Category: Investing

Categories
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.

Categories
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.

Categories
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.

Categories
Investing

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.

Categories
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.

Categories
Investing

A Review Of Current Risks

I had hoped to hold onto my NZX and ASX listed stocks for years to come and ride out any dips in the markets, with the view that my stocks were of such quality and a good balance that I could just get a nice dividend return to cover my retirement.

Also, the planned exit from one of my private equity holdings would be significant enough to cover any losses and secure my position. However as inflation unfolds around the world, with some countries experiencing hyper inflation and comments from the BoE saying that they’re not going to shy away from generating a recession to curb inflation, I had a moment of panic yesterday and sold some stocks. Specifically my panic was that as my private equity exit isn’t happening as early as planned (and I might end up holding for more years to come), if the RBNZ were to put rates up this could mean that I am unable to service my mortgage in future and my stocks could become so undervalued that I would be bankrupt with a negative equity situation on my home.

As I’m feeling a bit calmer today, I decided to reconsider things with a goal of holding on to as many of my stocks as possible, particularly the more resilient ones, while diminishing the possibility of bankruptcy from my future.

The first thing to consider is a summary of what’s currently going on that might affect me, so I made a list:

  • Inflation for all goods due to monetary policy and COVID related supply issues
  • Inflation of food and fuel throughout the world due to war related supply issues
  • Inflation of wages in NZ due to lack of labour supply
  • Wealth destruction from NZ housing policy
  • Wealth destruction from falling share market due to all of the above
  • … and it’s going to be a contentious one, but I’m going to add an incompetent NZ government to this list, too.

Looking at how this might play out, it seems that COVID is here to stay for a few more years; and while the war in the Ukraine is a bit of a wild card, from my research into Russia’s military losses vs stock, when considering the time it takes to resupply their losses, it seems that Russia can keep up their invasion indefinitely if they choose to do so. This means that consumer price inflation is likely to stay for a while – certainly at least as long as the war and sanctions persist.

From what I can see (with the limited research I’ve done), the media’s reporting of house price falls lags significantly (about a month). The superior data that I’m fortunate enough to have access to suggests that things might be a lot worse than reported, with houses similar to mine having fallen by 23% where I live (based on a limited dataset – I should probably do more research on the other data). What’s worrying about this, is that it’s likely common consensus that the housing market is in a downward trend, which becomes a self fulfilling prophecy, pushing prices down further. The same can be said for losses in the stock market, though this is forward looking in a different way.

Wage inflation is in my opinion, the only thing that’s allaying a recession. Here’s why I say that and why I was panicked yesterday.

Inflation results in high interest rates (aimed to reduce spending) which results in less spending by consumers. This results in less company revenue and then poor company outlook, which results in less company investment. When companies invest less money, they hire fewer people, resulting in less demand for labour and fewer jobs. This results in less money in the hands of the public, which results in less spending by consumers (which loops back to the start, causing a downward economic spiral that is difficult to manage. Even if this is managed well by our current government (I say government rather than RBNZ because there are problems in supply that cannot be fixed by monetary policy alone), this difficult challenge will have to be handled well by more than most governments of the world to avoid global contagion of financial issues.

To compound the problem, the above also results in lower house prices, due to less buyer capacity. Lower house prices are a particular problem for NZ because a lot of wealth is held in houses. The loss of the wealth effect from people having value in their houses looks like this:

House prices go down, which means that people have less borrowing power (think: LVR). This results in less spending which is the cause for the downward economic spiral I mentioned in the former paragraph.

As I mentioned before, wage inflation is the only thing that can allay a recession because it enables people to keep spending, and gives them enough money to pay more for goods and services, which means that companies can pass on their costs, keep their profits up and therefore keep investing, which means more people hired… etc. In other words, it breaks the downward spiral.

Because of this, I am keeping a sharp eye on retail stats which I believe are a bellwether for wage inflation. Unfortunately, even though I have things like Paymark stats that can give indicators, I can’t tell if costs are being fully passed on to consumers until retail stocks publish their NPAT figures. I believe that a fall in consumer spend reported by Paymark is an early recession indicator, but a flatline or below CPI increase is an indicator of a possible recession.

