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Investment Perspectives - 2003 outlook
FFG Global Investment Research
January 2003
FORUM FINANCE GROUP S.A
Investment Perspectives 2003 - Outlook
Review
2002 a devastating year...
CAC 40
5000
4500
4000
3500
3000
2500
Dec-01
Mar-02
Jun-02
Sep-02
2002 will likely go down as one of the most frustrating years on record for
economists and strategists around the globe. A year after the bottom in a
seemingly mild recession and with corporate profits beginning to grow, few
expected markets to finish down as much as they did. 2002 extended the bear
market to historic levels, making it the deepest and longest bear market since the
great depression.
While 2001 saw the collapse of technology and growth
investing, 2002 evened the playing field as blue chip companies across all sectors
saw stock losses of 20 to 70%.
It was the tale of two crushing market slides - in the spring and again in the fall with varying degrees of pessimism and optimism in between. While the year
started on a positive note, coming on the back of a spectacular recovery after Sept.
11 2001, it disintegrated into a catastrophe of corporate malfeasance, accounting
scandal, bankruptcy and war.
NASDAQ 100
1680
1580
1480
1380
1280
1180
1080
980
880
780
Dec-01
Mar-02
Jun-02
Sep-02
S&P 500
1200
1150
1100
1050
Corporate governance was under attack and revelations that many of the world’s
most respected companies participated in fraudulent or at least questionable
business practices had a significant impact on investor confidence. The Enron
debacle was followed by other energy trading companies like Dynegy, followed
by Tyco and then Worldcom. In addition, the US was faced with the largest set of
corporate bankruptcies since the depression, taking thousands of Jobs and investor
savings down with them. Twelve of the 20 largest in history (including the three
largest - table #1 - following page) came between 2001 and 2002 including Global
Crossing, Worldcom, Enron, Kmart, Adelphia, Conseco, and United Airlines.
Arthur Andersen was broken up in the final salute to what was once considered
the preeminent accounting house in the world.
1000
950
900
850
800
750
Dec-01
Mar-02
Jun-02
Sep-02
SMI
Europe was not to be spared, while few companies (Swissair was one notable
casualty) actually went bankrupt, tenuous cash lines and stretched balance sheets
reduced some previously revered companies to penny stocks.
From
Conglomerates such as Vivendi to technology stocks like Ericsson almost every
blue chip stock was crushed. Dealing with the potential bankruptcy of ABB,
investors were also faced with massive losses at insurance companies such as
Swiss life and banks like Credit Suisse (who is still filling the hole left by
Winterthur, its insurance arm).
6800
6300
5800
5300
4800
4300
Dec-01
2
Mar-02
Jun-02
Sep-02
After a year of significant volatility the final descent in the fall took the market to
dizzying lows in both price and levels of gloom, just as many were hoping that the
foundation for a recovery was in sight. The 3rd quarter of 2002 was the 2nd worst
quarter in market history (on the heals of -13% in the 2nd quarter.). At their
lows, major markets were down between 30% (S&P500) to 51% (DAX in
Germany) for the year and 50 to 70% off their 2000 highs. December 2002 was
fittingly the worst ever final month of the year the market had seen and investors
were now living through the worst bear market since the great depression
Copyright Forum Finance Group S.A.
January 2003
FORUM FINANCE GROUP S.A
Investment Perspectives 2003 - Outlook
Economy
Uncertainties abound
US Bankruptcies 2001 to 2002
20 largest
Table #1
Company
Worldcom
Enron
Conseco
Texaco
Financial Co. Am.
Global Crossing
UAL Corp.
Adelphia
Pacific G & E
MCorp
First Executive
Gibraltar Financial
Kmart
FINOVA Group
HomeFed Corp.
Southeast Bank
NTL
Reliance Group
Imperial Corp.
