can turkey's economic situation recover?
DESCRIPTION
Included in this Invast Insights report, Turkey's economic condition was highlighted along with potential trading opportunities if the Turkish Lira collapses completely. Despite the economic issues of other countries, our Wealth Creation portfolio continued to hold up well and the Drawdown Phase portfolio traded above target. Meanwhile, a case study for assessing other stocks is also included in this report. The case study - Forge Group (FGE): Example Of Fragility - showed that it is better to buy a robust business with little earnings than buying a business which appears to be making strong earnings but with poor composition.TRANSCRIPT
Invast Insights
Week Commencing January 28, 2014
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This week we look at the following topics:
1.0 Can Turkey’s economic situation recover?
2.0 Monthly portfolio review and changes
3.0 Forge Group (FGE) – example of fragility
4.0 Educational trading video – Nassim Taleb
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1.0 Can Turkey’s economic situation recover?
There has been lot of press coverage over the fall in the Turkish currency over
the past few weeks and the knee jerk reaction of the Turkish Central Bank to
boost rates above 12% last week. The decline in the currency is due to a
number of factors including political instability and a widening graft probe, a
worsening fiscal situation and the flight of cash away from emerging markets
as the US Federal Reserve expands its tapering efforts. The real reason for the
currency decline is hard to pinpoint and this isn’t really our main focus.
Instead we are more interested in where the currency goes and if there are
further trading opportunities should the Turkish Lira completely collapse.
How likely is this?
This isn’t the first time a central bank has intervened to stem a currency
collapse. There is a long history of markets shifting capital outside of
economies when certain political forces take power. France in the early 1980s
is a perfect example. Efforts were made to stem the currency collapse by
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lifting short term interest rates. There are other examples though of
unsuccessful efforts. Indonesia comes to mind during the Asian Financial
Crisis. The Indonesian Rupiah depreciated from Rp2436 in mid 1997 to around
Rp7900 in the space of two years despite the Indonesian Central Bank
boosting interest rates to as high as 70-80% range for overnight money.
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Investors were clearly shaken and since the depreciation, the Indonesian
currency is yet to recover. Our point here is that when a currency starts to
collapse, it is very unlikely for it to recover ground. Central bank action to
temporarily prop up the value of currency is a short term solution. Turkish
businesses have experienced a large fall in their purchasing power and now a
huge rise in the cost of borrowing to finance their operations. This will start to
flow through the domestic economy, driving down economic growth and
plunging the country further into a financial mess.
The sudden increase in Turkish interest rates will only temporarily halt the
flood of cash leaving the economy. The Indonesian example, coupled with
many others globally, will no doubt resonate among the capital elite. There is
a fine balance between depreciating your currency to help improve export
competitiveness and a certain currency being sold off on fear that the central
bank and government situation will lead to hyper inflation. Turkey is on the
verge of spilling over into the later unlike the United States which has bank
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and government situation will lead to hyper inflation. Turkey is on the verge
of spilling over into the later unlike the United States which has benefited
from the former. Below is a chart taken from Invast’s MT4 platform, which
shows the US Dollar rising against the Turkish Lira over the past few months.
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Image: USDTRY hourly chart via Invast MT4 platform
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Turkey’s economy cannot be fairly compared to Indonesia in the late 1990s. Turkey is diverse - a gateway between Asia and Europe. The economy is worth around US$800bn annually which is significantly larger than Iran at around US$500bn and more than three times the size of Greece. Turkey is the 17th largest economy in the world. GDP growth has been running at a respectable rate of 2.2% but this is likely to drastically slow as monetary policy tightens. The 74m population has generally benefited from economic prosperity over the past decade or so as trade ties and capital flows helped double GDP per capita to around US$10,665, on the most recent measure.
Unemployment is high at around 9.8% and public debt to GDP is at 35.5% which isn’t large on face value but has been steadily rising. Turkey needs to turn a corner in its domestic politics if it wants to stem the economic fallout. This will be the most pivotal point. The fiscal situation has the capacity to change but only if government confidence returns. As a democracy the next few months will be crucial. Fiscal expenses are quickly exceeding revenues and while Turkey can fund this through issuing more debt there will come a point where the market completely loses trust. We will continue to monitor the situation over the next few months to see if any European intervention helps stave off a complete government and fiscal collapse.
