The investment world can be split into many camps, but, in discussions of risk, owners and custodians of capital, their agents, academics, analysts and journeymen pitch their tents firmly in one of two camps. In one field we have those for whom risk means the probability of a permanent loss of capital which would cancel all hope of achieving an investment objective. This group will oft reference the Sage of Omaha, Warren Buffet, who has been robust in his observation that risk is not synonymous with the preferred definition of the other camp – volatility.

In business school classrooms, university lecture halls and many of the world’s largest asset managers it has been standard practice to use volatility, or the “spikiness” of a price chart, as a proxy for the risk of a tradeable asset, sector or asset class. The use of volatility stems from the study of the role markets play in setting the price of individual assets in the short term. It is the role of markets to rapidly assimilate information and establish a price. The mechanism by which this is achieved is the assessment of future returns by a myriad of market participants, each of whom will establish a fair value and then trade the asset using deviations from fair value to determine the buy or sell decision. For assets with a clearly defined profile of cash flows, such as a bond, or the equity of a utility company, the assessment will not differ greatly from one participant to the next over short periods of time, and thus, volatility will be low. On the other hand, where there is significant divergence of opinion on the likely outcome for a company, volatility will be higher. Volatility is therefore a measure of the difficulty short term price setters have in understanding likely outcomes for long duration assets.

Friends of Warren would chuckle at the preceding paragraph. The reason for this is that the speculator’s measure of risk is the long-term investor’s friend. Volatility provides long-term investor with the opportunity to reinvest cash flow into an asset at times when the market’s short term view of the asset is unfavourable. The result is that the long-term investor can enhance returns by taking advantage of the market’s near-sightedness.
The use of volatility to assess risk of individual assets is extended to analysis of portfolios and plays a central role in the optimistically named “Modern Portfolio Theory” written by Harry Markowitz in 1952. Sorry Harry, no longer modern but sadly still a theory. We find that the volatility camp will measure the up and down movements of a portfolio and use this as a measure of the risk being taken by the portfolio manager. We now find ourselves in a rather mixed up world with a short-term measure of risk being applied to an activity which is (hopefully) undertaken with a long-term perspective.

Some long-term investors doggedly shun any use of volatility as a measure of risk. We take a more nuanced view. As a measure of investment risk, volatility falls short and simply minimising volatility is not a sure way of avoiding permanent capital loss. This can only be achieved by in depth analysis of prospective investments and selection of only those that meet a sensible set of investment criteria. However, for as long as capital is owned or placed in the trust of humans who bristle with the emotions of fear and greed, volatility will represent a degree of behavioural risk, which, for want of a better expression we might describe as the danger of doing something stupid: a highly volatile portfolio will present, with some regularity, an individual or committee with the opportunity of turning a short term disappointing performance into a long-lasting destruction of capital. The sage advice at these times is: “Don’t just do something, sit there”.

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The trade-weighted U.S. Dollar Index (DXY) is the de facto benchmark used to gauge the value of the US dollar devised by the ICE. The index is a weighted geometric mean of the dollar’s value relative to a basket of six currencies, where both the constituents and the weights have little changed since the series began in 1973, except to account for the creation of the Euro. The index can be decomposed as follows:

Exhibit 1: The composition of the trade-weighted US dollar index (DXY)

Currency Weight
Euro 57.6%
Japanese Yen 13.6%
Pound Sterling 11.9%
Canadian Dollar 9.1%
Swedish Krona 4.2%
Swiss Franc 3.6%

Source: ICE

The term ‘trade-weighted’, however, appears somewhat inappropriate on this occasion. For one, with the Euro accounting for nearly 60% of the index weight, it renders the DXY Index into a predominantly USD/EUR phenomenon, where the fate of the Euro has an outsized impact on the index value. For the period 1975-2015, the correlation coefficient between the two are as high as 0.98 based on monthly data (Exhibit 2), and on average, the EUR accounted for over two-thirds (69%) of the movements in the dollar index (Exhibit 3). Adding GBP, CHF and SEK into the equation, the index becomes overwhelmingly Europe-centric at 75% weighting.

Exhibit: 2: The DXY Index versus USD/EUR since 1975

Source: Bloomberg

Exhibit: 3: Breakdown of the 12 Month rolling returns of the DXY Index by currency

Source: Bloomberg

Actual trade data points to a different picture. The Euro Area currently represents 16.6% of US total foreign trade (imports plus exports), its position as the largest trading partner to the US was taken over by China in 2009, who today makes up 21.5% of US total foreign trade. Sweden and Switzerland, together accounting for 7.8% of the index, are also less significant compared to 30 years ago, not to mention that the Swedish Krona weighs heavier than the Swiss Franc, which in itself begs more questions. At present, Switzerland is the 11th largest player (1.8% of total trade), while Sweden ranks much further down at 23rd in size (0.7%).