Federal-Mogul
Assets PreBankruptcy
($blns)
$103.91
Jul-02
$63.39
Dec-01
Dec-02
$61.39
$35.89
Apr-87
$33.86
Sep-88
$30.19
Jan-02
$25.20
Dec-02
$21.50
Jun-02
$21.47
Apr-01
$20.23
Mar-89
$15.19
May-91
$15.01
Feb-90
Jan-02
$14.60
$14.05
Mar-01
$13.89
Oct-92
$13.39
Sep-91
May-02
$13.00
$12.60
Jun-01
$12.26
Feb-90
$10.15
Oct-01
Date
Industrial Production Y-O-Y
10
#1
8
6
4
2
0
Jan-93
Jan-96
Jan-99
-6
Business Inventories Y-O-Y
10
#2
8
6
4
2
0
-4
While globalization is increasing the interrelations among economies, we focus our
outlook on conditions in the US as they remain the driving force behind recovery in
today’s world. With the Japan’s continued structural issues unresolved we expect
no help from the world’s second largest economy. Europe more importantly is
again showing signs of strain. Consumer and business confidence is faltering, as
unemployment rises and demand falls. Germany is on the brink of major economic
fallout and while France remains moderately healthy it cannot drive regional growth
on its own. It is therefore the US economy which will pull the world out of its
slump, and as such we will focus on it for the remainder of the report.
Geopolitical Tensions
-4
Jan-90
The outlook for the coming twelve months confirms this view, requiring investors to
consider many possibilities, both painful and pleasant. While a number of
indicators are slowly becoming more positive, overall the unfolding economic
picture in our opinion, remains neutral at best. Falling consumer confidence, lack of
policy traction, the credit bubble, and capacity utilization remain strong headwinds
in the long journey back to recovery. In addition, war jitters and a weak global
economy have put a break on expansion.
Jan-02
-2
-2
In our 2002 mid-year outlook, we expected that the consumer would continue to
weaken, and that the housing market would begin to top out. Slumping demand,
combined with a still nascent pick-up in corporate profits would put a capex
recovery on hold, pushing it out to early 2003. Finally, the ever worsening
geopolitical situation would inflate the risk premium, thus increasing the possibility
of further deterioration in market conditions. Our outlook called for a completion of
the recessionary cycle as the consumer finally ran out of steam. We expected the
overall recovery to be pushed out to the 2nd or 3rd quarter 2003.
Jan-93
Jan-96
Jan-99
Jan-02
The economic outlook is tempered heavily by the tensions in the Middle East,
Korea and of course the likelihood that terrorism globally is here to stay. The war
in Iraq is the most significant near term factor in the current outlook; a quick
solution would clear many paths to a global recovery in equity markets, while
continued uncertainty or a long and dirty war would only add to the malaise
overhanging the economy. The impact is both economic and psychological. On
the economic side, high oil prices act as a significant threat to any economic
recovery (current price levels could take up to 1% growth out of GDP over the
coming 4 quarters). On the psychological side, while end demand is the
determining factor in most business decisions, we believe that the current
geopolitical situation is playing a determining role in many projects. Until the
consumer and business is rid of the albatross of war and are more confident in our
ability to counteract the almost certain continuation of global terrorism, any
recovery will be difficult to sustain.
-6
-8
3
Copyright Forum Finance Group S.A.
January 2003
FORUM FINANCE GROUP S.A
Investment Perspectives 2003 - Outlook
The Consumer
Industrial Production is recovering...
The story begins with a recovery in industrial production (IP - chart #1) in early
2002. As one can see from the chart, IP began its come back as companies put
product back on the shelves, empty from months of inventory correction and in
anticipation of a demand led recovery in the second half. Unfortunately, the
economy did not recover as planned and by late 2002 inventories had begun to
grow (chart #2) - the anticipated demand had fallen short.
Personal Income Y-O-Y
10
#3
9
8
7
6
5
Final demand remains elusive…
4
3
2
1
0
Jan-90
Jan-93
Jan-96
Jan-99
Jan-02
Personal Spending Y-O-Y
7
#4
6
Consumer spending remains positive...
5
4
3
2
1
0
Jan-90
-1
Looking forward to 2003, we see no reason to believe that this final demand will
become any stronger. Made up mostly of end consumer demand, which to date has
remained remarkably resilient, future weakness appears linked to several factors:
falling confidence, mounting unemployment, increased leverage and record
durable goods consumption during the downturn.
