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Week Commencing February 03, 2014

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This week we look at the following topics:1.0 Can Turkey’s economic situation recover?2.0 Monthly portfolio review and changes3.0 Forge Group (FGE) – example of fragility4.0 Educational trading video – Nassim Taleb

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1.0 Can Turkey’s economic situation recover?

This isn’t the first time a central bank has intervened to stem a currency collapse. There is a long history of markets shifting capital outside of economies when certain political forces take power. France in the early 1980s is a perfect example. Efforts were made to stem the currency collapse by lifting short term interest rates. There are other examples though of unsuccessful efforts. Indonesia comes to mind during the Asian Financial Crisis. The Indonesian Rupiah depreciated from Rp2436 in mid 1997 to around Rp7900 in the space of two years despite the Indonesian Central Bank boosting interest rates to as high as 70-80% range for overnight money.

There has been lot of press coverage over the fall in the Turkish currency over the past few weeks and the knee jerk reaction of the Turkish Central Bank to boost rates above 12% last week. The decline in the currency is due to a number of factors including political instability and a widening graft probe, a worsening fiscal situation and the flight of cash away from emerging markets as the US Federal Reserve expands its tapering efforts. The real reason for the currency decline is hard to pinpoint and this isn’t really our main focus. Instead we are more interested in where the currency goes and if there are further trading opportunities should the Turkish Lira completely collapse. How likely is this?

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Investors were clearly shaken and since the depreciation, the Indonesian currency is yet to recover. Our point here is that when a currency starts to collapse, it is very unlikely for it to recover ground. Central bank action to temporarily prop up the value of currency is a short term solution. Turkish businesses have experienced a large fall in their purchasing power and now a huge rise in the cost of borrowing to finance their operations. This will start to flow through the domestic economy, driving down economic growth and plunging the country further into a financial mess.

The sudden increase in Turkish interest rates will only temporarily halt the flood of cash leaving the economy. The Indonesian example, coupled with many others globally, will no doubt resonate among the capital elite. There is a fine balance between depreciating your currency to help improve export competitiveness and a certain currency being sold off on fear that the central bank and government situation will lead to hyper inflation. Turkey is on the verge of spilling over into the later unlike the United States which has benefited from the former. Below is a chart taken from Invast’s MT4 platform, which shows the US Dollar rising against the Turkish Lira over the past few months.

Image: USDTRY hourly chart via Invast MT4 platform

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Turkey’s economy cannot be fairly compared to Indonesia in the late 1990s. Turkey is diverse - a gateway between Asia and Europe. The economy is worth around US$800bn annually which is significantly larger than Iran at around US$500bn and more than three times the size of Greece. Turkey is the 17th largest economy in the world. GDP growth has been running at a respectable rate of 2.2% but this is likely to drastically slow as monetary policy tightens. The 74m population has generally benefited from economic prosperity over the past decade or so as trade ties and capital flows helped double GDP per capita to around US$10,665, on the most recent measure.

Unemployment is high at around 9.8% and public debt to GDP is at 35.5% which isn’t large on face value but has been steadily rising. Turkey needs to turn a corner in its domestic politics if it wants to stem the economic fallout. This will be the most pivotal point. The fiscal situation has the capacity to change but only if government confidence returns. As a democracy the next few months will be crucial. Fiscal expenses are quickly exceeding revenues and while Turkey can fund this through issuing more debt there will come a point where the market completely loses trust. We will continue to monitor the situation over the next few months to see if any European intervention helps stave off a complete government and fiscal collapse.

The reason we started this week’s publication with comments on Turkey is because very rarely in history have investors been able to trade the potential collapse of a currency. Usually this luxury has been afforded to only large institutional investors. Usually the individual investor is left with a currency that continues to depreciate and their purchasing power diminished. Invast has added the Turkish currency to its list of available markets due to strong client demand. We feel iIt’s worth keeping the USDTRY or EURTRY on your watch list.

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2.0 Monthly portfolio review and changes

Our portfolios have held up relatively well over the holiday period. We haven’t seen the types of gains which we booked late last year but given the global market turbulence and falling indices as the US Federal Reserve tapers, our portfolios have not seen any significant losses either. Keep in mind that our main focus is to beat our modest targets.

We started the portfolios off with modest $50,000 balances in each and we purposely said that we won’t be benchmarking against an index but investing according to stated goals. The most disappointing portfolio has been our Wealth Preservation – not because we have suffered losses but because our gains have evaporated. Nevertheless, our primary focus is to hold a wide range of diversified securities that allow us to sleep overnight and this hasn’t changed.

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The Wealth Creation portfolio continues to hold up well, we’re pleased with the 14% return since inception. The short S&P500 index position has worked against us since inception but we continue to hang on and it is encouraging to see markets starting to pull back. Unfortunately the depreciation in the A$ has helped offset any gains but we’re sticking to our conviction and see this as a nice hedge against falling markets. We have just under $9500 in cash and we continue to shop around for some small cap opportunities. We are likely to announce these in the next review before making new acquisitions. Any pullback in markets will create even great opportunities to enter.