In terms of my strategy (without discussing the specifics), I will:

  • Assume my exit from the private equity will not eventuate
  • Assume that my 6 figure shareholder loan will be paid back at the start of next year
  • Use that money and other money from yesterday’s fire sale to reduce my mortgage as terms allow
  • Consider locking in a multi year term for my mortgages that come off fixed rates
  • Continue to hold onto my high quality stocks for the long term – which includes a retail stock that will likely struggle, but has a history of always paying a dividend
  • Not bother selling the remaining handful of lower quality stocks whose value is sufficiently low that it’s wouldn’t change my financial position to sell anyway (The value of which is about $4,000)

In the event that I lose my job during a particularly bleak recession, I will use the value in my listed stocks, savings and hopefully shareholder loan, to try to outlast the recession.

Risks to my strategy are:

  • I lose my job AND (the shareholder loan defaults OR stocks drop in value by >60% from their current position and I can’t get another job for 6 months)
  • Interest rates go crazy after next year when my largest mortgage expires and I don’t get pay rises. The level of “crazy” depends on what other failures happen in my investments that prevent me from paying down my mortgage.
Categories
Investing

2022 Stock Picking Competition

In last year’s stock picking competition, my picks gained a mere 10.8%, mainly lacking due to my selection of Ryman Healthcare (not a stock in my personal portfolio) and Fisher Paykel Healthcare not gaining much (a stock held in my personal portfolio, but as a bond proxy). Not bad compared to the NZX 50 which was in the negative for the year and not bad compared to the brokers picks, only 2 of which beat me (Forsyth Barr and Jarden). I’m not pleased with my result overall, but I didn’t expect much as this time of year is a difficult one to buy stocks after the Santa Rally and there wasn’t a lot of thought that went into it due to the holiday.

Hopefully I’ll do better this year (though I don’t have high conviction for this statement). My picks for 2022 are:

  • MFT
  • FRE
  • HLG
  • SCL
  • TRA
  • Sixth pick: SKL

I have to say that it’s hard picking out some stocks that aren’t currently over-priced and also have potential tailwinds for the coming (highly unknown) year. As with last year, very little research has been done in preparation for these selections. I picked these selection based on inflation expectations, previous performance and in the case of SCL, orchard fruition coming in 2023 (in the hope they’ll re-announce this towards the end of year and get re-rated). 3/5 of the above picks are in my personal portfolio.

Disclaimer: These picks (or anything on this website) does not constitute financial advice and [as inferred in the article] very little research has gone into this selection of stocks for the purpose of this competition.

Categories
Investing

Snowball Interview Part 2

It seems that the second blog article covering my Snowball Effect interview was released in early September.

I highly recommend reading this, as it nicely summarizes something I’ve written about before on how to make an investment strategy.

Categories
Investing

Buying Cryptocurrency In NZ

I’m vehemently against cryptocurrency as an investment for a number of reasons that I won’t go into in depth in this article (think: no intrinsic value, no laws governing the currency, no reason for particular cryptocurrencies, to many scams around, etc.). For me it’s not really investing because investing is about calculating return based on real factors; cryptocurrency investing is more like gambling in my opinion.

Nonetheless, I decided to partake in the fun and buy some Ethereum (ETH) and Bitcoin (BTC). I figured $1,000 on each wouldn’t do any harm and wouldn’t be the end of the world if I got scammed or lost my money in some other way (lost wallet, hardware failure, virus, currency related issues, etc.).

After reading an article on MoneyHub, I signed up for EasyCrypto. EasyCrypto is not a crypto exchange (matching buyers and sellers), but instead it’s a retail shop (selling you currency and buying it off you, making profit on the difference). Upon preparing to make my purchase, I noticed that the fees are very different for small purchases (~$100) vs “large” purchases of a whole crypto token ($6,239). Here are the prices I was offered:

NZD$6,239 = 1 ETH
NZD$105 = 0.01190783 ETH

EasyCrypto’s price to buy ETH vs NZD at the time of writing

If we divide NZD$105 by 0.01190783 to get the price for the whole coin, that gives NZD$8,818. That’s a 41% increase in price for buying a smaller unit of ETH, which is a phenomenal difference if we consider that the brokerage fee.