Jan-93
Jan-96
Jan-99
Jan-02
-2
New Home sales
1100
#5
1000
900
While most recessions are characterized by a consumer who holds back durable
goods and discretionary spending as times turn bad, this one is unique in the
continued surprising strength of such spending. The housing market has been
booming with new home sales setting records in 2002 (chart #5) and low interest
rate plans have spurred the purchase of automobiles and durable goods (again at
very healthy rates). And although personal income growth has remained positive
(chart #3) it remains below its historic average and the spread between income and
spending (chart #4) remains well below the savings rate. As the year unfolds the
consumer who already has an ample number of cars and washing machines will
likely choose (in the face of mounting uncertainty) to cut spending to maintain his
savings.
800
But the source of funds may soon recede...
700
600
500
400
Jan-90
Jan-93
Jan-96
Jan-99
Jan-02
Consumer Debt Service
% of Income
14.5
#6
14
13.5
Most of the liquidity in the consumer markets by our estimation has come from
home refinancing. Nearly 70% of Americans own their own home (up nearly 20%
in the 1990’s) and in 2002 refinancing put over $350bln into the hands of
consumers. Savings rates have grown only slightly since then, as Americans saved
approximately $450bln over 2001 and 2002 (a rate still well below historic norms),
while refinancing and home equity loans provided nearly that same amount to
homeowners over the two years. This leads us to conclude that this is all that has
been supporting 2 years of spending, and it should begin a slow and steady decline
in 2003, as much of the existing equity in homes has already been extracted (only
$90bln of ReFi cash flows are expected in 2003)
13
12.5
12
11.5
Mar-80
4
Mar-86
Mar-92
Mar-98
Mar-02
More importantly there is concern that consumer balance sheets are over leveraged
(like their corporate brethren). It is clear that the explosion of mortgage lending
has led to an increase in the service level of debt as a percentage of income. We
are currently hovering around those levels attained in 1987 at just over 14% of
disposable income (chart #6) . We would note that interest rates at the time were
2-3 times as high as today and that this level corresponded to the top in the the US
housing market. Should the economy not recover rapidly enough to maintain
income growth above debt service growth, the resulting impact on consumer
spending and real estate value will be significant.
Copyright Forum Finance Group S.A.
January 2003
FORUM FINANCE GROUP S.A
Investment Perspectives 2003 - Outlook
And the consumer is losing confidence…
Consumer Confidence
160
#7
140
120
100
Consumer confidence (chart #7) has historically been positively correlated to
spending and thus economic recovery. Unfortunately mounting job losses (chart
#8) combined with the threat of war have taken there toll. Consumer
confidence, after briefly stabilizing, has resumed its downward trend, boding
poorly for a strong economic recovery. Given that the consumer has held up in
the face of a declining economy, one could draw parallels to the capital
investment bubble of the late ‘90’s. As consumer confidence fades and spending
drops, how long will it take to amortize the massive quantity of goods already
purchased. Even if Capex recovers, there may be no bounce left in the
consumer’s step.
GDP
80
60
40
Jan-90
Jan-93
Jan-96
Jan-99
Jan-02
Unemployment Rate US
#8
8
GDP= Consumption (70%) + Government Expenditure (18%)+ Net Exports (5%) + Capital Expenditure (17%)…
While GDP has been growing since 2001 (chart #9) , it looks to be faltering here
in Q4 and Q1 2003. Although consumer demand remains present, the question
remains whether the other components of GDP can make up for any potential
future weakness.
Government spending may help...
7
6
5
4
3
Jan-90
Jan-93
Jan-96
Jan-99
Jan-02
Much of the growth attributed to a recovering economy in the last few quarters
can be traced straight back to government spending. While the overall economy
expanded by an annualized amount of $18bln in Q4, government spending
accounted for over $20bln, while the $16bln rise in consumer spending was
offset by $18bln growth in the export deficit. The current administration looks
set to continue to try to spend there way back to growth, so it would seem that at
least for the near future, this will provide some support.
And the falling dollar may give exports a boost...