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The reason we started this week’s publication with comments on Turkey is
because very rarely in history have investors been able to trade the potential
collapse of a currency. Usually this luxury has been afforded to only large
institutional investors. Usually the individual investor is left with a currency
that continues to depreciate and their purchasing power diminished. Invast
has added the Turkish currency to its list of available markets due to strong
client demand. We feel iIt’s worth keeping the USDTRY or EURTRY on your
watch list.
2.0 Monthly portfolio review and changes
Our portfolios have held up relatively well over the holiday period. We haven’t
seen the types of gains which we booked late last year but given the global
market turbulence and falling indices as the US Federal Reserve tapers, our
portfolios have not seen any significant losses either. Keep in mind that our
main focus is to beat our modest targets.
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We started the portfolios off with modest $50,000 balances in each and we
purposely said that we won’t be benchmarking against an index but investing
according to stated goals. The most disappointing portfolio has been our
Wealth Preservation – not because we have suffered losses but because our
gains have evaporated. Nevertheless, our primary focus is to hold a wide
range of diversified securities that allow us to sleep overnight and this hasn’t
changed.
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The Wealth Creation portfolio continues to hold up well, we’re pleased with
the 14% return since inception. The short S&P500 index position has worked
against us since inception but we continue to hang on and it is encouraging
to see markets starting to pull back. Unfortunately the depreciation in the A$
has helped offset any gains but we’re sticking to our conviction and see this
as a nice hedge against falling markets. We have just under $9500 in cash and
we continue to shop around for some small cap opportunities. We are likely to
announce these in the next review before making new acquisitions. Any
pullback in markets will create even great opportunities to enter.
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Westfield continues to be a disappointment for the Wealth Preservation
portfolio, mainly around its split into two difference vehicles. The fact that the
US Federal Reserve is starting to taper suggests that the US economy is
improving and Westfield is a major beneficiary of this, with its vast portfolio
of real estate assets. We’re digging in and holding on for at least the next year,
Westfield has strong income certainty and at the very least we will be picking
up a solid dividend yield in the order of 4-4.5% which helps contain any
temporary losses. The IJP ETF position has also performed nicely as the
Japanese market holds onto its gains and the Australian dollar declines
slightly against the Yen.
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The Drawdown Phase portfolio continues to trade above our target. We sold
our AMP position as previously advised and subscribed to the AMP
Subordinated Notes issue – basically taking the income component without
worrying about further capital downside. We wouldn’t be surprised if AMP
shares actually rise following their result next month but this is a conservative
portfolio and we don’t want to have any type of volatility, so future losses will
also be quickly cut. The realised loss is large but the rest of the portfolio is
performing strongly. We have recognised the upcoming dividends from the
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TAHHA and GMPPA securities that we are holding and these are sitting nicely
in the cash balance now at $1139.
3.0 Forge Group (FGE) – example of fragility
Forge Group (FGE) shares have fallen from a yearly high of $6.98 to around
$0.76 as of the time of writing. They have touched a low of $0.28. This isn’t the
most important stock on the market by any means but the reason we are
writing about it this week is to use it as a case study for assessing other
stocks. This is a perfect example of how the market can like a business for a
long time and then suddenly the value can evaporate overnight. We analyse
the situation below.
Forge is an engineering, procurement and construction business focused on
mining regions in Western Australia. It managed to grow earnings steadily
over the years by winning large contracts. The market loved the stock as work
continued to pile in but what many missed was the composition of earnings.
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There is a big difference in the way mining construction businesses earn
revenue compared to a supermarket or telecommunications provider.
Contracting businesses rely on a few, large contracts. It’s all very well to win a
$100m construction project but the risk of underperforming is large.
Sometimes it’s better to have 10 million transactions at $10 each. The fragility
of a business is often overlooked by the market – and many analysts for that
matter – with too much emphasis on actual earnings in isolation.
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Forge’s glory run eventually came to an end, it blew up basically overnight on
a few key contracts. The main problem projects have been the Diamantina
Power Station and West Angelas Power Station projects which have seen large
losses. Earnings have evaporated and caused the business to move into a loss
making position for the 2014 financial year in the order of $20-25m. What
makes matters worse is that Forge has used debt to fund its growth and
lenders are now sitting cautiously on the sideline to see how key risks play
out.
