March 2017 | Lumenary Investment Management

Should investors adopt short-selling?

Posted on March 22, 2017May 16, 2018 by Lawrence Lam

Short-selling is a trading strategy, not a long term investment strategy. It relies on correctly identifying both the direction of the stock price movement and then anticipating market sentiment. The “difficulty to benefit” equation is not one we view favourably

Taxes and interest are hidden costs that further erode any potential short-selling profits

Profiting from market sentiment

Since the start of this year, Harvey Norman (HVN) and Myer (MYR) have been on the receiving end of increased short-seller activity. The stock prices of both retailers have decreased significantly since the start of the year with the imminent arrival of Amazon(AMZN) to the Australian retail market.

Source: AFR

Whilst many have found success with short-selling strategies (think the film The Big Short), we are not proponents of this style of investing for three main reasons. First, short-selling relies on predicting market sentiment. Short-selling relies on being ahead of the market and selling before the rest of the market does. Unlike how it is portraying in The Big Short, this is difficult to do consistently over the long run, as every short sale relies on a buyer who believes in the opposite – that the stock will appreciate. With the high level of public information available today, we are sceptical of those pundits purporting to be able to consistently out-predict the market. It is for this reason we do not play the short-term trading game.

Second, not only is the level of difficulty high, but the rewards are capped since stock prices can never fall below zero. We prefer to target investments that produce profits in the multiples and short-selling does not allow that to occur. From our experience, good businesses return many multiples over the long run and gains are limitless.

Third, the short-selling strategy is very rarely based on objective information. For example, the impact that Amazon will have on Harvey Norman and Myer is based on modelling and assumptions made by analysts. The market cannot accurately quantify the exact impact to Harvey Norman or Myer’s profitability. And because the trade is based on subjective information, ie the imminent arrival of Amazon, this information is available to all and not highly reliable.

Hidden costs of short-selling

It is important to highlight the impact of taxes and interest cost to the short-selling strategy which erode any profits of short-selling. Trades that occur over a period of less than one year incur a higher tax rate. Moreover, short-selling typically involves paying an interest charge during the period which the position is held, which is the cost of waiting for the stock price to fall.

The “difficulty to benefit” equation

The degree of difficulty of short-selling is high for the reasons outlined above, yet the profits are capped. Combined with hidden transactions costs that erode the potential gains significantly, short-selling seems to us a counter-intuitive strategy. One that increases the level of investing difficulty but has a cap on increased profit potential.

For us, our profitability has come from taking advantage of market sentiment that has presented itself, not predicting market sentiment. As Warren Buffett aptly describes his approach judging the “difficulty to benefit” equation: “I like to go for cinches. I like to shoot fish in a barrel. But I do it after the water has run out.”

The outcome of how the recent short-selling activity plays out may well present us with interesting opportunities should the market overreact. That is when we will join the party.

Summary of the 2017 AFR Business Summit

Posted on March 14, 2017May 16, 2018 by Lawrence Lam

Globalisation will fail if wealth gap between rich and poor is not addressed fairly.

CEOs and managers with long term outlook produce far superior businesses over the long term.

Last week I attended the 2017 AFR Business Summit held in Sydney over two days. An extensive roster of Australia’s most successful business people, politicians and entrepreneurs were invited to speak and discuss the future of Australia.

Many themes were discussed over the two day summit and the speakers I found most insightful were:

Anthony Pratt

Anthony Pratt (Executive Chairman, Visy Industries) – emphasised the importance of growing businesses organically over the long term. Growing businesses from within its own existing circle of competency whilst avoiding growth by over extending into industries or locations unrelated to the current business.

Christian Majgaard

Christian Majgaard (former Head of Global Brand & Business Development, Lego) – grow businesses that focus on the customers/clients needs.

Tim Sims

Tim Sims (second from right: Managing Director, Pacific Equity Partners) – bonuses and other short term incentives for CEOs and managers ineffective. CEOs and managers will aim to set lower targets with the view to exceeding them and maximising their bonus.

Malcolm Turnbull

Malcolm Turnbull (Prime Minister of Australia) – increasing international competition requires Australia to review its company tax rate whilst ensuring globalisation and free trade leave all Australians better off.

