Seeking to generate value in a challenging market

2018 was an exceptionally challenging year for international investors. In some respects it has proven even more challenging than the big financial crisis of 2008. During the financial crisis some asset classes still managed to generate appreciable returns, particularly US Treasuries which benefitted from the “flight to safety”. In 2018 the prices of both equities and bonds dropped as well as most other asset classes. In fact, according to Deutsche Bank since 1901 there has not been any other instance where so many asset classes went down as illustrated in the following graph (1). 

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The S&P 500 was down 6% and other indexes did much worse with the Euro Stoxx 50 down 14% and the German DAX down 18%. The iBoxx Investment Grade bond index was down 4%. Commodities are often inversely correlated to the markets and gold is often a beneficiary in times of uncertainty. This year it was not the case. Those two asset classes traded down 14% and 2% respectively. Overall hedge fund managers did poorly, with the global HFRX fund index which includes all types of strategies down 7%. The HFRX Equity Hedge index which focuses on long-short managers was down 9%. 

Fortunately we have been very cautious about the markets for some time and had warned repeatedly about the risky mix of increasing interest rates and elevated valuations. All this being further exacerbated by macro risks such as a cooling of the Chinese economy and international political tensions. We therefore had limited exposure to equity markets as well as to long-duration fixed income. Overall our hedge funds performed better than the industry average, validating our careful selection of managers who have a real ability to manage risks and add value. At the bottom line, we managed to preserve capital and to largely insulate our portfolios from nerve-wrecking volatility.

We continue to believe that the same risks that were present at the beginning of 2018 remain now even after the correction. We continue to advocate caution although some opportunities are starting to emerge. Healthcare and biotech stocks in particular are trading at historically low valuation levels and offer a good entry point for the long term investor.

One of the most promising avenues to generate returns uncorrelated to the markets are investments into promising private companies with high growth potential. To the difference of the financial markets whose evolution depends largely on external factors the outcome of good private equity investments is a lot more under the control of the investors. 

One such opportunities is Paltop dental into which we invested some of our clients’ money over the last four years. The company, which is growing strongly and is already profitable, just merged with the American dental implant distributor Keystone to form a new dental implants player with the potential to become one of the industry leaders. The merger was reported in the Israeli press (2).

As the case of Paltop shows opportunities also exist in more traditional industries through technologic and managerial innovation. In terms of timing we prefer to avoid the highest-risk early stages and to enter at later stages where the feasibility of the venture is more established but the gain potential still high. Israel as the Startup Nation offers plenty of opportunities since many high quality professionals are eager to start successful, innovative businesses. The main limitation of such private investments is the above-average risk, the lack of liquidity and the relatively high minimal investment amounts. This prevents many investors from participating in them. Going forward, we want to take more and more advantage of such opportunities and we will think of possible ways to make them more accessible to investors who are not traditionally exposed to such investments.

While preparing for all types of scenarios we hope that 2019 will surprise us on the upside.

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Between fortune-telling and careful strategic planning

One of the most striking aspects of the global economy is how complex it is and how it is influenced by an immense numbers of parameters which are often not well understood and hardly predictable. Although it incorporates mathematical tools and concepts from the sciences, the field of economics remains very much a social “science”.

Trying to forecast the future with imprecise tools can prove very disappointing and amounts oftentimes to fortune-telling. Faced with ambiguous and often contradictory data many investors nevertheless feel that they need to “predict” future market developments. And what will happen is that their forecasts will, like a Rorschach test, reveal more about their mindset than about markets and the economy. The optimists will mainly look at the positives while overlooking the negatives; the pessimists and the alarmists will focus on the negatives and dismiss the positives.

In addition there is no lack of players who face business conflicts of interests that will impact their forecasts. And in many cases there is an interest to just stick to the herd mentality and follow the crowd even though it is often wrong as it is perceived as safer and more comfortable.

Looking at history we are not aware of anyone neither in academia nor in the investing world who has over the long term been able to successfully and systematically anticipate the major economic and financial developments. Of course, some people accurately predicted some crisis or some other event but usually on a punctual rather than sustained basis.The situation over the last two years illustrates well the challenge of making predictions. As is usually the case with the economy at any point in time there are both positives and negatives. 

For example, the macro-economic data in America is undeniably positive with unemployment at 3.7%, a 49 years low while the economy continues to show solid growth with no sign of abating. Interest rates remain low and financial valuations are not extreme. On the other side the current bull-market has been going on for a decade with no major correction which is relatively rare (but has happened before). History would suggest that at some point in time a correction is due and this has been expected for a long time by some intelligent investors who, at least in the past, had a solid track record of success. Albeit not extreme, valuations are high by historic standard according to most yardsticks. 

So if predicting economic developments is so hard what can be done? Are we suggesting, as some do, to disregard the macro picture? Absolutely not – to the contrary we believe that it should be addressed through careful strategic planning. But this should be done in a constructive way by identifying the main risks and opportunities in the market. The smart investor should like a radar be constantly screening the markets for risks and opportunities and make sure that he takes preventive measures to minimize the risks and that he also actively takes advantage of the opportunities. The investor should think in terms of how (s)he can optimally position him/herself for a range of possible scenarios rather than somehow naively trying to predict what will precisely happen in any given year. Importantly, this reflection should focus on both the short, middle and long terms.

Of particular importance to the reflection are the large megatrends that can last for decades. They have the strongest and most sustained impact on markets, much more so than short-term economic developments such as a temporary economic slowdown. 

The continued reduction of interest rates since the peak in the 1980s and then following the 2008 financial crisis was a major megatrend of the last decades and certainly the key driver of the 30-years bond bull market that is now in our view coming to an end. 

The IT revolution has been a large megatrend for the last two decades at least and is still unfolding. It continues to provide excellent opportunities for wealth generation. This can be capitalized on both through investment into the right listed tech companies as well as through smart venture capital investing.

The aging of the population and the revolutionary developments in the pharma and biotech industry represent another such trend which can similarly be capitalized on. After a few years of under performance due to now resolved regulatory uncertainty in the U.S. the pharma/biotech sector is attractive. Listed companies in the sector are quite resilient to the economic cycle and a good fund manager will be able to pick-up the winners and outperform the market.

While these mega trends have deeply transformed the world and our lives and have had major economic impact, the effect of international wars and tensions over the same period amounted to blips at most. Similarly in Israel the reduction in interest rate over the last decade was a key driver of the real-estate bull market while repeated wars and tensions had no significant impact on prices.

In the current environment we continue to see an increase in interest rates as one of the major risks. The 10-year Treasury recently broke the 3.2% level. As we mentioned previously, an increase to 5% in the middle term is a possibility. This would affect first and foremost fixed rate bonds and that is why we are by and large avoiding that asset class. On the other side, the recent increase in LIBOR means that some floating-rate notes (FRNs) are currently offering an attractive risk-reward as it is possible to get yields of around 3% from solid issuers without interest-rate risk.

The fact that the valuations in equity markets are elevated means that the risks are increasing and that conservative investors in particular should be cautious in terms of their exposure. As we have said before, we believe that the current times are particularly well-suited for alternative investments offering limited correlation to the developments in the financial markets. Alternatives, a field in which we have a deep understanding, have therefore a high weight in our portfolios.

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