At TAMIM Asset Management we speak to hundreds of DIY investors on a weekly basis, as they seek to achieve improved returns from their investment portfolio. A common theme we come across every week is where an investor has decided not to sell their shares due to capital gains tax implications. BHP seems to be one of the most common coming across our desk at present.
This is true for both business and portfolio investing, “Tax alone shouldn’t drive the decision.”
At Tamim, we speak to hundreds of DIY investors on a weekly basis, as they seek to achieve improved returns from their investment portfolio. A common theme we come across every week is where an investor has decided not to sell their shares due to capital gains tax implications. BHP seems to be one of the most common coming across our desk at present.
This week we discuss Pfizer and shed light on why making investment decisions based on a tax outcome as opposed to an investment outcome is not always optimal. We ask DIY investors reading this to reflect on any poor investment decisions made in the past that were a result of worrying too much about the effect of taking a capital gain. Prudent portfolio management is the key to long-term investment success. After all, you can’t go broke realising a profit.
The underlying fund for the Tamim Global Equity High Conviction IMA, managed by Robert Swift, has owned the global biopharmaceutical company Pfizer for a few years now, and as an investment it has been strong performer for the portfolio. It was originally an attractive investment due to the fact it was undervalued, but also for the following reasons:
Strong pipeline of drugs albeit mature – Lipitor (cholesterol), Viagra and Celebrex (anti inflammatory). These drugs were heavily geared to an aging population which is the current situation in the USA, and also that of the rest of the world which buys them
Acquisitions of Warner Lambert, Pharmacia and Wyeth in 2000’s all showed that the company could develop and buy growth. These acquisitions are getting harder (eg Astra Zeneca proposal was effectively blocked by UK politicians)
No material problems with governance or accounting
We are now at the point where we believe the risk/reward trade-off is no longer in our favour, and our proprietary VMQ score while still favourable is not at the attractive levels it was when we first entered the position.
Pfizer operates in a sector facing common challenges. All pharmaceutical companies have an increasingly higher research and development (R&D) spend in order to come up with the next blockbuster drug. But that means more and more capital is at risk with each drug investment: i.e. the capital intensity is rising and it strikes us that many drug companies are looking more and more like car companies where it costs so much to develop a new car platform, that a failed model can jeopardise the whole business. Generics are also coming to market faster which erodes periods of super profitability for the established companies; and recently a political threat is now posed by Bernie Sanders and Hillary Clinton where we perceive both would be happy to bash the large US pharmaceutical companies.
Pfizer is also about to do a tax inversion deal. As we wrote in late 2015 as we pondered our investment: “It has been widely documented that a key rationale of the Pfizer-Allergan mega merger is tax minimisation. By re-domiciling the company in Ireland, Allergan’s home, Pfizer will have the ability to avoid US taxes on $128bn of profits earned outside the United States.” A tactic commonly referred to as ‘tax inversion’.
Exploitation of this tax ‘loophole’, while great for potentially increasing shareholder value in the short term (and is not a sustainable way of growing earnings), presents a dilemma for the US government which has the authority to block the transaction. If they allow it to happen will we see a further rush of companies looking to follow in Pfizer’s footsteps? Or, could this deal be the catalyst for legislators to review and overhaul US corporate tax policy, acknowledging that high corporate taxes on USA based companies are not the way to encourage inward business investment?
Pfizer is not alone. Many multi-nationals in the US and UK are fed up with high costs, capricious regulations, and relatively higher taxes. It is not surprising that Pfizer are trying to minimise corporation tax since they already incur higher costs of doing business in the US including the funding of expensive healthcare and pension plans. Currently HSBC is ‘running the numbers’ on whether it should relocate to Hong Kong.
We are troubled by this deal not because of the tax benefits, but because it appears to be the only reason to do the deal. Corporate finance 101 taught us that the underlying purpose of a merger was to achieve a result of 1+1>2. Attempted tax arbitrage may fall into this category but for the wrong reasons.
So, if the regulators and governments allow the merger to proceed, it is our view that Pfizer may have just bitten off more than they can chew…doing something for tax reasons alone is seldom a good reason.
This is true for both business and portfolio investing, “Tax alone shouldn’t drive the decision.”
The complexities associated with merging two companies of enormous size and differing cultures across multiple jurisdictions will alone present its own series of problems and if there are no true benefits to be ground out then it’s a deal that leaves us lukewarm.