Exhibit 4: US Total trade (import plus export) by country, in percentage terms

Source: Federal Reserve

In context to this, the other shortcoming in the composition of the index is consequently the lack of Emerging Market representation. The importance of Emerging Market countries as trading partners to the United States have risen over the past twenty years, in particular, the total trade in 2014 ranks China, Brazil, Mexico, South Korea, India, and Taiwan in the top ten by size, outnumbering their traditional developed market counterparts (Euro Area, Canada, Japan, and UK). This, in turn, means that 44% of the total US foreign trade is unaccounted for by the so-called ‘trade-weighted’ US dollar index.  It therefore makes sense to consider alternative compositions and weights for the USD currency basket with a view to a more representative picture.

Such indices do already exist, although not widely adopted. A number of broad US dollar indices have been created that are closer aligned to evolving US trade patterns, including the US Trade-Weighted Broad Dollar Index[1] built by the Fed in 1998 consisting of a basket of 26 currencies that captures well over 90% of US international trade (weights as seen in Exhibit 4). The basket weights are adjusted annually, and the index can also be split into two sub-indices: Major Currencies and Other Important Trading Partners (OITP), where the weights are derived by rescaling the currencies’ respective weights in the broad index so that they sum to 1 in each sub-index.

The Major Currencies index closely resembles the DXY index in composition, consisting of the seven most liquidity-traded currencies with the only difference being the addition of the Australian dollar to the mix. The OITP index includes mainly EM trading partners and smaller players.

Exhibit 5: Federal Reserve US Trade-Weighted Indices (Real) versus DXY Index

Source: FRED, Bloomberg

Equally weighting the currencies is another alternative that has been introduced by a number of parties in recent years. The FTSE Curex USD G8 Index includes, for example, includes a basket of equally-weighted G8 currencies: Australian Dollar, Canadian Dollar, Swiss Franc, Chinese Renminbi, Euro, Sterling, Japanese Yen, and the New Zealand Dollar.

We have also experimented with an index comprising of an equally-weighted currency basket of top ten US trading partners. The series correlates relatively closely to the DXY in its return patterns with a correlation coefficient of 0.7 since 1995, albeit breaking down into the individual components, it is apparent that the underlying drivers are very different. In particular, it shows that the recent bout of USD strength is a result of BRL and MXN weakness, in contrast to the EUR driven DXY.

Exhibit 6: Equally-weight US dollar index (Top 10) versus the DXY Index

Source: Bloomberg, Cerno Capital

Other attempts to reformulate the US dollar index intend to compare the US dollar against the most liquidly-traded currencies, using either FX volume-weighted or equal-weighted methodologies, such as the Wall Street Journal Dollar Index (16 currencies) in the former category and the Dow Jones FXCM Dollar Index in the latter (4 currencies: EUR, GBP, JPY, AUD). The rationale behind this is to indicate financial market pressures on the dollar given that all the currencies trade in liquid FX markets and used as a speculative tool.

Exhibit 7: Correlation between various US dollar indices since 1975 (based on monthly data)

Source: Bloomberg

It is difficult to judge which method most effectively depicts the value of the dollar. The FX volume-weighted strategy will also have the same Euro skew as the DXY as the Euro is the second largest traded currency in the FX market (>30%).  Equal-weighted indices will overstate the importance of some currencies. The Federal Reserve’s inflation-adjusted broad dollar index is perhaps more relevant to today’s investors, in particular, being able to examine dollar value in two different dimensions through the Majors and OITP sub-indices can be a useful tool. Although the DXY, for all its inadequacies, still tracks the more diversified Fed indices reasonably well (see correlation in Exhibit 7), and it is traded widely as the underlying for dollar-index futures. Investors needs to be aware however, of the driver behind the index movements, and also that the DXY gives only a partial representation of dollar value and will not be able to capture significant movements outside its limited currency spectrum, the CNY devaluation back in August being a prime example.

Elements of this article first appeared in the Financial Times.


