Fasanara Capital | Appendix | Portfolio Buckets


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Fasanara Capital | Appendix | Portfolio Buckets

  1. 1. Fasanara Capital | Appendix(last updated 1st March 2013)Multi-Equilibria MarketsLonger-term, as our readers and investors know all too well, we remain skeptical on theeffectiveness of crisis resolution policies being implemented, wary of the sheermagnitude of the level of over-leverage built in the system and its drag on the realeconomy, conscious of the wild volatility which could be triggered by one too manyexternal or internal shocks in such crystal-fragile environment. As such, we design ourportfolio to sustain most of the states of the world we can see, and be protectedagainst new equilibria which deflect vastly from the baseline scenario currentlypriced in by markets, and which are diametrically opposite from one another. Thebaseline scenario remains one of a multi-year slow-deleverage Japan-style. But thesystem has never been as vulnerable as it currently is to shocks which may flip theequilibrium to a different set of variables than the status quo / mean reversionwould suggest.To be sure, as Central Bankers keep flooding the system with liquidity, our base casescenario is one of a stagnant economy and of a multi-year Japan-style deleverage.Under such a scenario, a disorderly deleverage would be avoided and inflation wouldnot be triggered… at least in the short term, until such delicate equilibrium willeventually break. In the coming years, we believe that 6 scenarios might play out (someof which are mutually exclusive or may happen in succession): Inflation Scenario(Currency Debasement, Debt Monetisation, Nominal Defaults), Default Scenario (RealDefaults, sequential failures of corporates/banks/sovereigns across Europe), RenewedCredit Crunch (similar to end-2008, end-2011 or mid-2012), EU Break-Up (eithercoming from Germany rebelling to subsidies or peripheral Europe rebelling toausterity), China Hard Landing, USD Devaluation.We also believe that current market prices and compressed Risk Premia make itworthwhile / relatively inexpensive to position for fat tail events, as they are currentlyheavily mispriced by markets. 1|Page
  2. 2. The OutlookOur thinking is simple. The market is underestimating the potential impact of thereal economy not picking up despite unprecedented liquidity being thrown at it,by extraordinarily expansive monetary policies, for too long a period of time. In doing it,the market underestimates the impact that a fast increasing level of unemployment inperipheral Europe can have on price dynamics in the second half of 2013 and beyond(youth unemployment at approx 60% in Greece/Spain, and 36% in Italy/Portugal). 2|Page
  3. 3. Here the market seems to be sedated to the flawed idea that the social compact andwelfare safety nets put in place by such democracies will suffice in keeping socialdiscontent at bay, and the army of unemployed in voting for yet another pro-Europeanpro-austerity government as soon as they are given another opportunity to do so overtime. As the readjustment needed to rebalance competitiveness across Europe is stillwide open (to closing the gap to German wages it would require Italian andSpanish labor costs to fall by an additional 30% to 40%), we tend to challengemarket’s complacency about it. Falling real wages, perhaps falling nominal wages, inItaly and Spain by up to 40% is the baseline scenario now, one of slow deleverage multi-year Japan-style. If anything, Japan did have a choice ten years ago, to devalue thecurrency in nominal terms, which they did not go for (they are taking a different view onit only now), whereas Europe does not even have that option, as fixed-exchangecurrency system impedes it, and allows only Internal Devaluation to happen. Until thecurrency system itself implodes, as we expect down the line.And more so now, as we enter a market environment of currency debasements onecountry against another, where no mystery is held up any longer on one’s intention todevalue and open wide the FX gates to its economy. More and more, evidence is in ourface of US and Japan intentions. South Korea, China, Latam, and the UK itself, mightfollow, although the tempo of their reaction functions might vary greatly. Europe itselfwill then face the choice of either catching up on the trend or split up, to allow individualcountries to opt for that route if they wish. Timing matters: the sequence of competitivedevaluations across countries might take years to materialize and be fully visible, and itmay be a stretch then to expect southern Europe to sustain multi-years of muchstronger EUR against pretty much anything else, and thus a more dramatic drop inwages and increase in unemployment needed to make up for it. Look at Japan, where aprogressively stronger nominal Yen in the last ten years was associated with an evenlarger Internal