy’s health. This article however, focuses on the alignment of events that will likely lead the world’s economy into the next prolonged bull market.

What got me thinking about this was the significant possibility that the Republicans (possibly lead by Trump) could take power in the next election (which I expect will be in 2024). A Republican win would herald a humanitarian disaster in Ukraine and triumph for Putin, given that:

  • Financial, humanitarian and military aid to the Ukraine from the USA dwarfs that of all other countries.
  • Trump supporters / Republicans don’t seem to be the sort of people to care about foreigners (they seem largely America-centric as per Trumps last campaigns) and don’t seem smart enough to understand the broader implications of foreign policy, never mind the complexity of how policies have come about and the effect of unwinding them.

That said, a Republican win in the mid terms would likely mean that Russia would be holding out for military defunding of Ukraine and a guaranteed prolonging of the war (if that’s not already his strategy anyway).

Fortunately it’s looking as though we don’t have to consider the above, as it looks like the Democrats may have seized it.

Economically speaking, I would expect that if America stopped funding Ukraine, this would result directly in a win for Putin, which would likely cause a return to normality for fuel and food inflation as the Ukraine suffered the new normal, whatever that may look like.

So it seems that despite my musings, we remain in no better position to predict future events than before. I have no answers for when the next bull market will break out. I will however suggest that the more things remain the same, the less will change.

That means more inflation to come, more OCR increases and more wage inflation until we hit a recession.

The best course of action seems to be to clear debt, invest sensibly (revise your financial models to consider inflation and personal risks, revise your goals, work out risk vs. reward requirements and investment allocations in your portfolio)… oh, and make sure you are highly employable to the labour market and not at risk where you currently work.

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Investing

More Thoughts On Inflation

I read an article from The Guardian which reported high levels of people retiring early in their 50’s, based on stats from the ONS (the UK equivalent to Stats NZ).

I can definitely see why this would be a thing. I’m age 40 and ready to retire once I’ve managed to exit my largest private holding (so I can put the money into something that can give me a reliable income).

We’ve all enjoyed over a decade of bull markets throughout the developed world and people must be flush with cash and/or assets which can be deployed into an early retirement.

Interestingly, NZ’s low unemployment figures suggest that this phenomenon isn’t happening over here. Nevertheless, anecdotal evidence suggests that this is also happening in other countries, such as America.

This has got me thinking about inflation risk. Yes, sorry, I’m taking about inflation again, but you were warned in the title of this article and it’s the most significant financial thing happening at the moment which needs to be considered, planned for, and therefore predicted… hostilities with large trading partner countries coming a close second (a brief note on this at the bottom of this article).

Anyway, I have two thoughts on this at the moment.

Firstly I think that with a mass exodus of the employment pool, there will likely be high inflation resulting from inefficiencies (including restricted growth) due to lack of staff, leading to supply and logistics issues. We all know what that means. This will put pressure on GDP, which will make these countries poorer by this measure.

Secondly, due to affluent newly retirees with all that extra time to spend their permanent holiday money, this could put additional demand on economies.

In other words, I foresee additional pressure on both sides of the supply and demand diagram, which leads to higher prices and less supply. To rephrase that into non school of economics speak, on average people will have less money because things will cost more and people will have less things over time because less stuff is being made. In other words, we could be looking at really big inflation over a number of years.

This change of GDP profile also adds to my theory that the trading / industrial profile of such countries will change. For example, those countries whose GDP is mostly made up of financial products might change to be mostly made up of manufacturing products. Such a change would be very disruptive to employees being made redundant, retraining and taking lower wages as novices in their new fields in lower earning companies with less money to pay people. Foreign consultants with newly required skill sets could become the flavour of the day… though this will take along time to play out.

Finally, it’s worth a quick note to say that I will be reducing my exposure to business that rely on trade with countries that could potentially become hostile and are not politically well aligned.

I feel like the coming years will be very difficult to pick long term investments in, due to the volatility, with lots of opportunities for mistakes. I suspect agile investors could be in a position to make a lot of money. This does not bode well for my aim to have minimal effort managing my portfolio and tax.

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Investing

Is Now The Right Time To Invest In Property?

Those who know me will know that I sold up my rental properties a few years ago, when it became apparent that basically the whole of NZ saw landlords as evil.

Renters were envious of landlords because they incorrectly saw them as the reason they couldn’t afford property. The media also saw them as evil and enjoyed whipping up a frenzy with renters, but more importantly the government saw them as evil and a good scapegoat for their failing policies (such as kiwibuild).

It wasn’t good business sense to be in a business that the government was trying to damage and the threat of nutty policies removing landlords basic rights made this less appealing. A history of having a couple of bad tenants also helped make my decision.