[1] https://research.stlouisfed.org/fred2/categories/105

The trade-weighted U.S. Dollar Index (DXY) is the de facto benchmark used to gauge the value of the US dollar devised by the ICE. The index is a weighted geometric mean of the dollar’s value relative to a basket of six currencies, where both the constituents and the weights have little changed since the series began in 1973, except to account for the creation of the Euro. The index can be decomposed as follows:

Exhibit 1: The composition of the trade-weighted US dollar index (DXY)

Currency Weight
Euro 57.6%
Japanese Yen 13.6%
Pound Sterling 11.9%
Canadian Dollar 9.1%
Swedish Krona 4.2%
Swiss Franc 3.6%

Source: ICE

The term ‘trade-weighted’, however, appears somewhat inappropriate on this occasion. For one, with the Euro accounting for nearly 60% of the index weight, it renders the DXY Index into a predominantly USD/EUR phenomenon, where the fate of the Euro has an outsized impact on the index value. For the period 1975-2015, the correlation coefficient between the two are as high as 0.98 based on monthly data (Exhibit 2), and on average, the EUR accounted for over two-thirds (69%) of the movements in the dollar index (Exhibit 3). Adding GBP, CHF and SEK into the equation, the index becomes overwhelmingly Europe-centric at 75% weighting.

Exhibit: 2: The DXY Index versus USD/EUR since 1975

Source: Bloomberg

Exhibit: 3: Breakdown of the 12 Month rolling returns of the DXY Index by currency

Source: Bloomberg

Actual trade data points to a different picture. The Euro Area currently represents 16.6% of US total foreign trade (imports plus exports), its position as the largest trading partner to the US was taken over by China in 2009, who today makes up 21.5% of US total foreign trade. Sweden and Switzerland, together accounting for 7.8% of the index, are also less significant compared to 30 years ago, not to mention that the Swedish Krona weighs heavier than the Swiss Franc, which in itself begs more questions. At present, Switzerland is the 11th largest player (1.8% of total trade), while Sweden ranks much further down at 23rd in size (0.7%).

Exhibit 4: US Total trade (import plus export) by country, in percentage terms

Source: Federal Reserve

In context to this, the other shortcoming in the composition of the index is consequently the lack of Emerging Market representation. The importance of Emerging Market countries as trading partners to the United States have risen over the past twenty years, in particular, the total trade in 2014 ranks China, Brazil, Mexico, South Korea, India, and Taiwan in the top ten by size, outnumbering their traditional developed market counterparts (Euro Area, Canada, Japan, and UK). This, in turn, means that 44% of the total US foreign trade is unaccounted for by the so-called ‘trade-weighted’ US dollar index.  It therefore makes sense to consider alternative compositions and weights for the USD currency basket with a view to a more representative picture.

Such indices do already exist, although not widely adopted. A number of broad US dollar indices have been created that are closer aligned to evolving US trade patterns, including the US Trade-Weighted Broad Dollar Index[1] built by the Fed in 1998 consisting of a basket of 26 currencies that captures well over 90% of US international trade (weights as seen in Exhibit 4). The basket weights are adjusted annually, and the index can also be split into two sub-indices: Major Currencies and Other Important Trading Partners (OITP), where the weights are derived by rescaling the currencies’ respective weights in the broad index so that they sum to 1 in each sub-index.

The Major Currencies index closely resembles the DXY index in composition, consisting of the seven most liquidity-traded currencies with the only difference being the addition of the Australian dollar to the mix. The OITP index includes mainly EM trading partners and smaller players.

Exhibit 5: Federal Reserve US Trade-Weighted Indices (Real) versus DXY Index

Source: FRED, Bloomberg

Equally weighting the currencies is another alternative that has been introduced by a number of parties in recent years. The FTSE Curex USD G8 Index includes, for example, includes a basket of equally-weighted G8 currencies: Australian Dollar, Canadian Dollar, Swiss Franc, Chinese Renminbi, Euro, Sterling, Japanese Yen, and the New Zealand Dollar.

We have also experimented with an index comprising of an equally-weighted currency basket of top ten US trading partners. The series correlates relatively closely to the DXY in its return patterns with a correlation coefficient of 0.7 since 1995, albeit breaking down into the individual components, it is apparent that the underlying drivers are very different. In particular, it shows that the recent bout of USD strength is a result of BRL and MXN weakness, in contrast to the EUR driven DXY.

Exhibit 6: Equally-weight US dollar index (Top 10) versus the DXY Index

Source: Bloomberg, Cerno Capital

Other attempts to reformulate the US dollar index intend to compare the US dollar against the most liquidly-traded currencies, using either FX volume-weighted or equal-weighted methodologies, such as the Wall Street Journal Dollar Index (16 currencies) in the former category and the Dow Jones FXCM Dollar Index in the latter (4 currencies: EUR, GBP, JPY, AUD). The rationale behind this is to indicate financial market pressures on the dollar given that all the currencies trade in liquid FX markets and used as a speculative tool.