US GDP % Change
Q-O-Q annualized
8
#9
6
4
2
0
Dec-89
Dec-92
Dec-95
Dec-98
Dec-01
While the dollar’s fall may have a dampening effect on many of the world’s
economies, for the US it could provide an all important swing factor for growth
in GDP. A falling dollar will reduce some of the competitive pressure on local
producers, encourage more domestic consumption and reduce imports as dollar
pricing rises. While it was positive for Europe, Japan and China during the 90’s,
the reversal of the trend may now help the US economy move in the right
direction. The only caveat being of course that should the situation in the middle
east be quickly resolved, the dollar may recoup come of its losses.
-2
-4
The key question remains: CapEx…
Although it only represents 16% of overall GDP, the impact of investment
spending carries much more weight, as it has a powerful multiplier effect. For
5
Copyright Forum Finance Group S.A.
January 2003
FORUM FINANCE GROUP S.A
Investment Perspectives 2003 - Outlook
every new machine, building, desk or software program purchased, the company
must deploy human capital along side, thus increasing employment and consumer
spending.
US CapEx vs. Industrial Prod.
Yoy % Change
30
#10
25
20
Capital Expenditure
Industrial Production
15
10
5
0
Mar-76
Mar-82
Mar-88
Mar-94
Mar-00
-5
Heavily correlated to industrial production and corporate profits, capex in our
opinion has its worst behind it (chart #10). As we move into 2003, we are
beginning to see the turn in Capex that we have been waiting for. In fact Capex
growth turned less negative for the first time in the 4th quarter of 2001, and turned
positive in Q4 2002 (Q/Q annualized). These figures while still in their infancy
bode well for the corporate spending environment in 2003 and beyond.
But utilization rates and confidence keep it muted…
-10
-15
Capacity Utilization
86
#11
84
82
80
78
76
74
Jan-90
Although this turn in investment spending is comforting, current levels of capacity
utilization will likely keep a cap on spending for some time. Generally as
economies recover so do corporate profits, followed closely by corporate spending.
Unfortunately capacity utilization remains at near record low levels (chart #11) and
companies are still facing very uncertain demand (chart #12). With consumer
confidence falling and the threat of war ever present, corporate managers remain
reluctant to spend unless absolutely necessary. Taken together we think that
business spending while on the mend will take much longer to recover than most
think, thus putting into question the strength of any economic rebound.
Corporate America
Jan-93
Jan-96
Jan-99
Jan-02
Corporate profits are rebounding…
NAPM Backlog
65
#12
60
55
50
45
40
35
30
Jan-93
Jan-96
Jan-99
Jan-02
Although the message from many market pundits is that corporate profits are a
mess, S&P 500 earnings bottomed in the 3rd quarter of 2001 and have been
growing modestly ever since (chart #13). Trailing 12 month earnings for the S&P
500 hit $24.69 in September of ‘01 and are set to hit $31.40 in Q4 of ‘02, with
expectations of them rising to $39.50 by the end of ‘03. Moreover, corporate cash
flows at US corporations are recovering. After a low in early 2001, cash flows at
US companies improved every quarter - outpacing earnings as non-cash write-offs
dominated the adjustments in 2001 due to new FASB rules to account for goodwill
accounting.
Pension under-funding and balance sheet restructuring will eat up much of that in
2003…
S&P 500 EPS Quarterly
16.00
15.00
#13
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
6
Estimated
As profits and cash flows increase, companies normally spend some of that money
on fixed investment. As mentioned, we believe that fixed investment spending
has hit a bottom, we however remain cautious on the strength of any recovery, as
much of the profits generated (over half of the growth expected in 2003 - $5per
share of the $9 per share change over 2002 by our estimates) will go towards
topping up severely under-funded pension plans. Moreover any additional cash
flow will likely go to continued debt reduction (chart #16, next page), leaving little
real growth in fixed spending before 2004.
Copyright Forum Finance Group S.A.