That said, being in the position I am in, with access to more property data than just about everyone in NZ, coupled with the falling property market, I find myself reconsidering whether now is the right time to buy property again.

Property doesn’t quite fit into my retirement portfolio because without considering capital gains, it has a net zero ROI after taking out amortized costs. But it could be an option as part of Plan B (if my impending company sale doesn’t happen) or post Plan A to reduce my retirement inflation risk.

Aside from the social and legal risks of owning property, I think it’s clear that a short/medium term property play could fit into my portfolio. The next question to ask is whether it’s a good time to buy property right now.

For me, I think it’s not the right time to buy property, but it could become the right time soon. The reason I say this is because my most recent analysis of current risks suggests that there’s probably more inflation to come, which means higher OCR, less affordability and therefore potentially lower property prices to come next year. There’s too much risk at the moment.

In terms of yield, rents could drop as more houses are built and immigration remains low. As houses become less affordable, more people could end up renting, but I really wouldn’t know how net demand would look when considering factors such as zero immigration, people choosing to live with family, etc. One thing that’s worth noting is that we have seen a proportional relationship between home buying and rental price, as people living in their own homes tend to reduce supply of housing due to creating fewer inhabitants per household vs. Renter households. It’s difficult to know which factors will prevail over rental prices. My gut feeling is that there will be downward pressure in rental prices over the coming year. We shall see.

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Investing

A Review Of Current Risks Part 3

In my last review of current risks, I identified a number of risks and hypothesized that inflation would tick along until attitudes towards COVID change. I think that attitudes to COVID are changing, albeit at different rates around the world, which infers that workforce efficiency could improve.

Although notably, China is maintaining it’s Zero Covid policy, which means that workforce efficiency will remain low for trades relating to China.

Addendum

Another contributing factor to this will be higher global OCR rates that will increase people’s dependence on their employment. Coupled with the fact that rates have been increased at such a fast rate that it’ll be difficult to see the effect of the volume of change, it’s entirely possible that the rate changes alone will push the world into recession early-mid 2023. All these factors will likely kill off the high demand for labour and quash wage inflation.

We also have Putin who will likely be becoming more desperate as despots who lose wars usually lose their power (excuse the pun). I feel that he will be unlikely to use nuclear weapons because everyone fairly unanimously views using nukes as bad for people who choose to live on Earth. While this won’t deter Putin personally, even his allies would struggle to defend his actions, which would give NATO the freedom to turn the full power of their technologically superior arsenal directly on Russia to set them back to the stone age and remove any possibility of future threat.

In summary, I predict that 2023 is lining up for:

  • Recession.
  • Wage deflation.
  • Continued high inflation for energy due to a continued stalemate between Russia and civilized society.
  • Medium-to-low* Medium-to-high inflation for necessary goods that depend on energy / logistics (food), though these will feel expensive because of the wage deflation.
  • Low* Medium inflation for luxury goods due to increased costs because of energy/logistics, but tempered by the lack of demand from the recession.
  • There are many countries with unconventional economic policies from unconventional leaders, such as England, Turkey, etc. Who have lead their country into a dire economic situation. I don’t know how this will affect the balance of global trade when it settles, but there could be some industries that are no longer viable in particular countries and other industries that are new to those countries due to currency values changing – this will lead to inefficiency, paucity and lower wages.
  • Property will likely continue to fall as recession hits demand, OCR reduces affordability and population growth remains lackluster.

* Revisions made due to the above addendum relating to China’s Covid issues.

It’s hard to know where best to put the money to preserve it in line with inflation, never mind investing for growth. That said, my personal financial strategy remains to cover my risk of exposure to debt by reducing liquid holdings and claw back what I can of my illiquid holdings.

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Investing

A Review Of Current Risks Part 2

I’m still trying to get my head around what’s going on in the world and more importantly where things are going, so I can act accordingly with my investment strategy. I wrote up an article a couple of months ago outlining the current risks as I saw them, but I think it’s time to review that and think about which risks are important to my strategy.

I think the current risks remain, which can be broadly categorized as inflation (resulting in recession) & wealth destruction. Ultimately I’m looking to mitigate the risk of being unable to repay my hefty mortgage due to increases in OCR / mortgage rates, while keeping my investments if possible. Let’s look at the cause of each and whether things are going to change.

Wealth Destruction

This is being caused by the falling stock market and falling house prices. The fall in the stock market is caused by fear of inflation. The cause of the house price fall is possibly due to government policy enabling people to build more property and (more significantly) restricting banks from lending.

Inflation

Causes of inflation are mainly around COVID and war, but may also be affected a little bit by the “wealth effect” from being at the end of an investment boom in property and shares (less significant). The concern is that inflation will increase costs and decrease consumer demand, which will decrease profits and maybe cause a recession.