Exhibit 7: Correlation between various US dollar indices since 1975 (based on monthly data)

Source: Bloomberg

It is difficult to judge which method most effectively depicts the value of the dollar. The FX volume-weighted strategy will also have the same Euro skew as the DXY as the Euro is the second largest traded currency in the FX market (>30%).  Equal-weighted indices will overstate the importance of some currencies. The Federal Reserve’s inflation-adjusted broad dollar index is perhaps more relevant to today’s investors, in particular, being able to examine dollar value in two different dimensions through the Majors and OITP sub-indices can be a useful tool. Although the DXY, for all its inadequacies, still tracks the more diversified Fed indices reasonably well (see correlation in Exhibit 7), and it is traded widely as the underlying for dollar-index futures. Investors needs to be aware however, of the driver behind the index movements, and also that the DXY gives only a partial representation of dollar value and will not be able to capture significant movements outside its limited currency spectrum, the CNY devaluation back in August being a prime example.


[1] https://research.stlouisfed.org/fred2/categories/105

Friday, September 26th 2014 will be etched into the memory of followers of investment management companies and fixed income investors alike. Shortly after lunchtime, when London based manager researchers and consultants were probably settling down to an afternoon of email inbox and desk tidying, Janus Capital announced the recruitment of William “Bill” H Gross. Indeed, many will have missed this given the high likelihood of an email from Janus being ignored or deleted (Janus has struggled to reinvent itself after riding the tech bubble up and down and then becoming embroiled in the 2003 market timing scandal).

Within minutes the newswires were alive with the news that PIMCO – Bill Gross’ home for the last 43 years – eventually confirmed in a statement which confirmed the general observation that relationships within PIMCOs Investment Committee and with the business heads had become increasingly challenging.

This is the “big one” which will have transition managers salivating. Investment manager moves are not uncommon; sometimes they run a few hundred million dollars, maybe a few billion. Occasionally, a manager is responsible for a few tens of billions of dollars. The size of the AUM under a managers’ control will typically determine the workload for the manager research and investment consulting community along with the number of words written by journalists. Bill Gross is best known as the manager of the US$220bn Total Return Bond Fund and was the named portfolio manager on 27 PIMCO Funds and ETFs according to their own press release. It is probable he was named manager on many more segregated accounts run for pension funds and other institutions. As CIO of PIMCO, and given Gross’ temperament, he will have had some level of influence on every one of the US$2 trillion dollars managed by PIMCO.

The very scale of these figures is overwhelming and they are all well reported in the press which means the ‘phone of every manager researcher or investment consultant with exposure to PIMCO will be ringing and the inbox will fill up faster than he or she can press delete. Anyone tasked with coming to a reasoned opinion on the strategies that were run by Bill Gross, other PIMCO strategies and indeed PIMCO as an investment house should turn the newswires off and the Do Not Disturb button on. It behoves these consultants to now think clearly and advise their clients about PIMCO ex Gross.

Bill Gross led the investment team of PIMCO.

There was a clearly articulated investment process built around regular meetings of the upper echelons of the investment team, a team which has been expanded significantly over recent years. Depending on which of the new CIOs you speak to, PIMCO has between 240 and 400 portfolio managers.

In their communications so far, PIMCO have noted that until Friday 26th September, the investment competency operated on a founder-led model.

In plain English, this means that Bill Gross determined investment policy and strategy.

This agrees with our understanding of Bill Gross’ level of influence across the firm, built from conversations with employees past and present. The highly structured investment process allowed the firm to run a huge book of business efficiently (PIMCOs operational protocols are top-notch). Going forward, PIMCO will operate a team based model. To this end, PIMCO now has a Group CIO; Dan Ivascyn and five additional CIOs; Andrew Balls, CIO Global; Mark Kiesel, CIO Global Credit; Virginie Maisonneuve, CIO Equities; Scott Mather, CIO US Core Strategies; and Mihir Worah, CIO Real Return and Asset Allocation.

What is the collective term for a group of Chief Investment Officers? A clutch? A huddle? For evidence of this move to a team approach, we can see that on all the high profile fund strategies, a single named portfolio manager (Gross or Scott Mather) has been replaced with a team of two or three portfolio managers. These managers are going to have to spend time with manager researchers to demonstrate clear lines of accountability within this approach. They must convince investors of their ability to adapt to a new operating model – notwithstanding any protestations that they are just “doing what they have always done”.

