Biotech Boom Lifting All Boats

The following is a 3 year chart of the iShares Biotech ETF IBB. The 200-day (blue) and 100-day (red) simple moving averages are also shown to give a sense of the strong momentum and up-move there has been. The so called 'animal spirits' are back.

Returns on the ETF have been pretty spectacular 65% in 2013 and 32% 2012. There is a boom going on in biotech stocks that is lifting all boats.

Below shows some valuation metrics in this ETF. They are not shockingly high, especially for biotech's that are seen as growth stocks, although it should be noted they are forward looking an there rely on predictions of future earning etc.

If we take a look in the Swedish markets there have been some huge moves the past year in healthcare related stocks

Orexo 206%
Sectra 65%
Allenex 175%
ELOS 109%
Oasmia Pharmaceuticals 101%
Vitrolife 128%
Swedish Orphan Biovitrium 95%

Even large cap stock AstraZeneca is moving up with big returns of 35% the past year and 20% in just the past 3 months! It is now trading at a P/E 17 and P/FCF 33, this is a generous valuation for a company that has had falling revenues and net profit the past years. Some of its drugs will be coming off patent so further reductions are expected in the coming years.  Growth however is expected to return earlier than previously thought with sales in 2017 matching 2013 here. Clearly the market is much more willing these days to believe and price in positive future scenarios.

Biotech stocks are popular with private investors (or should I say speculators) because of their big moves, however understanding these types of stocks and valuing them is very tricky. Future cash flows depend on the success and predicted sales of a multitude of projects and potential drugs in the pipeline. One negative announcement or a clinical trial failure can crush a stock price.

You either have to be a very good analyst or diversify over many stocks or have very strict money management trading rules such as stop losses. Take for example, Active Biotech. Its stock price fell 50% when CHMP (Committee for Medical Products for Human Use) surprised investors when they recommended a refusal to market Nerventra (Laquinimod) for the treatment of multiple sclerosis. The sales of this drug have now been completely discounted from the share price here.

Drillcon: An anti-Buffett stock

A small drilling company called Drillcon AB has had my attention the last week or so. I've called it an anti -Buffett stock as it is a capital intensive business, with as far as I can tell no moat, no economic goodwill nor brand. On top of that its performance relies heavily on commodity prices.

First a bit of background. It is a Swedish small cap that whose main activities are diamond core drilling above and below ground, directional core drilling, raise boring and horizontal raise boring. It's operations cover Sweden, Finland and Portugal.


I've not been able to pinpoint exactly how many machines it has but the end of year report 2012 report refers to about 51 being in use in it's three geographical operations (double counting is highly likely as the Swedish arm of the business hires out machines to the Portuguese arm.)

Anyway, since mid-2013 the company has suffered a drop in revenues in Finland due to reduced prospecting activities and lower precious metal prices. The company of course has a high level of CapEx as fixed costs, meaning a relatively small drop in revenues (-8%) caused operating profit and net income to fall off a cliff by over 70%! (Of course this world both ways if these lost sales are recovered, profits will bounce back.)

Interestingly I think this has resulted in a situation where the company looks expensive in respect to its earning power and cash flow, yet looks cheap relative to its assets. For instance, all rolling P/E, EV/EBIT and EV/EBITDA ratios look relatively high and are significantly higher than end of 2012, despite the 26% drop in stock price. 

In contrast to its income the share price is trading just above it's book and tangible book value of 3,07sek. The vast majority of the companies equity is made up of its tangible assets (i.e. drilling machines) and it has little debt.

P/B & P/TB 1.02
Current ratio 1.64
Total debt/Equity 29%

An investor buying this companies stock is effectively buying its drilling machines at book value, nice, but unfortunately overpaying the current income stream (such is the case with these type of situtations). This leaves an interesting dichotomy about which is more important in determining the company's fair value. 

A deeper look in the notes shows that Drillcon's machine purchases total about twice the current tangible book value, the difference has been depreciated away over the years. This begs the question, what is the real market value of these assets and what would be their value in the event of a liquidation? I assume the latter would be significantly lower as the company would be a forced seller and the market for drilling machines wouldn't being very liquid.

Clearly Drillcon is in a cyclical industry and mining is in a depressed state at the moment. The key is knowing whether Drillcon specifically is in a permanent decline and whether it will get it's profits back. What I've been trying to decide is whether the current price gives a sufficient margin of safety to protect from this potential negative outcome.

No doubt the share price could fall significantly below tangible book, especially if the company continues to loose sales and profits. In actual fact the share price could fall at a constant P/TB ratio as the value of its assets are depreciated away and the company can no longer afford new CapEx. The company would then be worth more dead than alive.