Devaluation and Price Deflation, so big that the Yen actually depreciatedin real terms by 35%/40% against EUR and USD over the past 15 years, counter-intuitively, whilst appreciating in nominal terms by 75%.All told, if the political gridlock over ECB OMT activities and other forms of heavyQE is here to stay for long enough, we have one more reason to consider the riskscenario of a EUR break-up a genuine one. Yet another one of the scenarios we seekto be hedged (and over-hedged) against. We might as well have those hedgesimplemented now, for it is still inexpensive to do so. If such tail events do not take place,then great, as our Value portfolio will not be impaired, and we will enjoy the nominalrally in the market. On the other end, if such events were to take place, we would beamongst a few ones who bothered to spend that money on a hedge, before such hedgebecame overly expensive or not available at all. 3|Page
  4. 4. Bottom-line, over the next few years, if money printing failed to restart theeconomy, we face the real chance of a multiple choice between a Default Scenario(Real Defaults, Haircuts & Restructuring; potential Euro break-up, as either peripheralEurope derails from the bottom, or Germany reconsiders it from the top) and anInflation Scenario (Nominal Default, Currency Debasement whilst engineering DebtMonetization, as money printing continued unabated, until money multipliers/velocityof money made a U-turn to fully drive it out of control). More on it in the attached.Opportunity Set for 2013As the strategy was unchanged over the last few months, let us quote freely from ourDecember Outlook (while updating some of the short dated investment positioning inhere described): ‘’In the following few lines we offer our observations on the mainthemes underlying our portfolio construction, across its three main building blocks. Ourcurrent Investment Outlook in implement into an actionable Investment Strategy alongthe following three parts: The StrategyValue InvestingOver the course of 2012, our Value Investing portion of the portfolio was staticand entirely filled by Senior Secured bonds issued by strong companies fromnorthern Europe and the US (i.e. countries with their own domestic currencies –UK,US – or on the right side of a foreign currency – Germany, Holland), export champs with 4|Page
  5. 5. exposure to EM flows, high but affordable leverage, running yields of 5%-10% area,target IRR at inception of 10%-15%. We thought the tail risks underneath markets thisyear warranted to stay clear of peripheral Europe assets, clear of junior/mezzaninepaper, and clear of equity markets altogether. As we performed strongly into above 20%returns, we still clearly lost the opportunity for even bigger gains: however, weconcluded that such opportunity was not appealing when adjusted for the large risks itentailed. Risks did not materialize in the end, but in retrospect it is always easier toread markets.Now then, we are at a crossroad as High Yield valuations have reached bubblelevels. One thing is to say our senior bonds were good investments and deserved torally, another thing is to say they deserve to trade at 4% to 6% yields to worst. We donot believe such sustained valuations are justified, especially as we do not discount thetail risks out there at zero, and we believe it is only a matter of timing before thevaluations realigns to fundamentals somehow. True, liquidity is large in the system andmoney printing (especially in the US) might target corporate paper directly and drivevaluations even further and yield even lower: however, the more time goes by the morethat equated to an Inflation Scenario (Debt Monetisation achieved via CurrencyDebasement). An Inflation Scenario, where negative real rates and QE-type interventionhelps inflate one’s way out of nominal debt, is effectively just another form of DefaultScenario. Whether the debt is not paid back in full or whether its real value is eroded byinflation does not make a huge difference to most investors. Inflation destroys thevalue of fixed income claims as surely as default.On the other end, should the money printing slow down or stop outright, should theoxygen mask be removed from the debilitated patient, and the reversal of the trendwould be abnormally asymmetric, leading to important capital losses across the capitalstructure. Playing for even lower yields on stretched corporate balance sheets (and evenmore on government bonds) equates to pick up dimes in front of a steamroller. Webelieve that the risk of rising interest rates is highly underestimated by themarket right now.The bubble in the credit markets is unmistakable, starting with government bonds toslide down the credit curve into High Yield markets. Valuations are so high that anyroom for further appreciation is close to exhaustion. 2013 might be the first yearearmarked with a negative return (of some dimension) for government bondsever since 1994. To continue slowly or quickly, in the following year, until it changesgear. Cracks are well visible in the High Yield and Loan markets too, as issuancevolumes reached approx. $600bn, which is 2007 record levels (another creditbubble market back then, which was going to pop a year later). More importantly, theshare of covenant-lite issuance has reached a staggering 30% of the total (in 2005 5|Page