It was encouraging to hear these prominent speakers recognise the importance of wealth distribution. Significant time was spent discussing ways of ensuring the positive economic effects of globalisation were properly distributed to those contributing to Australia’s success. Increasing wages and the role of government in redistributing income were heavily emphasised. In my view, it is imperative that business and government seek to address effective wealth distribution – protectionism and closing trade flows is not a viable alternative long term solution.

Disproportionate CEO and senior executive remuneration has also contributed to overall public discontent. In my opinion, this topic must be addressed on a case-by-case basis. Discussion at a generalist level does not adequate address the performance versus salary of each individual CEO.

As an investment manager, the importance of CEO remuneration is relevant to the long term performance and growth of the business – so it matters greatly. The objective of incentives is to align the CEO’s pay packet with those of the investors. In theory, the use of bonuses seems reasonable. In practice, however, they are ineffective. CEO’s will inevitably ‘manage expectations’ of the board by setting their performance targets lower to enable higher outperformance of annual targets. The focus becomes a game of short term expectations management rather than long term business growth.

For an investment manager, it is important to recognise true ownership – we have found that businesses with long term heart keep growing and become more profitable over time.

Warren Buffett’s latest wager

Posted on March 2, 2017May 14, 2018 by Lawrence Lam

The debate between the merits of active versus passive investing needn’t be one. These are just tools in toolkit that every investor should use depending on the investing environment.

The wager

In his most recent 2016 letter to shareholders released last weekend, Warren Buffett described a bet which he had with a hedge fund manager. Commencing in 2008 and now in its 9th year, Warren Buffett wagered that over a 10 year period, a passive index fund invested purely in the S&P 500 Index would outperform a collection of five hedge funds to be selected by an investment professional.

Buffett’s thesis was this – actively managed hedge funds, whilst charging higher fees for investment expertise, could not outperform a passively managed index fund with low fees. The result? With one year to run on the wager, the annual return of the index fund is 7.1% pa and the collection of five hedge funds are returning 2.2% pa. So the lesson it appears, besides from never betting against Warren Buffett, is that every investor should simply invest in index funds.

9 years into Buffett’s wager, here are the results from his annual letter

But I proffer a slightly different argument. Investors should treat active and passive investing as weapons in their arsenal to be used under different investing circumstances. We should not be constrained by the dogma defining us as being a strictly active or strictly passive investor.

A different angle from the Australian perspective

Buffett’s bet should be taken into context. First, his bet is focused on the US stock market. The S&P 500 Index is a collection of the 500 largest companies in America – a truly wide collection of businesses in different industries reflecting the diverse American economy. Of course, Australians can invest in the S&P 500 Index, but from a practical perspective, there would be an implicit foreign exchange exposure distorting the true stock-only returns of the index. The performance would not be an apples for apples comparison. So instead, which indices would a passively minded Australian investor consider? The two possible considerations would be the ASX 300 Index or the All Ordinaries Index.

However we know that the Australian stock market is heavily dominated by the big 4 banks and mining/materials companies. This is the nature of the Australian economy. As shown in the 2 comparison charts below, a passive investor in the ASX 300 is not very passive at all. They are investing over half of their funds in the banking and mining/materials industries.

Source: S&P Dow Jones Indices as at 2 March 2017

Compare this to the S&P 500 index which is much more diversified. The chart below shows that the American passive investor is truly passive and diversified across many sectors. They are not overweight or underweight in any industry.

Source: S&P Dow Jones Indices as at 2 March 2017

Second, Buffett’s bet commenced in 2008 and is due to finish in 2018 – an unprecedented bull market following the extensive downturn of the Global Financial Crisis. The overall stock market has recovered strongly over this decade. The rising tide has lifted all boats. It is much harder to separate active stock pickers from the overall market if all stocks have rebounded strongly following the GFC. During market downturns is where the great stock pickers are able to separate themselves from the rest of the market.

Why every investor should combine active and passive investing

Instead of defining ourselves as strictly active or strictly passive, we advocate the use of both approaches depending on the environment. From our perspective, we observe that the businesses we would like to purchase are currently overpriced. As such, in this environment, we prefer to allocate our funds to a more passive investing approach. This allows us to temporarily ride the upward tide with the rest of the market. As the tide recedes, we shift towards active stock picking. Our allocation towards purchasing specific businesses increases as we see opportunities arise in the market during a downturn. We have found this approach to be flexible and profitable. It does not tie us down to any strict doctrine but instead allows us to benefit from the best of both worlds.

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