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Christopher Pavese, CFA
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Mr. Pavese holds several positions within the Broyhill family offices, serving as Chief Investment Officer of Broyhill Asset Management and BMC Fund, Inc., an SEC registered investment company. His primary responsibilities include macroeconomic research, strategic asset allocation, portfolio... More
My company:
Broyhill Asset Management, LLC
My blog:
The View From the Blue Ridge
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  • Better Late Than Never?

    Our “first quarter” Broyhill Letter is embedded below.  We promise to be more prompt with our second quarter letter, which is right around the corner.

    The Broyhill Letter (Q1-11)

     

     
    Jun 07 8:34 AM | Link | Comment!
  • From Weeds to Flowers and Back

    If you had to choose a handful of letters to hone your value investing skill set, Howard Marks would easily fall near the top of our list.  His most recent piece is no exception.  We’ve attached it in full along with some of our favorite quotes (accompanied by various illustrations) which should prove to be timely as this bull cycle gets progressively longer in the tooth.

     

    High yield bonds and many other investment media have once again gone from being weeds to flowers – from pariahs to market darlings – and it happened in a startlingly short period of time. As is so often the case, things that investors wouldn’t touch in the depths of the crisis in late 2008 now strike them as good buys at twice the price. The swing of this pendulum recurs regularly and creates some of the greatest opportunities to lose or gain. Thus we must always be mindful.

    One of the most important things we can do is take note of other investors’ attitudes and behavior regarding risk. Fear, worry, skepticism and risk aversion are the things that keep the market at equilibrium and prospective returns fair. When investors fear loss appropriately, too-risky deals can’t get done, and risky investments are required to offer high prospective returns and generous risk premiums. (And when fear reaches extreme levels during crises, the capital markets turn too stingy, asset prices sink too low, and potential returns become excessive.)

    But when investors don’t fear sufficiently – when they’re risk tolerant rather than risk averse – they let down their guard, surrender their discipline, accept rosy projections, enter into unwise deals, and settle for too little in the way of prospective returns and risk premiums.

    There’s nothing more risky than a widespread belief that there’s no risk . . . and, as Alan Greenspan said, “. . . history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”

     

    I recite all of this because I have no doubt that investors are making substantial movement back in the same direction . . . In other words, in most regards the capital markets – and investors’ tolerance of risk – are retracing their steps back in the direction of the bubble-ish pre-crisis years. Low yields, declining yield spreads, rising leverage ratios, payment-in-kind bonds, covenant-lite debt, increasing levels of LBO activity and the beginnings of the return of levered, structured vehicles . . . all of these are available for the eye to see.

    There may be corners of the market where elevated popularity and enthusiastic buying have caused prices to move beyond reason . . . But for the most part, I think investors are taking the least risk they can while assembling portfolios that they think can achieve their needed returns or actuarial assumptions.

    In general, I would describe most security prices as falling somewhere between fair and full. Not necessarily bubbly, but also not cheap.

     

    If I had to identify a single key to consistently successful investing, I’d say it’s “cheapness.” Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses. It’s not the only thing that matters – obviously – but it’s something for which there is no substitute. Without doing the above, “investing” moves closer to “speculating,” a much less dependable activity. When investors are serene or even euphoric, rather than discomforted, prices rise and we become less likely to find the bargains we want.

    I try to get away from it, but I can’t. The quote I return to most often in these memos, even 17 years after the first time, is another from Warren Buffett: “The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs.” When others are paralyzed by fear, we can be aggressive. But when others are unafraid, we should tread with the utmost caution. Other people’s fearlessness invariably translates into inflated prices, depressed potential returns and elevated risk.

    Today, pension funds and endowments simply can’t achieve their goal of nominal returns in the vicinity of eight percent if they keep much money in Treasuries or high grade bonds, and they may not even expect public equities to be much help. They’ve moved into high yield bonds, private equity and hedge funds . . . not because they want to, but because they feel they have to. They just can’t settle for the returns available on more traditional investments. Thus their risk taking is in large part involuntary and perhaps unenthusiastic.