  6. 6. it was 5%): which means less maintainance covenants in exchange for pure incurrencecovenants, which means lower protection for investors. Market players now argue thatthis is a positive development as a potential catalyst to a credit event / downperformance is outright removed, forgetting it also damages recovery values. It soundslike typical complacent bubble market commentary, ready to justify overvaluations inretrospect as the new normal and make the case for further future appreciation. To us, itmay be wishful thinking, and it is only a matter of time for the market to catch upwith reality.For all these reasons, in 2013 we intend to keep migrating slowly and safely fromHigh Yield territory into Equity, hedged, with similar characteristics to seniordebt. As Equity most obviously presents different characteristics of expected volatility,we apply three layers of risk management: 1) security-specific hedges (typically throughlong/shorts, but also via capital structure arbitrage), 2) macro overlay strategies and 3)Fat Tail Risk hedging programs.Fat Tail Risk Hedging ProgramsThe leit-motiv of our Investment Strategy remains to take advantage of currentmarket manipulation and compressed Risk Premia to amass large quantities of(therefore cheap) hedges and Contingency Arrangements against the risk ofhitting Fat Tail events in the years to come. If we do not hit them, then great, it will bethe easiest catalyst to us hitting the target IRR on the value investment portion of ourportfolio (what we call Safe Haven, or Carry Generator). If we do hit one of those pre-identified low-probability high-impact scenarios, then cheap hedges will kick in forheavily asymmetric profiles (we typically targets long only/long expiry positions with10X to 100X multipliers). Such multipliers are courtesy of market manipulation and‘interest rate rigging’ by Central Banks. We believe they represent the only truly 6|Page
  7. 7. Distressed Opportunity in Europe. Timing-wise, the next months may offer aninteresting window of opportunity.Currently, thanks to Central Banks’ liquidity and asset value manipulation, threestrategic scenarios (out of the six strategic scenarios we have in mind) can first behedged at rock-bottom valuations. Such scenario include: Inflation, Renewed CreditCrunch & Euro Break-Up. Hedging against such scenarios is currently very cheapand as a result Fasanara aims to increment hedging on such opportunities first inQ1 2013.Tactical Short-Term Plays / Yield EnhancementWe will not expand on this section too much, as it is less relevant in our portfolioconstruction, which tends to be quite static and ‘buy and hold’. Short term tacticalpositioning / yield extraction strategies. Such positioning is typically tactical andshort term, for we remain prepared to adjust as information comes in.Francesco FiliaCEO & CIO of Fasanara Capital ltdMobile: +44 7715420001E-Mail: francesco.filia@fasanara.com16 Berkeley Street, London, W1J 8DZ, LondonAuthorised and Regulated by the Financial Services Authority 7|Page
  8. 8. “This document has been issued by Fasanara Capital Limited, which is authorised and regulated by theFinancial Services Authority. The information in this document does not constitute, or form part of, any offer tosell or issue, or any offer to purchase or subscribe for shares, nor shall this document or any part of it or thefact of its distribution form the basis of or be relied on in connection with any contract. Interests in anyinvestment funds managed by New Co will be offered and sold only pursuant to the prospectus [offeringmemorandum] relating to such funds. An investment in any Fasanara Capital Limited investment fund carriesa high degree of risk and is not suitable for retail investors.] Fasanara Capital Limited has not taken any stepsto ensure that the securities referred to in this document are suitable for any particular investor and noassurance can be given that the stated investment objectives will be achieved. Fasanara Capital Limited may,to the extent permitted by law, act upon or use the information or opinions presented herein, or the research oranalysis on which it is based, before the material is published. Fasanara Capital Limited [and its] personnelmay have, or have had, investments in these securities. The law may restrict distribution of this document incertain jurisdictions, therefore, persons into whose possession this document comes should inform themselvesabout and observe any such restrictions. 8|Page