Value Investing

Iolite Patners: Thoughts On Investing In A Negative Yield Environment

Iolite Patners Core Portfolio letter for the first half ended June 30, 2015.

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Iolite Patners Core Portfolio

Iolite Patners - Market Review

Equities had a mixed quarter despite continued loose monetary policies around the globe. European markets suffered from an escalating fiscal crisis in Greece, and Chinese markets experienced a sharp correction of almost 30% in June. Nevertheless, thanks to strong gains earlier in the year, Chinese equities still ended H1 well above year-end 2014 levels. The US dollar remained strong against most other currencies as investors hoped for a rate hike (that didn’t materialize). Commodity prices remained generally weak, but the debt and shares of oil companies saw a liquidity-driven rebound.

Iolite Patners - Portfolio Review

The portfolio had one of its weakest quarters as measured by market prices, as two of the largest holdings declined substantially (I kept adding to these positions as cash became available). Rather than focusing on this decline, it is important to note that my core investment theses haven’t changed. It is also important to note that the portfolio’s Australian positions (18% of assets) might have suffered from tax selling (in Australia, the tax year ends in June). During the quarter, I exited one position (Sichuan Expressway) at a healthy profit and entered into one new position.

Iolite Patners Core Portfolio

Since inception on October 1, 2008, the core portfolio has generated unleveraged net cumulative returns of +155.0% in EUR (+113.1% in USD) and annualized net returns of 14.9% in EUR (+11.9% in USD). In other words, €1.00 invested at inception has turned into €2.55 ($1.00 invested at inception has turned into $2.13).

Iolite Patners - Thoughts On Investing In A Negative Yield Environment

Earlier this year, Finland floated a €1 billion five-year note at a negative interest rate of -0.017%. The demand for this note showed that savers were willing to pay Finland for the privilege to keep and spend their money. This is not an aberration. Countries like Germany, France, Sweden, Netherland, Belgium and Austria have seen their two-year sovereign debt trade at negative yields.

The extended run of loose monetary policy by several major central banks has led to an overabundance of extremely cheap credit, which skews everything: demand, supply, profits and the price of all asset classes from bonds to equities to real estate.

The amount of money being pumped into the system is staggering and surpasses common human comprehension. Let’s try to put things into perspective. Over the last three years, the National Bank of Switzerland (a tiny country with only 8 million people) inflated its balance sheet by USD 300 billion to prevent a strengthening of the Swiss franc against a weakening euro. According to public estimates, this is enough to fund visionary projects such as DESERTEC (an enormous solar power plant in the Sahara desert capable of supplying most of Europe with energy) or a manned landing on Mars. Either project would employ thousands of highly skilled engineers (with the expected trickle-down effect to other sectors of the real economy) and lead to enormous technological breakthroughs.

If this sounds too much like science fiction, here is another example. The Gotthard Base Tunnel, a major high-speed railway link through the Alps and the world’s longest and deepest traffic tunnel when it will be finished next year, cost CHF 14 billion to build. This is only half the amount the Swiss National Bank printed in the three months to April 2015 – after officially ending its peg of the Swiss franc to the euro.

Given the unprecedented size of global monetary easing combined with record-low yields, I believe government and corporate bonds are in obvious bubble territory and cash yields no longer compensate savers for the significant risks they are taking, be it permanent loss of capital through defaults or loss of purchasing power through inflation. While I am aware that markets can stay irrational for a very long time, it should be a certainty that, at some point, they will revert to the mean.

Fixed income instruments were long known to deliver safe and stable nominal cash yields. For the last thirty years, they also delivered quotational gains (as yields were coming down and the bubble was building up, similar to multiple expansion in equity investments) that could be realized either through trading or refinancing. In today’s world, however, a fixed income investor takes significant downside risk while the upside is severely limited: cash returns are zero and quotational gains are dependent on a scenario of yields dropping further from today’s record lows. In addition, a quick look at the junk bond market reveals that underwriting standards have dropped severely given the market’s excessive liquidity, while inflation (i.e. the loss of purchasing power) is likely to pick up given global monetary easing at an unprecedented scale.

If anything, this might be the time to borrow, not to lend, at least for those who know how to value and structure an investment. However, while leverage can enhance returns, especially in an inflationary environment, prudent investors will still prepare for the possibility of the market softening and, consequently, refinancing risk further down the road.

Income-generating assets able to maintain their pricing power (i.e. equity in businesses and real estate), if bought and sold at the right price, might provide a better way to protect and increase purchasing power over time, especially for those willing to bear temporary illiquidity and market price volatility. The beauty of owning cash-generating assets is that the upside is potentially infinite (with returns driven by normal cash generation, real growth, inflation and multiple expansion) while the downside is dependent on the margin of safety as determined by the price paid relative to a business’ intrinsic value. Of course, the difficulty of fundamental (value) investing lies in properly assessing the value of a business and maintaining buying and selling discipline.

In many cases, however, given the lack of cheap opportunities, investors continue to justify paying higher prices for equities based on perceived and promoted qualities. This might look smart as long as markets are going up, but it is destined to disappoint once markets correct. By overpaying for an asset, investors become dependent on other market participants’ willingness to pay a similar or higher price, i.e. they become speculators in what is ultimately a “Greater Fool’s Game”.

I am aware that higher inflation might make the case for bullish and/or leveraged investors seem stronger, as well as diminish the purchasing power of cash reserves of cautious investors. Some people argue that governments can’t afford a rise in interest rates, as they are dependent on inflation to help them deleverage. For my part, I wouldn’t want to position my portfolio such that its success is dependent on low interest rates, earnings growth or multiple expansion. Instead, I believe an investment should generate sufficient cash returns to pay for itself over a short period of time – either in a going concern or liquidation scenario.

I recently read up on the Nifty Fifty bubble and see many parallels to today’s markets. The Nifty Fifty refers to popular large-cap stocks on the New York Stock Exchange in the 1960s and 1970s that were widely regarded as solid buy-and-hold growth stocks.