We were told on a conference call by PIMCO’s President that Bill Gross’ departure marked the “conclusion of a prolonged period of succession planning”. This indicates that the aforementioned CIOs and others have been positioning themselves over the last year to achieve their own personal ambitions. Hence, the new structure may well be the result of a series of horse trades. There will undoubtedly be disappointments which can lead to resentment, dysfunction and, ultimately, departures. A high level of organisational instability is a clear and present danger. Of course, the fact that Gross has turned his back on the team could unite the wider group in the same way as the presence of a management consultant can act as the focus of hostility in a dysfunctional organisation causing team members to put differences aside and work together towards a shared goal. Only time will tell and for now we have a high level of uncertainty around the organisational environment in which PIMCO’s investment team members operate.

At Cerno Capital, our preference is to be confident that the investment managers we entrust with capital are sitting in a stable environment which allows them to give their full attention to investment issues when they choose to do so.

Clients of PIMCO will look to the underlying exposure of their accounts as part of their analysis of the situation. A portfolio of US Treasuries has a very different complexion in comparison with an unconstrained bond fund or a total return bond fund – the favoured strategies of Bill Gross who has historically made significant use of credit, derivative overlays and securities, a concoction which is plainly not vanilla.

It is reasonable to expect some of the assets previously managed by Bill Gross to follow him to Janus; likewise it is reasonable to expect some clients to look for a manager with less organisational risk.

This inevitably leads to a consideration of liquidity as concern grows over a destabilising event in the markets. PIMCO have so far told us that “the bond market is big”, “people forget how liquid the bond markets are” and “cash and treasury holdings are high as a result of our new neutral hypothesis”.

It is true that bond markets are big; it is also true that PIMCO is big and it is true that size does not in itself infer liquidity. Some people may have forgotten what the over-riding level of liquidity is in bond markets, but most investment managers we talk to remind us regularly that liquidity in credit markets is exceptionally poor given changes in market structure since the financial crisis. Cash and treasury holdings may be high relative to PIMCO’s recent history, but the Total Return Bond Fund exposures to MBS, credit and emerging market debt remain significant at 41 percent of total market value according to PIMCOs last summary. In specie transfers, particularly in PIMCO’s book of segregated accounts would reduce any short term market impact, however, it is reasonable to expect some turnover and leveraged investors are likely to try to get ahead of any PIMCO position unwind.

Some might view it as fitting if events resulting from Bill Gross’ departure mark a significant juncture in the history of fixed income markets.

At the risk of sounding like a broken record, the organisational risk presented by significant outflow surely outweighs any short term market impact for an existing or potential client of Gross’ former shop. PIMCO have told us that they have hired significant numbers of people in recent years. PIMCOs revenues are tied to their asset base. If assets shrink, revenues shrink and the cost base (staff numbers) may have to shrink to retain profitability. A shrinking firm is rarely a happy firm.

Then, there is a potential impact on investment performance if outflows are sizeable and prolonged. Redemptions are funded by cash and payments will therefore lift the percentage of a fund exposed to less liquid assets. If selling pressure is maintained in the less liquid parts of the portfolio, the performance impact is magnified as the portfolio moves further away from the portfolio manager’s targeted allocations. Furthermore, there is the danger of a negative psychological impact from a continual stream of redemptions that can result in portfolio managers simply throwing in the towel – typically at the point of maximum pain.

The allocator or manager researcher tasked with delivering an opinion on a PIMCO strategy or on the firm must assess the above risks and place probabilities on the outcomes. To do so will require an intimate knowledge of the processes in place at PIMCO and of the relevant individuals and their relationships within the broader firm. With a firm the size of PIMCO, this knowledge can only be accumulated over many years of working with PIMCO.

PIMCO’s clearly presented investment approach, its well-resourced investment team and highly efficient operational structure has enabled it to run large blocks of capital in both tightly defined and more unconstrained investment mandates. The efficiencies of scale result in an ability to offer active portfolio management at relatively low cost. This has allowed PIMCO to become the fixed income manager of choice on many consultant buy-lists and gather large numbers of segregated accounts from institutions and addition to institutional subscriptions to its pooled vehicles.