Things affecting inflation are numerous:

  • Oil and food price increases from the lack of supply due to the Russian invasion of the Ukraine. This will likely persist for years.
  • Deflation of the value of cash resulting from money printing during COVID lock-down. It seems unlikely that this will be wound back.
  • Shipping cost increases, possibly caused by increased oil costs and labour supply issues.
  • Wage inflation due to lack of supply of labour. I’ve not understood this one until recently when chatting with a friend, who hypothesized that it’s not that companies are demanding more labour because of demand on their company; rather, employee output has decreased, so employers need to hire more people to do the same jobs that they had before. My friend believes that employee output has decreased because of COVID measures and attitudes. I.e. If an employee is sick, all healthy contacts may not be able to go to work (you can lose a whole department to that). Additionally attitudes towards taking sick days have changed: Managers are happy to allow days off without question and employees are willing to take a day of due to the slightest suggestion of a sniffle. I believe this is likely to continue until job scarcity causes employees to value their jobs more, which may happen if there’s a recession.

Wage inflation is an interesting one, because while it’s a bad thing for business costs, it seems to be the only thing keeping people spending (holding up the economy) during this time of increased costs and financial risk from increases to the OCR.

How Can Inflation Be Stopped?

Conventionally, inflation is stopped with monetary policy; specifically increasing the OCR. However, as long as people’s salaries keep going up, they’ll keep spending more because interest rates will be less of a factor for them. Therefore OCR increases cannot solve this problem without causing a recession.

The only other way I can see wage inflation stopping is if people’s attitudes towards COVID measures change and productivity increases. The idea that we all need to work more to reduce our salary is ironic. I feel that this is an unlikely scenario.

Predictions And Actions

Clearly it all boils down to how central banks across the world handle the inflation. It seems as though the options are:

  • Continued inflation and the economy ticks along until COVID attitudes and measures relax. Possible hyper inflation (my feeling is that hyperinflation is unlikely).
  • Recession caused by high OCR (mortgage cost increases)

My focus will be to keep an eye on the rate of increase of OCR vs the rate of wage inflation, which will be used to help decide whether or not exit my more liquid investments. In terms of my income, I will try to be the best, most valuable employee I can be (so I keep up with the wage inflation) in a company that looks like it will be robust through a recession (so I can keep my job). I will continue to try to exit my largest private equity position so I can clear all my debt and become financially independent. I will try to reduce my debt by paying more of my salary into my mortgage and become slightly more frugal if things look like they’re taking a turn for the worst. I may consider selling more liquid shares to reduce my debt risk, as information presents itself.

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Investing

Revaluing Shares In A Downward Market

As I watched share prices fall today, I’ve been considering how my previous calculations were all based around an expected minimum return of 5% pa after tax and whether or not this is valid anymore. The reason for this consideration is that there are some defensive stocks that I believe will continue to be profitable during the oncoming fray which appear as bargains using my previous formulae.

Before discussing this further I will share how I arrived at the value of an expected minimum return of 5% for my calculations. The value of 5% was basically the sum of the Risk Free Rate (which is the rate you can invest your money with theoretically zero risk – in my case my mortgage rate) plus a generic Risk Premium (representative of risks to the economy, outside of those factored into expected future return for the specific company) plus the amount I would like to make for taking that risk after considering tax (because my investment proposition is based on the return I want to make for myself, not the IRD).

In the derivation of the value of the 5% lies the problem, which is that the Risk Free Rate has increased and is set to increase in the coming year or more; hence the cause for concern over inflation for investors. Additionally the Risk Premium has also increased to reflect the level of uncertainty and negative sentiment for the future economy. Therefore it seems obvious that shares cannot be valued using my previous calculations.

I’ve already talked about how PE is no longer a good way to value stocks because it assumes a linear, constant progression of company earnings, but as you can see, there are some fundamental components to the way PE should be used that are also falling apart because it’s harder to assign a Risk Premium and Risk Free Rates are changing and unpredictable in the term that I look to invest in (years).

There are two components to calculating value in a company using PE: Firstly calculating the PE, then calculating what PE is appropriate for that particular company.

Lewis Hurst

The problem with investing in your Risk Free Rate option is that there’s also no risk of upside. This may change my financial models if we spend too long in these doldrums. Whatever the state of my modelling, it seems that I have no other course of action than to wait until the future of OCR changes becomes clearer, which will be preceded by tamed inflation; inflation being a sign of how the Risk Premium will be affected, also.

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Why PE Is No Longer A Good Way To Value Shares

Long time readers of my blog will have realised by now that I love to use PE to value shares (with the exception of angel investment, because it’s more complicated). I have a very handy set of graphs I use to show the value in PE over time, which I use to discern what PE is appropriate for any given growth. I like this method because it’s quick and easy so I’m less likely to make a mistake. It’s also shortsighted, looking only a few years ahead, which is great because my experience of business tells me that predictions looking further than a year are guesses anyway.