It should be mentioned at this point that both the Swedish and Portuguese businesses are still growing (albeit slowly). Plus investment company Traction increased its stake in the company back in the summer by making an offer to share holders at a share price of 2,90sek. This may put a short to medium term support level.

Looking forward if the Finnish operation claws back some sales and manages to generate zero EBITDA, instead of a loss so far seen in 2013, then EV/EBIT becomes 5 (about the same as 2012). I would like see a bit more pessimism and a better margin of safety to get me interested.

I expect a correction in the market soon (yes timing the market is not a good idea!) and combined with the possibility of poor report in February could present an opportunity as this stock goes lower.

It looks like Mr Market may deliver with another 2.2% loss yesterday. This is despite Catapillar's better than expected EPS numbers which pushed up related mining companies.

Buying what nobody else wants

Want to run the opposite way to the crowd and buy a stock that no one else wants? Well according to this article by Avanza there are three Swedish companies that top the most hated list of equity analysts.

PA Resources - an oil company that has been raising capital all year via bonds/shares and whose stock that has been crushed, down 85%.

SAS - an airline company that has made a small profit for the first time since 2008 but is in need of further financing. Interestingly it fell to a low of 5kr in Nov 2013, down 80%, but has since recovered most of that loss and back up another 300%, what a ride!

Axfood -a food retail company whose stock is near its three years high. It's at historically high valuations and I assume this is why it has several sell recommendations.

For me, only the first stock PA resources really passes the 'bombed out' and hated test. However, it's already up 21% this year and in an up trend, sentiment is starting to change from bad to less bad, from hated to less hated.

When sentiment is at its lowest then markets over react on the downside and opportunities arise. Most investors are looking at PA Resources and thinking 'get me out of this!' or 'no chance, I wouldn't buy that!' The sellers get washed out and there is none left to sell and take the stock lower.

This is certainly isn't a 'wonderful company' that you would want to hold forever, however all that is needed is a change of view from 'this is a terrible stcok' to 'this is just a bad stock' for a large pop up in price to occur.

One way I would play this is to treat the share like a call option but with no expiry date and invest no more than I would be prepared to loose completely or at least 50% on the downside.

I will keep track of these three stocks and post an update in the months to come.

Money for Nothing?

On Thursday Dagens Nyheter reported that Roburs vd Tomas Hedbrg had admitted that their most popular stock funds Allemansfonden and Kapitalinvest have probably not tried hard enough to beat their respective indexes (here).

He is quoted as saying that the funds had copied the indexes too closely resulting in just beating them just the once in the past 10 years. To fail to beat an index in itself is no big deal, plenty of others have tried and failed, but to not even try whilst charging a 1.42% fee is a complete failure to deliver value for its customers.

Both funds currently hold 70 billion sek in assets and pull in 1bn in fees avery year for funds that should be charging 0.4% as 'index' funds. That's 700m sek extra for doing nothing extra for their customers, a 175% markup! It's very easy too be cynical here and suspect they were treating these funds as easy money cash cows.

Why have so many people chosen these funds? Perhaps it's a lack of knowledge on their part and/or poor advice. The latter is more disturbing. Surely it goes against exactly what the professional advice should be telling their clients, 'avoid closet index funds'!

The following is a graph showing the funds performances over the past 10 years compared to AMF's World Share fund. All three hold a mixture of Swedish and global stocks, predominantly US and European.

AMF's is the clear winner over the past 3, 5 and 10 years (the Sharper ratio is also superior). The main difference? A far cheaper 0.4% fee. Interestingly in their material AMF claim this fund is actively managed based on low valuations and fundamentals.

The fund has a benchmarks that is 60% OMXSBGI (Swedish index) and 40% FTSE World Index.
Its relative performance is shown below, the benchmark normally wins but it's close; yearly compounded at 8.83% v 9.96%. Even with this better performing fund there is some room for improvement.

The take home message is fees really count. Some actively managed funds will be able to beat the indexes but they are few and far between. Without knowing specifically what strategies are being used by these funds it is unlikely you will find a future winner.

The absolute worst you can do is overpay for a fund that is no different to a passive fund. Know what the comparable index fund is charging and then try to find out what potential value the active fund is offering for the extra fees.

As an end note, Robur's admittenace of their mistakes is to be commended and they now say their two funds are being managed more actively in an effort to beat their index.

The question though investors should still be asking themselves is, will these funds be able to do so when so many others have failed and by a margin that will compensate for the high fee. Only time will tell!