    Those of us who calibrate our behavior based on what others are doing should increase watchfulness and, as Buffett suggests, apply rising amounts of prudence.

     

    Prudent Behavior in a Low-Return World

     

    • Go to cash – not a real alternative for most investors.
    • Ignore the lowness of absolute returns and pursue the best relative returns.
    • Forget that elevated prices might imply a correction, and buy for the long run.
    • Reach for return, going out further on the risk curve in pursuit of returns that used to be available with greater safety.
    • Concentrate investments in “special niches and special people”; by this I meant emphasizing strategies offering exceptional bargains and managers with enough skill to wring value-added returns from assets of moderate riskiness.

     

    Of all of these, I consider reaching for return to be the most flawed, especially if it’s done without being fully conscious (which is often the case when return becomes hard to come by). I’ve described this approach as “insisting on achieving high returns in a low-return world” and reminded people of Peter Bernstein’s admonition: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”

    In short, when the market is defaulting on its job of being a disciplinarian, discernment becomes our individual responsibility. I think we’re back to needing the cautious attributes, not the aggressive. An unusually large number of thorny macro issues are outstanding, including:

    • the so-so U.S. recovery;
    • the U.S.’s deficit, debt ceiling impasse and dysfunctional political process;
    • the economic impact of deleveraging and austerity;
    • the over-indebtedness of peripheral eurozone countries;
    • the possibility of rekindled inflation and rising interest rates;
    • the uncertain outlook for the dollar, euro and sterling; and
    • the instability in the Middle East and resulting uncertainty over the price of oil.

    With all of these, plus prices that are fair to full and investor behavior that has increased in aggressiveness, I would rather gird for the things that can go wrong than ensure maximum participation if things go right.


    We have a hard time finding anything to disagree with in Mark’s most recent letter and look forward to reading his most recent book.

    How Quickly They Forget 05-25-11



    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Jun 07 8:09 AM | Link | Comment!
  • Aussie Pride
     It was almost 80 degrees here in NC this past weekend.  Perfect weather for a Friday in the local library reviewing the outlook for global housing markets.  We stumbled across the 7thAnnual Demographia International Housing Affordability Survey last week, which offered some terrific insight into the scope of the bubble brewing Down Under, when we finally got around to reading it.  As defined in this study, all major markets in Australia and New Zealand are severely unaffordable.  With a Median Multiple (median house price divided by gross annual median household income) of 11.1, Sydney is the second most unaffordable market of the 325 markets included in the study, while Melbourne ranked 79th with a Median Multiple of 9.0.  For perspective, median house prices have historically averaged 3.0 or less times median household incomes.  Demographia summarizes the Australian market as follows:

    Housing remains the most unaffordable in Australia, except for the single market in China (Hong Kong) included in this Survey. Australia is characterized by more restrictive land use policies. The Organization for Economic Co-operation and Development has recommended that Australia “ease” its housing supply constraints, which have driven up housing prices.

    Australia’s major markets have a severely unaffordable Median Multiple of 7.1, nearly 2.4 times the 3.0 affordability standard. Each of the major markets, with the exception of Sydney had housing affordability within the 3.0 norm during the 1980s (Figure 2). Australia’s Median Multiple for all markets was also the highest outside China, at a severely unaffordable 6.1.

    Sydney, which has had long-standing limits on housing development on the urban fringe, was the most unaffordable major market. Sydney had a Median Multiple of 9.6. Prices rose strongly in Melbourne, which had a Median Multiple of 9.0. Adelaide had a Median Multiple of 7.1, despite being the lowest demand major market in the nation. Brisbane (6.6) and Perth (6.3) were less unaffordable, but were still well above the threshold of severe unaffordability.

    More troubling than price alone, is the conclusion that this house price escalation has occurred generally independent from varying demand levels.  In Sydney and Melbourne, the median priced house now costs a household at least $750,000 more than the historic housing affordability norm, ultimately retarding consumer spending.  Last year’s study showed that the median household would spend over half of its pre-tax income on mortgage payments.  We would note that these payments have only gotten larger with several RBA interest rate hikes since that study was published.  As we pointed out in our initial piece on the Troubles in Ozthe ratio of home prices to income has always fluctuated around a stagnant long term average, because income acts as an anchor limiting the price homeowners are able to pay and has always pulled price back to earth in every instance.

