Portfolio Positioning for 2018 and Beyond

In previous posts, I have expressed a concern about the potential for a significant correction in equities markets.

I have reduced my holdings while retaining a few which have the potential yet to register nice gains.  (See previous posts.)

My strategy is simple:

1. Be positioned to survive a significant downturn in equities markets;
2. Conduct research to identify some potential investments;
3. Invest when valuations seem to be more attractive.

1.    Weathering a Downturn

When faced with the potential for bad weather, prudent mariners take a variety of measures: sail to safe places; batten down the hatches; prepare the crew to execute measures when all goes to hell.  

It's much the same with investments: sell off companies which are likely to be more adversely affected by downturns in the market; retain more recession resistant companies; go to cash; conduct one's personal affairs with prudence.

A few brief remarks:

• Weed out the weaker members of your crew and keep the stalwarts - it is always helpful to have skin in the game as downturns are impossible to predict with any precision.  You can examine the "theoretical" capacity of various holdings in your portfolio to weather a downturn by looking at a variety of measures such as: financial strength, the resilience of the market for its products/services during bad times, quality of management and the agility of the company in adapting to change, etc.  

• Protect your stash of cash: diversify, allow for the potential for inflation, be prepared to accept lower returns; do your due diligence as some investment vehicles may not provide the expected level of "protection" due to unanticipated events.  Many assume that cash will be king - but things may change if rampant inflation prevails. 

• Adopt a prudent lifestyle: live within your means; reduce/eliminate debt; do not engage in financially risky behaviour (e.g. do anything to increase the chance of divorce), constantly improve your skill base, strengthen relationships with family and friends (one of the most sustaining bulwarks  during hard times), etc.  

2.   Research Themes

Investing is a messy process.  Like most investors, the scope of my research reflects a variety of things:

• personal interests and expertise;
• a desire to expand my knowledge by moving into new areas;
• expectations for future opportunities;
• attitude toward "risk"; and,
• a variety of other personal  considerations e.g. energy, level of self confidence, willingness to allocate time to investing etc.  

Through experience, I learned that my greatest successes were the result of sustained personal effort.  I love the search, thirst for new learning, and enjoy  the challenge of managing a portfolio.  It's not for everyone.  

Here are a few research themes - a mix of "enabling" technologies and processes (e.g. robotics, internet merchandising) products and services (usually with a focus on specific economic sectors), and other "emergent" areas of interest which are novel and worthy of further investigation "just because".  

Mines and Minerals

Why?  Because:

• demand is still increasing and, in most instances, technological innovation will not reduce demand to the point where investment will be unattractive
• supply is, in most instances, getting more difficult to bring on line

In previous posts, I expressed by admiration for  the work of Richard Schodde.  One of his recent presentations is insightful: 

"Long term trends in global exploration – are we finding enough metal?

Here is the summary: 

 – are we finding enough metal to meet the future needs of the World?

The key commodities of interest were gold, copper, nickel and zinc/lead.

The methodology used involved forecasting the likely future level of global expenditures on exploration (which are driven by the commodity price) out to 2040; This is then divided by the projected long-run unit discovery cost (in $/oz or $/lb) so as to calculate the annual discovery rate (in Moz  or Mt metal).  The resulting rate was then adjusted downwards for the fact that not all discoveries turn into mines.  This adjusted figure was then compared against the projected future mining rate for each metal – from which it is possible to determine whether the World is  finding sufficient metal to meet its needs.

The key conclusion was  that … when you look out over the next 10-20 years the projected discovery rate isn’t enough to keep the market in-balance for many of the nominated commodities.  The shortage is particularly severe for nickel and zinc, and lesser so for  lead and gold.  Copper seems OK ... but that is based on a fairly conservative forecast for future metal production, which ignores any massive up-tick in demand from electric cars.

Taking the 10 year view industry needs to boost the amount of gold discovered by 45% over the base-line forecast to stay in-balance.  For lead, zinc and nickel the rate of discovery needs to rise by 41% for zinc, 72% for lead and 156% for nickel.  The situation is even more challenging when you take a 20 year view.

The above analysis assumes a unit discovery cost of US$45/oz for  gold (and rising) , 3/clb for copper, 3 c/lb for zinc & lead and  28c/lb for nickel sulphides (and rising).  It also assumes a long run commodity price (in 2017 US dollars) of $1175/oz Au, $2.75/lb Cu, $1.00/lb Zn, $0.85/lb Pb and $7.30/lb Ni.  These prices are based on the latest consensus view of industry analysts.