Which is why prudent and active portfolio management is the key to long term investment success for any portfolio. After extracting some handsome gains in which we believe was a lower risk investment, Pfizer is now no longer a part of our investment portfolio and we will happily leave any further upside to the investor who was kind enough to take the stock off our hands.
The above scenario and resulting thought process is how we encourage you to think about your personal investments. If there are clouds gathering over a company within your portfolio, don’t ignore the warning signs as we are starting to see happening with Pfizer. This even more true if tax implications are the sole reason for your decision.
The Pain Report will provide you with a weekly independent and objective commentary on the global economy, in an attempt to help you identify the key forces which will shape the world in the years ahead. For example, I believe that the most significant and defining economic phenomenon of our time is the rise of the Asian middle classes. I urge you to beware the prism through which you view the world, and to be aware that much of the western media’s negative and sensationalist coverage is biased against the so-called emerging nations. In my view, the decades ahead will see an era of prosperity, enlightenment and opportunity that very few today are predicting. If any of the above resonates with you then please read “The Pain Report”.
Oh my, where do I begin?
Why not start with some charts.
But wait a minute.
What about this one?
Worked it out yet?
That’s right, commodity prices, particularly oil prices, have plummeted which has led to a sharp decline in the value of world trade, whilst volumes have remained relatively flat. There is also some strong US$ impact. As I have said many times, ‘statistics if tortured sufficiently will confess to anything.’
And no one, and I mean no one, can ‘spin’ a story, mangle and manipulate statistics like we can in the investment industry.
We are not ‘masters of the universe’, we are the ‘masters of spin.’
I give you 1990, and Japan is different.
I give you the Tech Bubble 2000, and P/E multiples don’t matter.
I give you 2007/2008, and debt doesn’t matter anymore.
I give you 2016, and Australian house prices are not overvalued.
But there is one person who does not mince his words. There is one man who is caustically abrasive and brutal in his sugar free, spin free servings of the spoken word. Here are some of his words.
“Space for monetary policy seems to be exhausted.”
“Expansive fiscal policy could cause further crisis.”
And just in case his illustrious audience in Shanghai hadn’t got the point, he went on to say.
“Fiscal, monetary policies have reached their limits.”
In essence this straight talking man had just told the finance ministers and central bankers of the 20 largest economies in the world to go home, because there was nothing more that they could do. So as we await the much anticipated G20 communique we have this little snippet from the WSJ. (with emphasis on little as the font size is without doubt little!)
“Downside risks and vulnerabilities have risen, including growing concerns about further slowdown in global economic activity,” a G-20 draft reviewed by The Wall Street Journal said. “To enhance our readiness to respond to emerging risks, we will explore policy options that the G-20 countries may undertake to support economic growth and safeguard financial stability.”
You see it wasn’t meant to be this way. The G20 meeting in Shanghai was meant to be an opportunity for China to showcase the magnificent transformation and liberalisation of its extraordinary economy. It was to be an opportunity to marvel at the wondrous and elevated state of the Shanghai Composite. It was to be a moment of back slapping self-congratulation of a job well done. A moment when Kuroda and Draghi could claim they had saved the world through the magical wand of ‘shock and awe’ monetary policies. But, in February 2016, a certain Wolfgang Schaeuble crashed the party and delivered the words all those assembled in Shanghai didn’t want to hear.
Of course everyone already knew this and on the way to Shanghai the world’s celebrity central bankers and finance ministers would have seen The Economist whose front cover read, ‘Out of ammo?”. Or they would have read the latest edition of Foreign Affairs with the ever irrepressible Larry Summer’s article, ‘ The Age of Secular Stagnation.’ A small footnote, Larry Summers is the son of two economists and the nephew of two Nobel laureates in economics. And you thought I was boring with two degrees in economics. I only took the second one to find out what the first one was about!
Now one thing I did learn a lot about, and actually found rather intriguing, was the notion of a ‘liquidity trap.’ I was then fortunate enough to experience one in real life.
Japan.
I was never the same ever again.
I saw the debt build up.
I saw the denial…this was the biggest lesson of all.
I saw the collapse.
I learnt a lesson.
Then I saw it all over again in 2008. (Yes, there was the Tech bubble, but that was valuation not debt) Am I seeing it again in 2016?
First up lets agree amongst friends that there is too much debt. Exhibit A China, exhibit B emerging market corporate debt. And we’re also seeing lots of denial…Exhibit C is the Sydney house price debate. But this time, unlike in 1990 or 2007, we have doom and gloom on the front page of every quality and influential publication. This tells me that the markets have done a pretty good job discounting the message I have been telling you since September.