The investment team at Cerno maintains an approved list of manager strategies from which we construct portfolios, a key difference when compared to a consultant buy list is that we do not require multiple options in each asset sub-class, in order to cope with the multi-billion dollar accounts which follow consultant recommendations. This naturally steers us away from asset gatherers and towards firms where investment performance is the number one priority. Furthermore, access to key decision makers is a core tenet of our approach and while this is easily obtainable by look to investment boutiques, we are also able to navigate the corridors of some larger operations where we can locate like-minded investment professionals who can clearly articulate an approach which we believe will make money and crucially, who have a clear thought process around the capacity of their strategy.

Cerno Capital client portfolios have no exposure to any PIMCO funds.

“It is not unnatural that, perhaps, in this matter of being misunderstood, Japan has more reason to complain than any other nation in modern times”. These words were written in 1900 in a book titled Misunderstood Japan.

After stellar returns for investors last year, the Japanese stock market has been much less exciting this year. The numbers on the external accounts have been poor and this has prompted questions about the Japanese recovery. We have retained our allocation to Japanese equities which remains our largest single country allocation. We believe that the deflationary pall has lifted and that improved capital efficiency of companies will deliver higher profits and so significant returns to shareholders. The move out of deflation and to higher profits is only just beginning, meaning that the rerating of valuations in the market is at a relatively early stage.

Figure 1. Share buyback Programs

Share buy back chartSource: Goldman Sachs. As at 8th September 2014.

One of the key features of improved corporate profitability is shown by the introduction of the JPX Nikkei 400 index. This is an index of the most profitable companies. Sony and Panasonic have been excluded, a shaming omission perhaps. This plays into the ‘shame culture’ in Japan and those companies not ‘part of the club’ are expected to take action to change this. Another key feature of the trend towards improved profitability is that corporates are paying out more in dividends and using cash on their balance sheets to buy back shares. Figure 1 above shows this trend clearly. Currently, Japanese corporates have Yen70tr net cash on their balance sheets, this is approximately 25% of the total stock market capitalisation. Buy backs of this kind will, of course, further increase return on equity (ROE) and profitability.

Figure 2. Table showing global equity valuations

EPS Growth P/E Ratio P/B Ratio EV/EBITDA ROE DVD Yield P/CF
Name FY15E FY16E FY15E FY16E FY15E FY15E FY15E FY15E FY15E
Japan 16% 14% 14.0 12.3 1.3 7.7 9.3 2.2 8.5
US 8% 8% 17.2 16.0 2.7 9.8 16.0 1.9 10.8
Europe 6% 12% 15.4 13.8 1.8 7.6 11.3 3.3 12.4
Asia ex. Japan 9% 13% 13.1 12.2 1.6 7.1 12.4 3.1 10.7

Source: Goldman Sachs. As at 12th September 2014.

It is interesting that despite the recent slow-down in economic growth, earnings growth in Japanese has continued to be strong. Table 2 above shows how Japanese company valuations compare very favourably with other global equity markets. ROE is currently rising and on the way to 11%. It was recently predicted at a lunch held in our office by Hugh Sloane of Sloane Robinson that Japanese profits will surprise on the upside and that an ROE of 15% is very achievable, furthermore in 5 years’ time Japanese ROE will be above that of the US. The point that US corporate profitability is at an all time high and Japanese profitably is rising from a low base is well made. The chart below, figure 3, shows how all major profit drivers are moving in the right direction. Du Pont analysis shows that so far the only underlying measure that has significantly turned up is net profit margins; asset turnover and leverage are only just starting to move. It would be unlikely not to get further improvement in asset turnover once deflation has formally ended, as it removes any incentive to hoard cash.

Figure 3. Evidence of improved profitability

Evidence of improved profitability chartSource: Mizuho Securities. As at April 2014.

The other major leg in the argument is that that the monetary expansion that has doubled the size of the monetary base is bringing about an asset reflation. Property rental prices are now starting to rise, see figure 4. There are negative real interest rates currently in Japan, this is confirmed by the break even yields on inflation linked bonds. Wage growth is still sluggish, but total compensation is up for the first time in decades. The Bank of Japan is explicitly targeting a 2% inflation rate, which is a significant change from past policy.

Figure 4. Evidence of rising rents

Evidence of reflation chartSource: Barclays Research. As at 1st September 2014

The risks to all the above are that Abenomics may fail to stop deflation. While we see this as an unlikely outcome, the poor economic numbers following the sales tax increase may continue and the trend in other developed markets currently is for less inflation not more. The marginal buyer of the stock market has been the foreigner, the hope is that with the end of deflation, domestic investors will turn bullish, change their preference for liquidity and will incrementally buy more equities. This is much less likely without an end to deflation.

