Walking up the pipeline

Robert Pires explains BIAS’ investment strategy following this year’s political turmoil and natural disasters. 

As it is part of the investment manager’s job to control risk in the portfolio, investment analysis always requires risk analysis as part of the evaluation of investment opportunities. Besides the traditional interest rate, inflation, market and business risks, one of the major risks in the first months of 2011 was event risk.

So far this year has been “unprecedented with respect to the frequency and scale of event risk”, says Robert Pires, CEO of Bermuda Investment Advisory Services.  

From an investment perspective the political turmoil in North Africa and the Middle East entails the risk that the power vacuum has to be filled with a stable business and investor friendly form of government. Initially, at least, the resulting uncertainty has led to a retraction of investment in the region. 

In addition, large scale natural disasters have struck within months, beginning with the floods and the effects of a cyclone in Australia, the earthquake in Christchurch New Zealand, followed by an even stronger earthquake and a tsunami hitting the North Eastern Coast of Japan. And most recently there was also the largest tornado outbreak in US history.

When these events happen, a sharp sell-off in the markets occurs, but this is followed by a relatively sudden recovery, Pires notes.  

“This means that these events can certainly have a significant short-term impact on the markets but at some stage the markets shake it off and events therefore present a risk but also an investment opportunity in the medium and long term, not least in terms of facilitating investments needed for the reconstruction and economic recovery.” 

For instance, in the case of Lybia, attempts to shake off Muammar Qhaddafi’s regime have put the supply of high quality crude oil produced in the country under pressure. When these supply issues occur, the general global market reaction is to look for a way to balance off that shortfall. 

Walking up the pipeline  

This is what one of BIAS’ main investment themes for the first months of this year was based on. Pires calls it ‘walking up the pipeline’, by trying to identify businesses capable of addressing the shortfall, such as oil exploration companies, as well as those able to supply needed resources and technology for the reconstruction efforts in Japan, New Zealand and other countries. BIAS expects 2011 to be the first year of a prolonged up-cycle in international exploration and production spending for energy companies. 

Correspondingly the firm this year has invested into companies like Ensco Energy, an offshore mid-water and deepwater drilling company and Schlumberger, a company that provides technology, project management and information solutions to the oil industry.

“We also have shareholdings in a company that is well positioned in Brazil. Brazil has a huge oil field off its coast that has yet really to be exploited and has a very high quality of crude,” Pires states. 

“So certainly with the reconstruction in response to the disasters, energy will have a huge input and this begins with extractions,” he says. “That is what we mean by walking back up the pipeline.” 

BIAS is still invested in companies like Royal Dutch Shell, but rather because of its dividend yield. Its oil investments are focused on extraction and not the major oil companies.

In addition BIAS has invested into commodities suppliers for copper and iron ore like Freeport McMoran or Cliffs Natural Resources, which will be crucial to the reconstruction effort. 

Paradigm shifts  

In addition to these events BIAS perceives a paradigm shift important for portfolio management considerations. “A lot of old rules are being challenged,” says Pires. 

In the past, government issued debt was considered the safest investment with the highest credit rating. Today this is no longer universally the case as the examples of Greece, Ireland, Portugal and others prove. Standard & Poors even threatened to lower the US credit rating to AA, if the debt is not reduced. 

One of the fundamental issues is that none of the governments that have accumulated high debt, whether they are from OECD countries or smaller islands like Cayman or Bermuda, are going to get elected, if they propose to raise taxes, says Pires. Yet this is likely what will be necessary to decrease the massive debt burden that has been accumulated. 

In this sense corporate debt is more accountable and BIAS believes that quality double A and triple A rated corporate debt is instead the place to be. “But we are not selling out US Treasuries, because the double A credit particularly from the US is probably going to do OK in terms of safety of capital,” says Pires. “It is just that we think that corporate bonds are probably going to do better, because there is a discipline imposed.” This is expressed in strong corporate balance sheets as the debt to assets ratio of corporate balance sheets has been declining from 32 per cent in 2007 to 26 per cent today. 

Another paradigm shift concerns equity investments. As opposed to stocks for growth, BIAS now considers stocks for income, as some companies are paying more dividends on their stocks than they are paying interest on their debt. 

Bonds on the other hand, which were seen as an instrument for total return in the past, are now increasingly considered for risk mitigation. 

Another shift in terms of portfolio allocation is that in the past, commodities were important for producers, users and speculators. BIAS for instance did not have commodities in its portfolio because their volatility, but nowadays commodities are considered as an asset class. 

And the final important change is that credit is no longer a right, it has become a privilege, says Pires. 

Equities for income  

In terms of asset allocation what follows from these points is that BIAS is overweight in equities, particularly in those that are paying yield and offer high or growing dividends. 

According to the Fed model, which looks at the yield on S&P 500 stocks (earnings per share as a percentage) in relation to the yield on 10 Year US Treasuries, stocks look cheap.  

At the same time you are getting much better yields on the earnings of stocks right now than you are from bonds, Pires notes. These stocks turn the logic on its head that one should buy bonds for income.  

Pires names Banco Santander, AT&T, Royal Dutch Shell, Bell, Vodafone and Microsoft as examples for companies that offer between 0.5 per cent and 7 per cent higher yields from dividends than interest income from their bonds. 

Fixed income  

With respect to fixed income BIAS prefers short-term bonds over long-term bonds, while interest rates are held at artificially low levels. But, Pires argues, this will be unsustainable and at some stage interest rates will have to go up. “This may not be in the next couple of years, but we want to make sure that our clients have bonds maturing when interest rates start to move up, which may be two, three or four years.”  

Commodities   

Pires predicts that energy consumption in emerging markets will continue to rise as a middle class rapidly develops in the major markets. The cumulative oil demand from OECD and non-OECD countries is growing but non-OECD oil demand is growing much faster, Pires showed. 

At the same time some European countries are decommissioning nuclear energy, which means that other forms of energy, including fossil fuels will have to be found. Spare capacity in the oil markets, however, will disappear from 2014 and 2015, as the relative demand will for oil will outstrip supply, according to research by Morgan Stanley.  

Because of the natural disasters materials are required on a large scale to rebuild what has been damaged and aid the economic recovery. Insurers estimate that the cost of reconstruction will be between $200 and $300 billion in Japan alone.  

“Those of us who come from hurricane economies know that after the initial destruction the insurance companies pay out and then the economy goes into overdrive,” Pires says. “So we expect economic growth to come out of Japan for instance and we actually bought Japan after the tragedy.”  

As far as gold is concerned, Pires is a sceptic. BIAS held gold in its portfolio, made a profit buying at $900 and $1,100 and selling at just under $1,500 and cut the position in half over the last quarter. In-house opinion is divided on the continued profit potential of gold and therefore half of the initial investment in gold remains in the portfolio. “I am comfortable with that,” says Pires. 

pipe

BIAS expects 2011 to be the first year of a prolonged up–cycle in international exploration and production spending for energy companies.

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