When cash starts flowing through the door and your business is reliant on
debt funding this usually creates a cocktail for disaster. That’s why the value of
Forge shares – the equity value – has almost completely diminished over the
past few months. When buying shares, you need to look beyond the actual
‘Price to Earnings ratio’ or earnings growth numbers and actually stress test
the quality of earnings themselves. Sometimes it is better to buy a robust
business with little earnings than buying a business which appears to be
making strong earnings but with poor composition. This is how we think
about stocks at Invast, particularly smaller companies.
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Investors should never cease to educate themselves, there are lessons in the
market every single day. The market will always continue to teach and
educate you regardless of your level of experience. If success was attained
through experience, no fund manager would ever lose money. We know that
many do and when markets tumble it is usually the experts that suffer the
largest losses. The lesson here is to never be complacent. The misfortune of
Forge shareholders should remind in your mind, as an investor, for the rest of
your life. Many investors and traders focus on the businesses that book huge
returns but we should equally spend time studying the businesses that blow
up.
Usually we learn more from the blow ups than we do from the success stories.
Ask yourself this question, how many success stories have you read where the
CEO or founder takes credit for all the success themselves and gives little
appreciation to luck. Now ask yourself how many disaster stories you read
where the CEO or founder ponders on external circumstances – the economy,
interest rates, the currency, politics, consumer sentiment etc – and gives little
criticism of their own mismanagement.
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We as humans like to pat ourselves on the back when luck goes our way and
criticise others and blame misfortune when we make mistakes. This won’t get
you anywhere as an investor or trader.
From the Forge group experience, we learn the following points:
• Contracting businesses usually don’t make money over the life of the
business cycle. There will come a time in the future where the financial
community will try to convince you otherwise. Don’t believe them. Keep
this written on a piece of paper and tuck it under a draw somewhere.
Revisit in 5-10 years time when the next mining investment boom is
around.
• Contracting businesses do make large profits at the top of the cycle. There
might be a few years where they win large contracts and everybody
jumps on-board, sold the message that there is a huge abundance of work
out there, but then growth usually leads to a blow up. It only takes one or
two large contract losses to completely wipe out the value of a business.
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• Shareholders usually take the largest losses. Lenders tend to cover
themselves against assets to fund business growth. Ordinary shareholders
are always the last to know when things go bad and by the time the news
is out there in the market, shares have probably already collapsed.
• Earnings are not all the same. The earnings quality of a supermarket or a
construction business is very different. One has more fragility while the
other. A supermarket’s earnings growth may not be as attractive at certain
times, earnings may even fall in some cases, but selling 10 million
transactions at $10 each might be much better than completing one
single $100m contract. You are less likely to blow up with 10 million
transactions then you are with one large contract.
• There is a reason why mining companies, property developers,
governments and companies generally outsource construction or
procurement – it is because they don’t want to take the risk. If contracting
was so successful over the long term, governments, property developers,
companies like BHP and Rio Tinto would all internalise the function rather
than outsourcing it.
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4.0 Educational trading video – Nassim Taleb
With the above section in mind, we thought we would bring you an
interesting video that caught our eye over the past few days. The whole issue
of quantifying risk and being able to measure probabilities against stumbling
blocks is core to our ideology. Nassim Taleb is an author which we first
mentioned in our book review of the Black Swan. Taleb’s name is synonymous
with risk taking and more recently being able to measure what is fragile and
what is anti-fragile. There are certain ways to position you as a trade to
benefit from rare events like Black Swans, but these are difficult to predict.
Taleb in this video instead focuses on being able to see what is fragile – like
Forge Group (FGE) for example – and then adjusting your circumstances or
investment portfolio accordingly. We end this publication with this video
because it is really relevant to all of the above sections. If you watch the video
you can see which parts of our portfolios are fragile and how we have tried to
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build robustness (particularly with the deep diversification in the Wealth
Preservation portfolio) and lastly the Forge example. Taleb presents his
findings at the Digital Life Design conference, click on the image below to go
directly to the link with will play the short video. On his Twitter page, Taleb
wrote that this is the “one thing I want to convey before I die”. Take a look.
Image: Author Nassim Taleb presenting at the DLD conference
Drop by our site to access other trading videos relevant to this topic.
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7.0 Disclaimer
Please note that you are receiving this report complimentary from Invast Financial Services Pty Ltd (AFSL 438 283). Invast staff members may from time to time purchase securities which are included in this or future reports. The authors of this report may or may not be holding a position in the securities mentioned. Please note that the information contained in this report and Invast's website is of a general nature only, and does not take into account your personal circumstances, financial situation or needs. You are strongly recommended to seek professional advice before opening an account with us.
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