Unfortunately, given the downward outlook for the economy, my graphs have become irrelevant as they all model positive trajectories. I contemplated making new graphs assuming negative growth, but figured that there’s no point without calculating future growth beyond the negative – otherwise where is the value in buying such a stock?

A poster on ShareTrader.co.nz (I think it might have been Winner69) stated that a PE valuation is just an abstraction of a DCF valuation (or words to that effect), and I wholeheartedly agree with that statement and it’s something I’ve opined to myself before, though I would append just two extra parts to that:

A PE valuation is an abstraction of a DCF valuation, that is shortsighted and only accounts for unidirectional growth at a constant rate.

Lewis Hurst

It is in this statement that belies the fault in using PE for valuations in the current stock market; growth will likely be neither unidirectional or constant.

Therefore I posit that presently some form of DCF valuation is a more appropriate way to value listed shares in the current market, though it’s also worth remembering that any valuation methodology would have to be selected / designed with your investment strategy in mind. On that note, I feel that dividend / income investors (such as myself) should also be considering value based on a DCF rather than potential dividend value, because as profits diminish and business risks increase, dividends can be cut disproportionately to the market value of the stock; hence a dividend based valuation could price you out of the market and cause you to invest later than you otherwise would, which would end up reducing your dividend yield.

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Investing

Thoughts On Contrarian Investing & How Everything’s A Bubble

It’s our natural inclination to lean towards contrarian investing. After all, waiting on shares to increase 10% pa after year yearly result is slow, and what better way than to double your money by buying them in the half price sale during an fire sale?

The Case Against Contrarian Investing

Contrarian investing has the feeling of mimicry of amateur investors saying “Buy low, sell high” without having any way to work out what “low” or “high” is, other than based on historic cost of shares. One could say that the shares are priced lower because that’s what they’re now worth. For example, if you owned a company that lost all it’s contracts and could no longer trade, it would very well be worth less and this fact would in no way make it a bargain. In such a fictitious example, there would be no reason for the shares to ever regain their value if the company couldn’t get new contracts – which is an abstract way to describe what essentially happened during the COVID 2020 slump, though in this case despite all odds and a bleak outlook from economists and other people in the know (directors or such companies), the economy survived and share values went back up.

I think over the past few years there’s also been a lot of Winner’s Bias, whereby people who didn’t understand what they were doing, bought in the recent stock market slump, got lucky and used this success to mentally justify their skillful tactic of contrarian investing without proper analysis of value.

That’s the case against contrarian investing. Before we look at the case for it, I’d like to talk about “bubbles”.

Everything Is A Bubble

I’ve been giving some thought to markets, debt and the concept of value in an economy recently.

I started my line of thinking around the idea that we all have assets that are worth less than they are worth… Wait, what?! What I mean by that is, whenever there is a tradable asset for which there is a market (such as a house or shares), those assets have a value. That value is set by the most recent value of those traded assets. In other words, if you have 100,000 shares in CompanyX and CompanyX shares were recently traded on the market for $100 each, your shares would be worth $10m. However, if you were to try to sell all your shares in CompanyX, the volume of shares for sale would push the price down (think of a supply and demand diagram), so the total value of the company could never be as high as the market capitalisation based on the current share price.

This overvaluation is effectively a bubble and it happens in all markets. This overvaluation is often used to justify spending and offer backing for debt, which creates a debt bubble and a spending bubble. At this point it’s clear that we are always living in some sort of bubble which exists in various levels of bubble size, but how small could a bubble go before there is no bubble and we find an economy at its underlying value?

The answer to that is impossible for me to work out, but I suspect the answer lies somewhere in the value of the Net Present Value of essential goods and services produced throughout the country that can be afforded at the time without debt, plus the value of some non essential goods and services that can be afforded with debt where the debt can be serviced from trade of essential goods and services (I think that GDP value probably has too many intangibles to consider reliable and relies on debt from a bubble). The answer is clearly too complex to calculate and repudiable based on the method and purpose. In any case, it’s certainly too complicated to be used to calculate the minimum value in an asset without a bubble.

The Case For Contrarian Investing

We can see from this, that the world always operates in bubbles and that bubble can never go away due to the way supply & demand, asset values and debt work. Given this, contrarian investing could be considered the purchase of assets on the understanding that upon normalisation of conditions, the bubble will return to its previously inflated state and the assets will be worth significantly more. The gamble I suppose, is that the asset you invest in doesn’t fail or that the rate of bubble inflation isn’t slower than the rate of success of a more reliable investment.

Like every investment, I suppose it has to fit into the overall financial plan / strategy. Nonetheless, this thinking has paved the way for me to consider such an investing style in a different way.