Britain’s referendum result on exiting the EU has been met with a flurry of responses from politicians and financial markets. The almost uniform negativity of the responses would, by itself, alarm the average global citizen. But I smell a rat.
I have a simple maxim that has served me well in life – when you want to know who won and who lost, listen for the most negative response. They are the losers.
Investment management when done with funds appears to have developed permanent blind spots. By being unaware or unconscious of these blind spots, investment managers using funds have quite often performed poorly. The greatest of these blind spots is a set of tools developed by Professor William Sharpe, a Nobel laureate and professor at the Stanford School of Business.
Prof Sharpe introduced three main tools into the investment world – the Capital Asset Pricing Model (CAPM), the Sharpe ratio and Style Analysis.
My co-author today is Karl Happe, chief investment officer of Allianz Global Investors’ Insurance Related Strategies. Although the strategies developed and deployed by Allianz are aimed at the insurance market, there are many important lessons that most investors would benefit from, in particular family offices.
The last few weeks have seen equity markets around the world register significant losses. Sudden downward price movements can be stressful and the conflicting analysis and advice can be confusing. Although I cannot give specific advice on what to do, perhaps I can point out some issues that might have been overlooked and would be useful to consider.
The general consensus is that the current market woes began with a crash of China’s equity markets on Monday, 24 August. The 8.5 per cent drop in the Shanghai Composite Index is what many market commentators agree triggered the global wave of selling. What is not made clear is why the Shanghai tanked and why this would trigger a global crash. The answers proffered are that China’s economy is slowing, and that this in turn will trigger a slowdown in the global economy. This is puzzling because the slowdown has been common knowledge for quite a while now, and anyway Chinese growth is still running at about 7 per cent a year. So what news came out to trigger the price plunge? Nobody seems to have an answer.
Even more perplexing is the effect of China’s economy on the world. The narrative that a brake on China’s economy would slow down global growth has things backwards. China is a supply side economy and depends on robust global demand. It is only if global demand, in particular the United States, were to slow down that we would expect a slowing in the global economy, including China.
My co-author this week is Brooke Coburn, Managing Director and Co-Head of Carlyle Growth Partners and Carlyle Equity Opportunity Fund.
The Carlyle Group is one of the largest and most successful alternative asset managers in the world. With nearly USD 200 billion in assets managed across 130 funds and 156 fund of funds it is daunting just trying to figure out where to start in learning from their best in class experience. I decided to approach the middle market team and highlight their story as, I believe, investors in the Middle East can learn the most from their approach and experience.
Portfolio managers and investment analysts like to say that due diligence, a deep review or audit of a potential investment, is an integral part of their business. They are most probably lying, or if we want to be charitable, they are deluded.
Due diligence is not considered sexy. It involves legal, financial and operational reviews. Where are the six screens with hundreds of flashing numbers? Where are the bank of telephones with people shouting orders into them? Where are the oak-panelled boardrooms? The late nights at Cipriani’s and Harry’s? Where, when all is said and done, are the … well, let us not get too carried away.
Portfolio managers and investment analysts rarely perform due diligence personally. They rarely even lead the process. Just look at all the professionals taken in by the Madoff scandal. This is a shame, as due diligence is the only way to consistently make money.
The debate of whether discounted cash flows or peer group comparisons are the better business model has raged ever since M&A became vogue. Let me put an end to the suspense right now: both are useless as effective valuation tools. Let’s find out why and what might work.
The problem with discounted cash flows (DCF) is the sensitivity to a large number of parameters especially since DCF is usually used to predict high-growth. It is hard enough to predict the future performance of stable businesses. Trying to predict the performance of companies in a growth phase is indistinguishable from guessing.
So how should you go about valuing the company that is about to go into a high-growth phase? The short answer is you use a value based on the scenario that the company continues as is. In other words the high-growth is as much a result of your cash as it is of the company’s business. Therefore the growth phase piece should be treated as if it is a complete start-up where everything is valued at book value and therefore there is no premium on the current business.
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An interesting phenomenon is when investors agree on valuation but incorrectly attribute the source of the valuation. The result is that incoming investors or buyers of the firm end up paying the sellers for value that the buyers create.
A common occurrence is when a start-up sells out to a major player, especially in the services industry. Imagine that there is a local start-up, which we will call Triangle, sells a particular service offering into the market.
Valuation techniques and methodologies are usually taught within the context of developing a financial model or using comparative ratios. In real life the actual decision makers might use the output of these models but will not be the ones who develop the models. Decision makers will also be influenced by other factors, not all of which are rational.
I have seen many examples of this and there are certain repeating patterns that are worth examining. In this post I will concentrate on how equity dilution leads to misperceptions and mistakes.
Here’s the reason market timers lose money: They are traders instead of investors, and as discussed in a previous article traders are time sensitive as their main dependence is on price movement. Therefore they need to invest as close to the upturn in price as possible and they need to hold on and exit only when the price stops appreciating.
Investors, though, can trade the cycle to their profit as an overlay strategy. What is an overlay strategy? It is an extension of an existing strategy. An enhancement. It makes sense only if the underlying strategy makes sense.