The study estimates that World exploration spend will rise by 65% (in real terms) over the next decade.  Even with that up-tick that’s still not enough to balance the market !

The clear conclusion from the above is that, for the global mining industry to sustain itself, it either needs to either reduce production, or increase the exploration spend (by more than the 65% currently projected), or it needs to be much more efficient at discovery (i.e. find more-for-less by a factor of 2x) or the commodity prices have to rise above that currently projected by the analysts; Or all of the above.

I will start my analysis by looking at the demand for various mining products.  Once done, I will look for specific companies.  That search will encompass all companies which have a stake in mining: suppliers of goods/services, miners, smelters, financiers, etc.

Here a few considerations related to future demand:

• supply (now and potentially)
• forecast demand for various uses
• things with the potential to alter supply and the movement of products to market (e.g. geopolitical instability, government regulation, technological innovation)

The intention is to develop a "view" and then to drill down for investment opportunities, usually in the form of specific enterprises as opposed to speculating in metals futures. 

Here are a few considerations related to investment opportunities:

• The first step will be to develop a systems model of the sector with a view to identifying the participants in a meaningful context (in the past, this exercise has revealed some precious nuggets of opportunity in various sub-sectors)
• The second step will be to identify specific potential investment opportunities promising sub-sectors.  I have written about this in previous posts.  Briefly, this will include: the quality of management (first and foremost); state of the geopolitical environment (e.g. respect for the rule of law, social stability etc.); cost and ease of bringing production on line to meet demand (I have a preference for operating mines where production could be ramped up quickly), competitive position of an enterprise relative to its peers etc.  

In future posts, I will present a high level synopsis of other aspects of my research themes.  

Failure of a Stock to Perform - some questions to ask

My reason for making this post was prompted by the following article:

The 12 Signs a Cheap Stock is a Value Trap

I thought, why not explore the use of the "12 signs" as avenues of inquiry when assessing potential investments?

In reading the article, you will note that most of the important signs do not address financial metrics directly.  It accords with lessons I have learned in thirty years of investing. 

When considering a potential investment, I look at a few key financials:

• various measures of indebtedness and the financial fitness of an enterprise to survive hard times
• trends in income
• expenditures and returns for various categories of expenditures

I spend more time on "non-financial" metrics. Why?  Because creative accounting can hide a lot.  Financial analysis constitutes the bulk of most analyst reports.  Why?  Because analysts are time pressed.  It's easier, faster, and safer to take the conventional route of going through the mechanical routines of standard financial analysis.  In my view, it is akin to creating a picture by using a "paint by numbers" approach.  There is also an element of "financial alchemy" to this process; namely, "forward earnings estimates".  At best, these estimates are based on hopes and wishes.  At worst, they are the products of shills.  As such, I hardly ever read reports by financial analysts.  And when I do, I always ask the questions: Why is the report being written?  Who stands to benefit?  There is no such thing as "altruism" in the equities management business.  

I am far more interested in investigating other aspects of an enterprise:

• the quality of its management (track record, governance and the make-up of the board, honesty, experience in the field of business)
• strategic plan (is it clear, concise, and purposeful?)
• positioning of the company's products/services relative to its competitors
• customer reaction to products/services
• quality of the workforce and worker assessment of the enterprise as a good place to work

I have written about this at length in earlier postings.  

In the end, businesses are all about people.  Financials are only a second-hand indicator of performance over the longer term.  That is why I maintain my positions with Clean Seed Capital and Questor (see earlier postings).  At one point, the stock price of Questor fell by more than 50 percent.  I ignored the charts because the sustaining power of the businesses rests on a few key attributes:

• seasoned management with a real understanding of the businesss
• sound  financials (no debt)
• agility and ability to adapt to a changing market
• products/services which meet a real need and confer a benefit to customers

The headline article is worth reading several times.  Make sure to read other articles by Nicolas Colas. He is a thoughtful writer.

For example, read his slightly different take on the sustainability of the stock market:

The Real Threats to the Equity Bull Market

It lead me to think about a few investment themes:

• businesses based on domestic markets which are likely to be sustainable in the face of global competition
• the potential of disruptive technologies/business models to yield handsome returns in the future
• "rebound kings" - enterprises which are likely to rebound nicely after the stock market tanks e.g. natural resource-based companies where product substitution is unlikely in the short to intermediate term

I have have reduced my exposure to equities significantly in light of my concerns about the stability of the equities markets.  And yet, I have never been busier with my research.  The "window of opportunity" will open again - entry points when most investors are discouraged and fearful.  The investment cycle will repeat.  It will pay to be prepared.