Selling Volatility As An Asset Class

I was thinking the other day about non-correlating asset classes in order to decrease portfolio risk and even improve return, when I got curious as to whether being long volatility could be used in such a way. My theory being volatility increases in down markets when fear takes hold, which would be opposite to the market trend and would hence add diversification (or at least a hedge) to a portfolio.

My first assumption was that it would be the implementation of such a strategy that would be the most difficult part as options are a wasting asset, decreasing in value with time, and the VIX ETF is not suitable for longterm hedging (see here).

This led me to the following paper 'VIX Futures and Options:A Case Study of Portfolio Diversification During the 2008 Financial Crisis' (here). Interestingly the author did find being long volatility, via either VIX futures or 25% out-of-the.money calls,  did improve returns sometimes even with lower volatility, when added to as a 1% or 3% allocation to different portfolios.

'So what's the catch?' you are probably asking. Well the study covers a particular time period between March 2006 and Dec 2008, when there was a significant downturn and volatility spiked upwards. No strategy is suggested unfortunately in how to implement this long volatility asset portfolio allocation in preparation of such a bear market.

This however is where it gets interesting as the author refers to previous studies that suggest the following

1. Long volatility is associated with a negative risk premium, therefore over extended periods of time, long volatility positions tend to underperform the market.
2. Being short volatility should be considered an asset class and option writing strategies find excess risk-adjusted returns for short volatility positions.

Further investigation then led me to another article, this time by Blackrock called 'VIX your portfolio: Selling volatility to improve performance' (here). Here the author looks into different ways at selling volatility on the S&P500 index and shows how such a strategy would perform as a stand alone or in a diversified portfolio.

Selling volatility should capture a positive risk premium as it is said to the the same as selling insurance. Investors buy this insurance to protect their portfolios from down markets when volatility rises. The seller of this insurance (read volatility) bears the risk for protecting these portfolios so is paid a risk premium over the longterm.

Below is a graph showing the implied end of month volatility in the S&P500 from 1990 and its comparison with the realised end of month volatility. The difference is usually positive, hence the risk premium sellers receive. It is worth noting the exceptions in bear markets, such as in 2009, a time period which was covered in the first article. 

Next is a graph showing the performance of the S&P500 compared to the CBOE S&P500 PutWrite Index, a hypothetical portfolio where an at-the-money index put is sold every month. The performance details are not shown here (but can be easily found in the paper) but selling volatility in this way resulted in a higher return than the index, with lower volatility and a smaller maximum drawdown.

There are also some paragraphs on 'Avoiding blowups' and 'Risk management' that are definitely worth reading. Selling puts provides an investor with a defined and limited upside but is combined with a potential unlimited loss!

The nature of this type of investing means there are long periods of small steady wins and limited drawdowns punctuated with sudden periodic large losses. Selling out-of-the-money puts with high leverage is a recipe for disaster when the next black swan comes along. 

Selling puts for income is a strategy I have added to my portfolio over the years. I like receiving the premium and using time decay to my advantage, so it was very interesting to read that in the longterm such a strategy has the odds stacked in its favour.  

As always do not invest in anything you do not fully understand. It takes a lot of reading to understand how options are structured, how they work, the risks involved and all the possible strategies in using them.

A simple two fund portfolio

Before I get into the original purpose of this blog entry I would firstly like to highly recommend this article by Fidelity  It describes the importance of diversification and how the addition non-correlating assets can lower the overall risk of a portfolio.

Some important messages include:

1. A simple diversified portfolio of stocks and bonds would have had a smaller draw down than that of just stocks during the financial crisis of 2008.
2. The recovery of the diversified portfolio from 2009 to 2013 is slightly lower but its overall performance is still superior to the 100% stock portfolio.
3. Correlations between assets classes did increase during the financial crisis but importantly they didn't become fully correlated. Diversification still worked!
4. To be able to fully benefit from diversification investors would have had to stick to the asset allocation throughout the bear market instead of being tempted to shift to lower risk assets and then missing the subsequent recovery in stocks.

The following is a suggestion for a very simple diversified portfolio, one fund in bonds and another in stocks. The primary goal is to maximise diversification for minimum cost. We ideally want global exposure, get it as cheap as possible, and exploit the low correlation between binds and stocks.

Starting with stocks we can find:

SPP Aktiefond global, 0.3% fee

AMF Aktiefond global, 0.4% fee

Both hold hundreds of shares from around the role predominantly in the USA, Europe and Japan. If there is any weakness it's that the emerging markets and Asia get a bit less than 10% exposure. Performances over the past 5 years are about the same at roughly 50%.