That message is a simple one. We are witnessing the deflation of a global credit bubble…and this time it is coming from the east, not the west. It could get messy, or it might just involve some gentle hissing without a bang! And that is all I am thinking about at the moment. This means I’m looking at falling HK real estate prices, declining South Korean and Taiwanese exports, Brazil, South Africa, Russia, Japanese and European bank stocks falling et al…it’s a long list.
Moving on from my prognostications, let’s look at the markets.
It’s been a pretty good week, except for Australia. In my previous weekly commentary I suggested markets could rally…well they did, except for Australia. So is it all over and we’re back to the races…not so fast. Instructive in this regard is the US Dow Jones Transportation Index, which I have shared with you before. Remember it was this index which gave us some early warning signals as to what was to come. You can see that we could still rally quite a bit more and still be in a bearish downward channel.
Now let’s look at an index of European banking stocks, which I have regularly featured in my weeklies.
This is still scary and has a lot of ‘healing’ to do before we are close to announcing the all clear.
Then there is this one, which I know means so much to so many of you…Australian banks.
Not so good.
So let’s take a step back and look at a longer term chart.
Maybe we shouldn’t have done that!
If you tell me what you think, I’ll tell you what I think.
Actually that’s not fair as you already know what I think.
And on that note have a good weekend.All the best,
Robert Swift explains his strategy and how the TAMIM Global Equity High Conviction IMA (or the underlying fund) has managed to achieve such impressive results over the years.
The VMQ Ranking System
Robert Swift – Head of Global Strategies
Aside from being small and nimble, today’s report seeks to highlight the main reason for this out-performance: A well-executed quantitative scoring system that ranks each company in our universe on its Value, Momentum and Quality rankings. One of the many tools that a skilled stock-picker can use to justify their existence as an active portfolio manager, and break down the common misconception that active portfolio management doesn’t work.
The three factors that make up our VMQ process are:
Value – We seek to identify securities that look cheap (intrinsic value is less than the prevailing market price). Our measure of value is calculated through a multi factor model based on forward looking estimates such as EVA adjusted B/P, earnings yield, dividend yield and cashflow yield.
Momentum – We like to see that price is moving in the right direction, indicating that the market sees what we see. This is highly critical as the market ultimately holds the power to stock-price movements. Catching a falling knife usually ends up with cut fingers, and there are many stubborn fund managers around the world who refuse to accept their mistakes, resulting in poorly performing investments where a stock price will languish for far too long.
Quality – This is profoundly important, especially in market conditions like these where lending standards have been increased by regulators globally, resulting in funding pressure for a lot of poor businesses. We prefer lower leverage, more stable earnings and higher return on equity because only the truly strong businesses prosper in the long term. The other effect of holding high quality names is the reduced amount of risk within the portfolio. Risk is measured by the probability of capital losses. If we hold high quality companies who have a strong financial position, our investors’ capital is not exposed to as much risk as a traditional index fund is exposed to. At TAMIM Asset Management, capital preservation and strong risk-adjusted returns are what we aim to deliver, and focusing on quality businesses is one way in which we aim to achieve these goals.
Once this detailed process is complete, we then look at the equally important qualitative business factors and make a decision on the companies place in our investment portfolio. Keep an eye out for the full education course including access to our VMQ modelling spreadsheet, video tutorials on stock picking, and portfolio construction techniques on the new InvestorU education service.
At TAMIM Asset Management we invest in stocks – not markets. The recent volatility in markets has highlighted to investors the need to own high quality stocks in their portfolios. Robert Swift utilises his VMQ (Value, momentum and quality) screen to access whether we would hold Rolls Royce in our client portfolio’s.
The TAMIM Global Equity High Conviction IMA works on a quantitative scoring system which ranks each company in our universe on its Value, Momentum and Quality rankings.(see the
VMQ Ranking article)The current and persistent low economic growth environment globally has recently seen a reassessment of credit risk all around the world. Many of you reading this would be feeling the pain of the reassessment through your holdings in any of the big 4 Australian banks, or the harsher losses seen in the sharp price declines in European bank stocks. We’ve seen this many times before and therefore believe that the best business to hold in the current market climate are those that are financially sound, that is, those who screen strongly on our quality metric amongst the other factors we look for. Financially weak companies are being punished by the market, including the business we investigate in this weeks’ article.