Japan continues to be misunderstood. When we think about the opportunity in Japan, some knowledge of Japanese history and character is useful. The Japanese domestic investment sector is of great significance. It continues to slumber for now and when it is awakened it will likely have a pronounced effect on equity market direction and tone. We suggest the opportunity is barely plumbed and target at least 40% of our equity market exposure towards Japan presently. If you would like to find out more about how we access the Japan opportunity, please contact Hannah Sharman (hannah@cernocapital.com).“It is not unnatural that, perhaps, in this matter of being misunderstood, Japan has more reason to complain than any other nation in modern times”. These words were written in 1900 in a book titled Misunderstood Japan.

After stellar returns for investors last year, the Japanese stock market has been much less exciting this year. The numbers on the external accounts have been poor and this has prompted questions about the Japanese recovery. We have retained and our allocation to Japanese equities which remains our largest single country allocation. We believe that the deflationary pall has lifted and that improved capital efficiency of companies will deliver higher profits and so significant returns to shareholders. The move out of deflation and to higher profits is only just beginning, meaning that the rerating of valuations in the market is at a relatively early stage.

Figure 1. Share buyback Programs

Share buy back chartSource: Goldman Sachs. As at 8th September 2014.

One of the key features of improved corporate profitability is shown by the introduction of the JPX Nikkei 400 index. This is an index of the most profitable companies. Sony and Panasonic have been excluded, a shaming omission perhaps. This plays into the ‘shame culture’ in Japan and those companies not ‘part of the club’ are expected to take action to change this. Another key feature of the trend towards improved profitability is that corporates are paying out more in dividends and using cash on their balance sheets to buy back shares. Figure 1 above shows this trend clearly. Currently, Japanese corporates have Yen70tr net cash on their balance sheets, this is approximately 25% of the total stock market capitalisation. Buy backs of this kind will, of course, further increase return on equity (ROE) and profitability.

Figure 2. Table showing global equity valuations

EPS Growth P/E Ratio P/B Ratio EV/EBITDA ROE DVD Yield P/CF
Name FY15E FY16E FY15E FY16E FY15E FY15E FY15E FY15E FY15E
Japan 16% 14% 14.0 12.3 1.3 7.7 9.3 2.2 8.5
US 8% 8% 17.2 16.0 2.7 9.8 16.0 1.9 10.8
Europe 6% 12% 15.4 13.8 1.8 7.6 11.3 3.3 12.4
Asia ex. Japan 9% 13% 13.1 12.2 1.6 7.1 12.4 3.1 10.7

Source: Goldman Sachs. As at 12th September 2014.

It is interesting that despite the recent slow-down in economic growth, earnings growth in Japanese has continued to be strong. Table 2 above shows how Japanese company valuations compare very favourably with other global equity markets. ROE is currently rising and on the way to 11%. It was recently predicted at a lunch held in our office by Hugh Sloane of Sloane Robinson that Japanese profits will surprise on the upside and that an ROE of 15% is very achievable, furthermore in 5 years’ time Japanese ROE will be above that of the US. The point that US corporate profitability is at an all time high and Japanese profitably is rising from a low base is well made. The chart below, figure 3, shows how all major profit drivers are moving in the right direction. Du Pont analysis shows that so far the only underlying measure that has significantly turned up is net profit margins; asset turnover and leverage are only just starting to move. It would be unlikely not to get further improvement in asset turnover once deflation has formally ended, as it removes any incentive to hoard cash.

Figure 3. Evidence of improved profitability

Evidence of improved profitability chartSource: Mizuho Securities. As at April 2014.

The other major leg in the argument is that that the monetary expansion that has doubled the size of the monetary base is bringing about an asset reflation. Property rental prices are now starting to rise, see figure 4. There are negative real interest rates currently in Japan, this is confirmed by the break even yields on inflation linked bonds. Wage growth is still sluggish, but total compensation is up for the first time in decades. The Bank of Japan is explicitly targeting a 2% inflation rate, which is a significant change from past policy.

Figure 4. Evidence of rising rents

Evidence of reflation chartSource: Barclays Research. As at 1st September 2014

The risks to all the above are that Abenomics may fail to stop deflation. While we see this as an unlikely outcome, the poor economic numbers following the sales tax increase may continue and the trend in other developed markets currently is for less inflation not more. The marginal buyer of the stock market has been the foreigner, the hope is that with the end of deflation, domestic investors will turn bullish, change their preference for liquidity and will incrementally buy more equities. This is much less likely without an end to deflation.