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Westfield continues to be a disappointment for the Wealth Preservation portfolio, mainly around its split into two difference vehicles. The fact that the US Federal Reserve is starting to taper suggests that the US economy is improving and Westfield is a major beneficiary of this, with its vast portfolio of real estate assets. We’re digging in and holding on for at least the next year, Westfield has strong income certainty and at the very least we will be picking up a solid dividend yield in the order of 4-4.5% which helps contain any temporary losses. The IJP ETF position has also performed nicely as the Japanese market holds onto its gains and the Australian dollar declines slightly against the Yen.

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The Drawdown Phase portfolio continues to trade above our target. We sold our AMP position as previously advised and subscribed to the AMP Subordinated Notes issue – basically taking the income component without worrying about further capital downside. We wouldn’t be surprised if AMP shares actually rise following their result next month but this is a conservative portfolio and we don’t want to have any type of volatility, so future losses will also be quickly cut. The realised loss is large but the rest of the portfolio is performing strongly. We have recognised the upcoming dividends from the TAHHA and GMPPA securities that we are holding and these are sitting nicely in the cash balance now at $1139.

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3.0 Forge Group (FGE) – example of fragility

There is a big difference in the way mining construction businesses earn revenue compared to a supermarket or telecommunications provider. Contracting businesses rely on a few, large contracts. It’s all very well to win a $100m construction project but the risk of underperforming is large. Sometimes it’s better to have 10 million transactions at $10 each. The fragility of a business is often overlooked by the market – and many analysts for that matter – with too much emphasis on actual earnings in isolation.

Forge Group (FGE) shares have fallen from a yearly high of $6.98 to around $0.76 as of the time of writing. They have touched a low of $0.28. This isn’t the most important stock on the market by any means but the reason we are writing about it this week is to use it as a case study for assessing other stocks. This is a perfect example of how the market can like a business for a long time and then suddenly the value can evaporate overnight. We analyse the situation below. Forge is an engineering, procurement and construction business focused on mining regions in Western Australia. It managed to grow earnings steadily over the years by winning large contracts. The market loved the stock as work continued to pile in but what many missed was the composition of earnings.

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We as humans like to pat ourselves on the back when luck goes our way and criticise others and blame misfortune when we make mistakes. This won’t get you anywhere as an investor or trader.

From the Forge group experience, we learn the following points:

•Contracting businesses usually don’t make money over the life of the business cycle. There will come a time in the future where the financial community will try to convince you otherwise. Don’t believe them. Keep this written on a piece of paper and tuck it under a draw somewhere. Revisit in 5-10 years time when the next mining investment boom is around.•Contracting businesses do make large profits at the top of the cycle. There might be a few years where they win large contracts and everybody jumps on-board, sold the message that there is a huge abundance of work out there, but then growth usually leads to a blow up. It only takes one or two large contract losses to completely wipe out the value of a business.•Shareholders usually take the largest losses. Lenders tend to cover themselves against assets to fund business growth. Ordinary shareholders are always the last to know when things go bad and by the time the news is out there in the market, shares have probably already collapsed.•Earnings are not all the same. The earnings quality of a supermarket or a construction business is very different. One has more fragility while the other. A supermarket’s earnings growth may not be as attractive at certain times, earnings may even fall in some cases, but selling 10 million transactions at $10 each might be much better than completing one single $100m contract. You are less likely to blow up with 10 million transactions then you are with one large contract.•There is a reason why mining companies, property developers, governments and companies generally outsource construction or procurement – it is because they don’t want to take the risk. If contracting was so successful over the long term, governments, property developers, companies like BHP and Rio Tinto would all internalise the function rather than outsourcing it.

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4.0 Educational trading video – Nassim Taleb

With the above section in mind, we thought we would bring you an interesting video that caught our eye over the past few days. The whole issue of quantifying risk and being able to measure probabilities against stumbling blocks is core to our ideology. Nassim Taleb is an author which we first mentioned in our book review of the Black Swan in Invast Insights Issue 3. Taleb’s name is synonymous with risk taking and more recently being able to measure what is fragile and what is anti-fragile. There are certain ways to position you as a trade to benefit from rare events like Black Swans, but these are difficult to predict.

Taleb in this video instead focuses on being able to see what is fragile – like Forge Group (FGE) for example – and then adjusting your circumstances or investment portfolio accordingly. We end this publication with this video because it is really relevant to all of the above sections. If you watch the video you can then re-analyse the situation in Turkey and the consequences of the central bank action, you can see which parts of our portfolios are fragile and how we have tried to build robustness (particularly with the deep diversification in the Wealth Preservation portfolio) and lastly the Forge example. Taleb presents his findings at the Digital Life Design conference, click on the image below to go directly to the link with will play the short video. On his Twitter page, Taleb wrote that this is the “one thing I want to convey before I die”. Take a look.

Image: Author Nassim Taleb presenting at the DLD conference

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