I didn’t bother looking at the difference in sell price (which could be less favourable as they may consider having you by the #@!!$ because if you’re buying from them, you might not have the technical nous to sell elsewhere), but if we assume that it’s similar, you’re looking at an 82% increase in your ETH investment to break even when buying and selling with EasyCrypto. This number is worse if you compare it to the ETH price listed on Google, rather than the rate they sell for when buying a whole unit of ETH. This shocked me enough to not even bother investigating the fees for the small volumes I was looking to buy.

In EasyCrypto’s defence, I guess it could be argued to be a fair rate; after all, a retail shop of any other nature might have similar markups and they are dealing in a commodity whose price can fluctuate wildly – coupled with the fact that purchases may be automated through the website and therefore subject to additional fluctuation risk.

However, given the fees of EasyCrypto I think this precludes me from making any investment through this website. Perhaps a crypto exchange is the way to go if I were to pursue an investment in cryptocurrency?

Categories
Investing

Thoughts On OCR Increases And Inflation In 2022

I’m feeling bearish about the economic impact of the RBNZ’s position on increasing the OCR.

The OCR is typically increased to reduce the economy’s propensity to spend money (AKA reduce demand) to cool an overheated economy, but also to put the central bank in a position where they can drop the OCR to stimulate demand in future, as required.

Inflation is a key indicator (and cause for concern) of an overheated economy; hence the RBNZ has started on the path of OCR increases to cool the inflation before it creates instability in the economy.

However I do not believe that OCR increases are the right tool to reduce inflation in this case, and I believe that OCR increases may actually harm the economy.

I say this because while increasing the OCR is a great way to keep price increases in check that result from a flourishing economy, that’s not what’s happening here. Instead we have a performant economy that is threatened by high prices due to supply issues.

The difference is subtle until you consider a supply and demand diagram.

If we consider a supply and demand diagram, we can see that as an economy performs well, participants have an increased propensity to buy (increased demand) and this pushes up prices. In this scenario, increasing the OCR is a great way to keep demand in check by presenting buyers with a more preferable alternative of a higher ROI for their money in the bank and reducing their debt levels. The below supply and demand diagram illustrates an increase in demand due to a flourishing economy.

A flourishing economy results in an increase in demand, causing prices to increase. This can be remedied by increasing OCR to decrease demand to a more desirable level.

Unfortunately our economy isn’t suffering from increasing prices due to increased demand (much). By far the greatest pressure on prices is due to a lack of supply caused by COVID related logistics issues and other supply constraints (lack of lorry drivers, shipping queues at ports, labour shortages, semiconductor shortages, etc.). This is represented in the below demand and supply diagram, which depicts the effects of a reduction in supply.

A reduction is supply causes increased prices and lower quantities of sales.

Let’s have a look at what happens when the OCR is increased to reduce demand along with the already reduced supply.

Reduced supply causes less to be bought and increases price. Reducing demand reduces the price, but at the cost of reducing quantities bought. Reducing demand to drop prices back to levels seen before a decrease in supply causes a massive reduction in quantity traded.

As we can see from the above diagram, when the OCR is used to tackle price increases from a reduction in supply, one of two things can happen:

  • The demand isn’t reduced enough, resulting in high prices and lower quantities traded
  • The demand is reduced (at least) enough to match prices before supply decreases, resulting in larger drop in quantities traded

In both scenarios we see a drop in trade and most likely this won’t fix the inflation problem (at least not without significantly damaging the economy). A drop in trade means a poor economy, job losses, business closures / contractions, etc.

I would argue that as the economy isn’t overheating and is performant, that minimal interference is appropriate. Also, as a lack of supply is causing price increases and the government can’t fix the lack of supply (I won’t discuss policies that could help remedy this situation right now), we’ll just have to try to cope with the increases in prices for now and suffer the consequences (which could mean permanently higher prices in some industries).

Finally, I will leave you with a definition of poverty, where poverty is described as people not having things (lack of supply) and not being able to afford things (high prices).