Getting defensive

This post is inspired by a question from a friend of how I like to play defense with my investments. 2018 has so far felt like treading water investing wise. Working pretty hard, not too much to show for it. That is the feeling. Numbers wise my account is up ~12% will SIXRX is down 2-3%, so I shouldn’t complain. My stockpicking has been a bit more spotty in the past with some decent successes in e.g. Xintela, Irisity, Smart Eye, KV77, Rottneros to name a few. However my largest weighted picks, Storytel and Xbrane have had a tough year. A lot of learning from those that I’ll try to write about in a future post. Here we’ll dwell on the macro outlook and how I’ve tried to adapt the portfolio the match the environment as it develops.

So the big picture is that central banks are, starting in the US, becoming less accomodative. This is expected to continue in Europe. Historically this has been tied, with some lag, to less favorable equity markets. The rising interest rate has, through the discounting mechanism, a stronger effect on the cash flow streams with a rising future payment. Such as growth stocks. Liquid assets are hurt less. Perpetuities such as preferred shares are hurt less since current payments are high. They will, all else equal decline, in both real and nominal terms with a rising interest rate. Inflation hedged cash flow streams, such as e.g. a tobacco company with pricing power (Swedish Match) will be able to increase their prices and have a stable demand outlook even in tough times. For this reason their cash flow stream can be expected to stay constant in real terms (rather than the nominal constancy of preferred shares). The cash flows will however be discounted more than at a lower interest rate. If they are also loaded with debt, such as SM, those payments will increase as well. So they are defensive, but only in relative terms.

Less coupled to interest rates are cash and commodities that always have utility value in the present moment (not counting commodity stocks here). In relative terms this will also apply to stocks holding such assets.

Currency-wise, the USD has been linked to relative outperformance in risk-off environments. There are arguments for a weaker dollar over the long term. I feel this will be overshadowed by the value of the reserve currency status, which is still mostly in place, during the coming 2-3 years. If this turns out to be the case exporters with costs in weaker currencies and incomes in dollars will have a slight cushion against the discounting of future cash flows in the form of increased growth at least over the medium term.

The opposite of being liquid is to need an influx of capital. Capital will become more costly to tie up than what the last decade has taught us, and cash drainers will likely see dilution at a level higher than they planned for before reaching profitability.

So to summarise, stock-picking should place an increased emphasis on:

1) Low capital needs

2) Exporters, primarily pricing in USD

3) Net cash rather than debt

4) Current profitability and profit levels

5) Demand resistant to recessions

If I match this to some stocks I like I see that MIPS checks 1,2,3, half of 4 and 5. It has also become expensive, so I have still sold most of my position.

Storytel has 1) thanks to funding themselves in the middle of the summer. They also have 5). Weaker on 2,3,4. Still, valuation has already come down and I see no reason to sell heavily now. Execution from the company and traction in the market seem stable to good.

Mekonomen has, after their purchase, 1,4 and 5.

SAAB are currently taking on more capital. Apart from that, they have 2, half of 4 and all of 5.

Forestry, e.g. Latvian forest, have 1-4) down pat. 5 is debatable, but current profits will not drive valuations as much as NAV. I have increased my holdings in Latvian during the autumn.

Gambling stocks, especially a service provider such as Evolution Gaming, has many of the qualities seen in 1-5. I have a minute position, but will evaluate it further inspired by writing this. I have an emotional problem with many gambling stocks, but Evolution are at least providing work for many young people and providing some form of real social interaction.

Banks have stable demand and high current profitability. Some prospects of raising interest margin with higher rates. Insurance companies have the same picture on the demand and profitability side. Interest income can increase with higher rates. Effect on profitability of claims inflation can usually be handled by price indexing. Here my main pick is Storebrand which in addition has a fairly sizable life portfolio where the liabilities will decrease in relative terms with an increasing interest rate. Sampo is also interesting and I have a small position. They are a counter-cyclical player that is currently well capitalised, e.g. high points on 3) above, as well as 1,4 and 5). The only fear is how declining new car sales and possibly an aging car fleet in case of a recession will hold back premium growth. On relative terms to other P&C insurers in the nordics recent results have been outstanding.

What to sell?

Growth plays of all kinds, especially those where unsure of eventual success or possible capital needs. List to come, but some obvious candidates are:

ClimeOn,Veoneer,Immunovia (I like the co..),Hövding (I like this co though..), BIMObject (demand in construction a headwind?),Optifreeze, Alzecure after IPO, Risk Intelligence. Feel a resistant to do this, but I think I will force myself to do it, and do it on a market up day since we seem to have a daily sigsaw going lately.

Apart from stocks and cash I have about 1% invested in put options for end of 2019, 15% below current level of OMX index. Also 5% in USD cash, 3% in gold and a few % in commodities. Now what remains is to be patient till it gets really cheap sometimes in the next few years, and not get left behind waiting for a bottom that never comes. I expect some leveraged players to have a thin sliver of equity when it turns, and have a quick ride up. Hope to take advantage of that when the time comes.

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