Japan continues to be misunderstood. When we think about the opportunity in Japan, some knowledge of Japanese history and character is useful. The Japanese domestic investment sector is of great significance. It continues to slumber for now and when it is awakened it will likely have a pronounced effect on equity market direction and tone. We suggest the opportunity is barely plumbed and target at least 40% of our equity market exposure towards Japan presently. If you would like to find out more about how we access the Japan opportunity, please contact Hannah Sharman (hannah@cernocapital.com).

Of great interest to us are the internal workings of markets. These are often very good indicators of where we are in the ebb and flow of valuation cycles. Valuations work, provided you are patient. They especially work if the constructed relationship is mean reverting and also non-mainstream.

Recently, we have been looking at equity valuation dispersions: that is, the gap between highly valued equities at one end and lowly valued equities at the other. It is unproductive to guess at where the natural relationship lies: it can be plotted and therefore a mean or average level can be observed, but does the average mean anything in this instance?

Of greater interest is when the range relationship becomes distorted due to the radical re-pricing of one group, or a thematically linked group of stocks.

 

normalised

 

A glance at the above chart indicates that, in recent financial times, this happened most dramatically in the TMT bubble which burst in 2000. In 2000 the ratio of the book multiple of the high price to book value stocks ran up to a multiple of 2x that of low price to book value stocks. Bear in mind, this is a measurement of all listed equities, not the most highly rated, nor is it sector specific. In the TMT boom, a group of telecom and tech companies became so spectacularly overvalued that they pushed the averages.

The most recent plot of this relationship is suggestive that another wave of enthusiasm is engulfing markets and in some of the same places: tech and biotech, two sectors that are very well represented in the NASDAQ index. The cumulative annual rate of outperformance of the NASDAQ compared with global equities has reached.

A simple chart of the world internet index against a world equities index reveals the magnum of outperformance very clearly.

BBIvsBBW

Turning back to our valuation dispersion chart: we note that an upswing is clearly underway. We also note that at a multiple of 1.3x, the relative valuation contortion is nothing compared to the 2000 period. Limited comfort can be drawn from this; the 2000 period measures as a 3.5x standard deviation event. It was the mother of all bubbles, unsurpassed by anything of the past 100 years and comparable only to the Japanese equity market bubble of the late ‘80s and the US residential bubbles of the ‘00s.

Financial commentators have become very sensitive in this area and the tendency to cry bubble has multiplied in recent years. Whereas we would certainly question the valuations on offer in some of the hotter concept areas, it is hard to entirely back the bubble claim.

The growth oriented equity investor is left in an uncomfortable place. In a world where the paths to commercialising intellectual property have become admirably short, we wish to invest in new technologies where human inventiveness is at its best. On the other hand, investors of every stamp know that one of the greatest determinants of value obtained is the price paid.

A cooling would be helpful now, it has just started.

 

Clifford Asness is the founding principal of AQR Capital Management. AQR is a US based, SEC registered investment advisor with approximately US$98bn under management in asset allocation and stock selection strategies which are mostly quantitatively implemented. Asness is a regular contributor to the Financial Analysts Journal and a deep thinking investor. In the latest copy of the FAJ he has a bit of fun by articulating a list of peeves. The full article is available by clicking here.

He observes a number of statements which are all too familiar and infuriating to hear; Commentators observe “bubbles” far too regularly, we agree, US Treasury Bills offers an exceptionally low return, but a return which can be justified by a reasonable argument nonetheless. Baltimore Technologies, in December 1999 certainly did not. “Arbitrage” is too often used to describe “a trade we like” rather than its true definition; “a riskless profit”. We’ve encountered this all too often in our often search for skilled investment managers. Then there are the market strategists who tell us about “cash on the side-lines”; there are no side-lines!

As a practitioner, Asness embraces technological advance; while some view High-Frequency Trading as a black-box evil, Asness rightly observes that market making on this basis has lowered the taxes that are transaction costs to the benefit of all market participants. He is less welcoming of “smart beta”. First, these products do not track market cap weighted benchmarks and should therefore be viewed as active strategies and not “better ways to gain market exposure”. Second, many implement a value and momentum strategy which are two factors very close to Asness’ heart.

Our view of risk is the chance of a permanent loss of capital. Asness doesn’t disagree but is quick to remind us that only dumb quants would use volatility without a corresponding expected return. I wonder what reaction “minimum variance strategy” elicits?

 

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