The only difference is the SPP fund does not invest in companies considered to be unethical such as those involved with weapons and tobacco. So it's up to the investor if this is important to: them or not when choosing between the two.

The next part is the bond component:

Öhman obligationsfond, 0.15% fee

AMF Räntefond Mix, 0.3% fee

Öhmans fund is the cheapest bond fund which invests in Swedish sovereign debt. However, I like the look of AMF's fund which invests in government bonds from not only Sweden but also the rest of Europe and USA. For a slightly higher fee one gets far more diversification. 

The allocation of the two funds depends on ones tolerance to risk; typically more bonds means less volatility and smaller drawdowns. This also means with age the older you are more a higher bond allocation is recommended to lock in gains and reduce any potential loses as retirement approaches.

It will be interesting to see how this type of strategy will work in the future as we are currently in a very low interest rate environment, bonds prices are very high and we have just come through a 30 year bond bull market. The expectation going forward is rising interest rates and big losses for those with investments in bonds.

However, for the moment, the standard portfolio is a 60/40 stock & bond mix but I'm a more of a stock fan so prefer more of a 70/30 allocation.  So here it is

70% AMF Global stock fund

30% AMF Mix bond fund

A simple two fund portfolio that achieves global diversification across two asset class at a relatively low fee of 0.37%. Both allow very small monthly investments, as low as 50 SEK, and being funds no trading fees would be incurred, such as with ETF's.

A possible 50% crash: What should I do?

Business insider recently released an article arguing the the case for the increasing likelihood of a crash, a big one in the range of 40%-55%. To be fair the article is quite balanced in that the author doesn't scream 'sell! sell!' and clearly states he is still invested in stocks but it did get me thinking.

I first became really interested in investing strategies soon after the financial crisis, which pretty much means I've only really experienced as a 'conscious investor' the wave of a bull market and never the white knuckle ride of seeing my investments cut in half by the panic of a possible world wide depression.

What has been fascinating though is during this time is the constant flow of end of the word predictions, end of the dollar, end of the euro, end of sovereign debt, end of USA, end of the european union, buy gold, buy silver, only to see the stock market just keep on going up, up, up!

It can be completely convincing and in fact compelling to read an article with deep analysis and flourishes of descriptive narration on how exactly the modern economy and its fiat currency will come to and end. The problem is all these predictions, despite their seemingly logical arguments have proven to be wrong!

The problem is with enough predictions going around combined with enough time someone somewhere will eventually look like a master predictor! As the staying goes 'even a broken clock is correct twice a day', although I prefer 'even a blind chicken finds a kernel of corn every once in a while'. Bear markets come and go, keep on predicting one long enough and you will eventually be proven correct.

Does it mean it will never happen, no of course not. It just means any prediction, bullish or bearish, is taken by my good self with a huge lorry load of salt! I read them, understand them, but then just file them in the 'could happen' category. I do not under any circumstance keep changes my investment strategies based on what I read. 

So back to this prediction that is currently taking hold especially with those with a bearish bent. Apparently valuations have only ever been this high twice before in history. That's right, twice, thats barely a correlation let alone a causation of severe bear markets.

Yes, there could be a 50% pull back from here, history shows they are rare but do happen. Should I though really care? When I care I mean, should I pull out all my money, change tactics, panic buy gold etc. Well I'm certainly not going to pull all my money out. Going to cash could easily mean I end up watching the market go to new highs whilst I sit on the sidelines waiting for Mr Market to deliver the big pull back that had been predicted.

(At this point it is important to say I have the benefit of not retiring in the next couple of years. For near retirees an upcoming bear market that could half your pension would be very worrying indeed).

Fact is bear market or not I will continue every month to add to my diversified portfolio of stocks and bonds in different countries across the globe. That will not change. On top of that with a 50% drop I will actually be scooping up twice as many shares for my future pension. 

Two years ago I was still adding to my European stocks when it looked like Greece would default and the whole union would fall apart. I was still adding to my emerging market stocks earlier this year when the supposed FED taper caused a pull back and the chatter was then about the end of the emerging market bubble.

This is the magic of passive index investing. Set up the monthly payments on automatic and let it run year after year, slowly accumulating stocks, ignoring the ups and downs of what might happen next.

Investors can even add a simple in/out trigger based on the 200-day moving average of each of the indices they are following in their portfolio. Simple. This way when the bears start shouting 'I told you so, look, look!' you can remain calm and simply sell and go to cash when prices fall though the moving average, then get back when prices move higher again above the moving average.

The markets are a complex ecosystem of many factors that do not always produce the same events and outcomes. Step away from the predictions, focus on putting together a sound investment plan and hold the mindset that no one really knows what will happen from here on.