    A similar ratio, calculated by the Economist puts the Australian housing market at the top of the charts.  In theory, the price of a home should reflect the value of the services it provides, so the Economist  calculates the ratio of prices to rents in 20 economies.  Using this measuring stick, the Land of Oz is 56% overvalued and inching toward fair value as prices fell 1.6% month over month.  But as Michael Lewis so eloquently described in a recent Vanity Fair article, When Irish Eyes Are Crying:

    Real-estate bubbles never end with soft landings.  A bubble is inflated by nothing firmer than expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long-term investment real estate has become and flee the market, and the market will crash.  It was the nature of real-estate booms to end with crashes.

    Their real-estate boom had the flavor of a family lie: it was sustainable so long as it went unquestioned, and it went unquestioned so long as it appeared sustainable.  After all, once the value of Irish real estate came untethered from rents there was no value for it that couldn’t be justified.

    There is an iron law of house prices . . . The more house prices rise relative to income and rents, the more they subsequently fall.

    Smart investors in the U.S. looked for a slow-down in the appreciation of home prices as an indication that momentum was waning and price increases were unstable.  Month over month declines also served as early warning sign that the bubble was beginning to deflate at home.  Perhaps we are nearing an inflection point Down Under as well.  Steve Keen, who has followed the Australian real estate market closer than anyone on the street, argues that the government-stimulated debt-driven boost to aggregate demand was the primary reason Australia got through the Great Financial Crisis (NYSE:GFC) so well, and also why Australian real estate prices avoided anything but a hick-up in an upward trend.  But he shows (first chart below) that the most recent data for Australia indicate that this Credit Impulse has now peaked and is turning back towards zero.  With a ratio of Private Debt to GDP still in nose-bleed territory (second chart below), deleveraging in the household sector should have a significant impact on real estate prices.

    The bulls hang onto the hope that demand for housing in Australia far outstrips supply.  Indeed, even the Demographia study highlighted “smart growth” with restrictions on development on the edge of the urban fringe, as a driver of higher prices in markets like Australia.  Maybe, but the skeptic in us wonders why such a large percentage of mortgages on bank balance sheets are loans to “investors.”  We hope these aren’t the same “investors” that were buying homes in Dublin or in California.  For what it’s worth, a 2005 paper by the OECD on Recent House Price Developments pointed to complex and inefficient local zoning regulations among the reasons for the rigidity of supply in Ireland.  According to this paper, heavy land-use regulations in some US metropolitan areas were also associated with considerably lower levels of new housing construction which restricted housing supply and increased home prices.  We would note that these “supply restrictions” didn’t exactly prevent prices from ultimately returning to earth in California (see chart below).

    Perhaps Aussie Pride is enough to keep the bubble inflated and prevent folks from questioning the sustainability of ever-increasing housing prices.  Then again, we’re pretty sure our Irish friends would tell you they are a proud people as well.  The Australian banks tell investors that because their mortgages are non-recourse, they do not have to worry about the same types of risks and losses experienced by lenders in the U.S.  Then again, there’s no such thing as a non-recourse home mortgage in Ireland either, so perhaps the Irish banks are a better proxy for Australian bank investors. We wonder how the currency would react should Aussie officials be forced to recapitalize the banking system, given investors’ current optimism on the AUD.  We believe the Australian Dollar has begun a topping process and investors should position accordingly.  Options on lower Australian interest rates also provide investors with a cheap hedge against a bumpy Chinese landing, should policy makers continue to stomp on the brakes with the same delicate touch as my fiancé’s foot on the pedal.

    Disclosure: At the time of publication, the author was short the Australian Dollar, Australian interest rates and various Australian financials via traditional and derivative investment vehicles, although positions may change at any time.



    Disclosure: I am short FXA.
    Tags: FXA
    Mar 22 2:36 PM | Link | Comment!
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