Recently we ran the VMQ screen over Rolls Royce Holding PLC, a UK based aerospace company making jet engines, not to be confused with the car company that is owned by BMW. Rolls Royce was popular with analysts for a number of years because of its order book growth and steady progression in declared EPS. Our VMQ scores in recent years gave us doubts. Quite simply, the EPS growth wasn’t reflected in free cash flow and upon further investigation we decided that the VMQ rank was correct. This assessment and strict adherence to our processes meant that we haven’t been worried about not owning this market darling.
The above workings will show that our quantitative VMQ process has resulted in a very unfavourable rating for Rolls Royce. The lower the VMQ score the worse the ranking. This alone does not tell us to avoid the stock completely, so we dug a bit further and produced the following important qualitative findings:
Rolls Royce (RR) announced on 12 November 2015 an earnings revision based on a negative outlook for 2016. This was the fifth downgrade in 2015. The share price fell by 20% overnight and was down 48% for the calendar year 2015.
RR order book is very reliant on demand for aircraft from fleets operating in emerging market countries which are economically challenged as commodity prices fall.
Many of the planes powered by RR engines are being retired by airlines that are seeking more fuel-efficient models
RR is also challenged by the accounting treatment of revenue and earnings.
The accounting treatment for “risk and revenue sharing partnerships” has long dogged the company. This was first flagged in 2002 and has always been at the back of our minds. Effectively component suppliers contributed to the cost of new engine development in exchange for a share of the profits. Rolls Royce considered these as revenues as opposed to loans or R&D to be amortised.
In 2013 the Financial Reporting Council, the UK accounting regulator, forced the company to restate this practice.
Additionally the maintenance contract revenue is booked on a smoothed basis in advance of the actual work being done over the life of the engine.
It’s transparently done for all analysts to see but it is aggressive recognition of revenue – something we don’t like.
There is still a fair size pension fund deficit with defined benefit obligations exceeding value by about GBP1.1bn (A$2.3bn)
The company had never changed its aggressive accounting treatment of revenue and the use of off balance sheet R&D (partners) to reduce engine development costs. The company was making a lot of money from service contracts on older generation aeroplanes and was alienating customers with the terms of those contracts. All this came to a head and the CEO was replaced late last year and the share price fell back to where it was 5 years ago. The company’s new CEO, Warren East, has decided to reset the guidance of the business and reduce costs. This is a standard procedure for a new CEO and we expect a few more nasty ‘surprises’. Interestingly an activist investor has now appeared on the share register. We continue to watch this through the lens of the VMQ scores. We currently hold Northrop Grumman from the USA instead which has performed better than Rolls Royce and has far fewer issues with respect to its balance sheet and strategic position. We will take some time to explain our investment in this great business in a later edition of our weekly investment newsletter.
Summary Our quantitative analysis indicates very poor earnings yield and earnings quality (both bottom decile), arising from accounting restatements. The bottom decile momentum score arises from the short term market reaction to the earnings downgrades. Earnings guidance restatement tends to be serially correlated (both good and bad news), which the momentum factor picks up.
The outcome demonstrates the importance of evaluating multiple factors and avoiding reliance solely on one dimension. Value factors are liable to have exposure to value traps (superficial analysis suggests stock is cheap, but to get better stock selection results you need to understand why and if it will change). Analysis still indicates a poor outlook, even after the share price declined significantly in 2015.
The point of this story is not that we will always avoid these kinds of stocks; we won’t.
Nor that other investors are stupid; they aren’t.
It is more about the conviction we have in our investment process and the fact that applying a well constructed quantitative stock selection model with some knowledge of a company’s “fundamentals”, is a powerful and rewarding combination. This can be seen in the stellar performance of the underlying fund which has grown by 144.5% since inception compared to the All Ordinaries which is only up by 10% in that time-frame.
The Pain Report will provide you with a weekly independent and objective commentary on the global economy, in an attempt to help you identify the key forces which will shape the world in the years ahead. For example, I believe that the most significant and defining economic phenomenon of our time is the rise of the Asian middle classes. I urge you to beware the prism through which you view the world, and to be aware that much of the western media’s negative and sensationalist coverage is biased against the so-called emerging nations. In my view, the decades ahead will see an era of prosperity, enlightenment and opportunity that very few today are predicting. If any of the above resonates with you then please read “The Pain Report”.
Let’s sit back, relax and enjoy the pictures. Global equity markets had a good week. In fact mid-week the S&P 500 strung together its best 3-day winning streak since October 2011. And talking of 2011 quite a few investors think that the current decline in equity markets is analogous to that period, which we remember as the depths of the eurozone sovereign debt crisis. (see chart below)
S&P500 Index
I wish I could feel that way too. Do you think the current environment is like 2011? I’m sorry I don’t. In fact everything, and I mean everything, is different. China was doing just fine. Emerging market companies were happily borrowing lots of money and hadn’t yet borrowed too much. The ECB hadn’t yet launched QE and Kuroda hadn’t yet arrived at the BOJ to launch the biggest shock and awe monetary campaign of all time. The FED was aggressively easing policy. Since 2011 we have had a Chinese stock market crash, an oil market and commodities crash and Donald Trump…to mention just a few! I think the “its 2011 all over again” cheerleader squad have lost the plot and are clutching at straws, and that there are simply too many differences to mention. You see the simple and stark reality is that it really is DIFFERENT THIS TIME. And yes I know those are loaded and emotive words for all of us in the investment industry, but, really, you have to agree we have never been here before. We have no roadmap, well, no monetary roadmap. This time investors appear to be losing faith in the central bank’s ability to influence markets. Just look at the reaction of the market to the BOJ move to a negative rate and the subsequent strengthening in the YEN, post Jan 28.
Japanese Yen Spot
And, as I have mentioned in previous weeklies and The Pain Report, look at the performance of bank stocks in Japan (first chart below) and Europe.
Topix Banks Index
Stoxx Europe 600 Banks Index
These charts, as I have mentioned before, are telling me that the ‘hissing’ sound you can hear is the deflation of a global credit bubble.
Now let me be very clear, as there is much discussion of late about the prospect of a US recession. I do not see a recession in America this year. I also believe that the US banking system is fundamentally sound, in fact I think it is very robust, unlike in 2007/2008. I also do not believe that the crash in oil prices, and the indebtedness of oil and oil related companies, pose any kind of systemic risk to the US banking system. Most of the risk is held outside the banking system in various credit funds, ETFs and the like. I do recognise the weakness in the industrial and manufacturing sector in America, BUT the US consumer is in pretty good shape…ditto the housing market looks fine. Having said all of that the US economy will not set the world on fire with sparkling economic performance. Quite the contrary, growth will be about 1.5% to 2% this year. The problem THIS time is not in America. THIS time the winds of deflation come from the east, and not the west. Stuck in the middle we have Europe. We have a migration crisis, we have a bad debt problem in Italy, we have issues in Portugal and yes we also have issues in Greece…but really, who cares about Greece anymore? The recovery in Europe is young and fragile and the bank stocks are suggesting some trouble ahead, nothing systemic as yet, but the problems in the east could not have come at a worst time. Keep an eye on European truck sales…as you know my favourite economic indicator. And talking of economic indicators, and to make things even more complicated…oh boy…and they are complicated…I feel that we have a data integrity problem across much of the world. We all know the China story and the integrity of the GDP figure, but here in Australia, we have the nonsense that the ABS issues each month in the employment report. Then there is the mother of all economic statistics, the US employment report. In times such as these I rely on the charts. Listen to what the market is telling you. They are looking forward, not backward. Right here and now equity markets look like they want to move higher. Not surprising given how far we have fallen. The two charts below (Dow Jones Transportation Index and the Russell 2000) tell me that markets want to go higher.
Don’t forget it was these two markets which led the broader indices lower.
Russell 2000 Index
Dow Jones Transportation Index
But both these markets could move a lot higher and still be in a downward channel. So, to try and sum up, the short term trend is higher, but the long term trend is lower. Also, worth mentioning that the Chinese appear super-determined to defend the YUAN and most importantly we at long last heard from PBOC Governor Zhou. Many say that part of the problem in markets is the lack of communication by Chinese policymakers. In the west, particularly in America, a day does not go by without a FED official saying this or that. In China we can go months without any comment from the PBOC. Well, Governor Zhou has spoken with a long and detailed interview in the Caixin Weekly and his message was LOUD AND CLEAR, don’t mess with my currency!! Just let me devalue it quietly…he didn’t say that bit! All in all financial markets appear to be stabilising and the ‘chatter’ of an imminent Chinese devaluation is fading.
And on that note I am fading too…have a good weekend.All the best,