January 2003
FORUM FINANCE GROUP S.A
Investment Perspectives 2003 - Outlook
Strong money growth and fiscal stimulus have been supportive…
Real Interest Rates
5
#14
4
3
Past examples of serious post-bubble eras (read: Japan , 30’s Depression) were
marked by the reluctance of policy makers to quickly increase money supply and
create monetary stimulus. This time the Fed and the US government have both
acted quickly to drop rates and taxes to spur economic growth. The Fed has
indicated its willingness to go to zero on rates and Bush’s dividend and other tax
cuts looks set to put money back into the pockets of American consumers
(although the dividend tax cut will likely suffer many modifications if it passes at
all). Today’s real interest rates have been solidly negative for a number of
months and money supply growth remains strong (chart #14).
2
But multiplying that money has not been easy…
1
0
Jan-90
Jan-93
Jan-96
Jan-99
Jan-02
-1
Construction Spending - Corporate
30
As mentioned above, monetary stimulus has been substantial, however this time
the lag in its effectiveness has been acute - almost 24 months since stimulus began
vs. a normal lag of 9-12 months. Clearly liquidity that the Fed is moving into the
economy is not flowing through as one would have hoped or expected. As
mentioned on the previous page, liquidity is being eaten up by the credit hole
created by the pricking of the credit bubble in the US. Corporate credit grew an
average of nearly 10% per year from 1995 to 2000 and one could assume that it
will take sometime for these excesses to be cleaned up.
#15
20
10
0
Jan-90
Jan-93
Jan-96
Jan-99
Jan-02
-10
-20
-30
Between the record default levels in the corporate bond sector, to the massive
defaults of high profile bankruptcies (i.e. Worldcom etc.) and accelerating small
business defaults on credit - we think that Fed efforts to jump start the economy,
while extremely important, are not yet reaching their target. Any liquidity freed
up in the corporate world are currently being used to decrease debt loads, not
increase them. As long as credit growth remains negative (chart #15) liquidity
will stay in the banks and the resulting multiplier effect will be small.
Conclusion
A strong recovery still out of sight...
Commercial Credit Y-O-Y
15
#16
10
5
0
Jan-90
-5
-10
7
Jan-93
Jan-96
Jan-99
Jan-02
We therefore believe that while 2003 will post positive GDP growth, it will be
well below expectations. 2003 will be a stabilizing year as the profit recovery
gains ground and companies begin to spend again. However consumer demand
will not be sufficient in the near term to justify any increase in spending until later
in the year. We continue to believe that the 4th quarter 2002 and 1st quarter 2003
will come in below market expectations. Too many headwinds - debt, consumer
confidence, capacity and war - stand in the way of a meaningful recovery until
2004.
In summary, a spent out and leveraged consumer will not likely provide the boost
required to ignite capex spending given the low rates of utilization. Government
efforts to stimulate economic growth still fall short as restructuring, debt reduction
and pension fund contributions eat through much of the injected liquidity. And the
impact of a looming war weighs too heavily on the consumer and business to
allow for anything but a slow and painful recovery.
Copyright Forum Finance Group S.A.
January 2003
FORUM FINANCE GROUP S.A
Investment Perspectives 2003 - Outlook
Risks
Geopolitical turmoil…
The longer the threat of war looms, the less likely an economic recovery. Should the
situation be resolved with little or no bloodshed, in a short period of time, the economy
and market may recover much more quickly than we have estimated in this report.
Should it drag on however, the consequences would be negative and would certainly
increase the likelihood of continued weakness. Moreover, regardless of the outcome of
the war, it is probable that additional terrorist attacks will be attempted. The magnitude
and frequency of continued terrorism will be an important factor in any long term
recovery.
The housing market…
There is a possibility that as part of a final breakdown in the economy, the consumer
sector begins to fade. While in itself not too alarming (giving the already low base from
which we currently operate), it may be severe enough to spark a drop in real estate
pricing. The average price of homes over the past year have started to fall, with some
large metro areas down by 20% for higher priced homes.
Surging home values have enabled many homeowners to tap into the equity of their
homes to spend it on goods and services, which may become a concern as average
earnings fall and households earn less in a stalled recovery. The household affordability
index has begun to show some weakness, and while still high it may be the harbinger of
bad news on the horizon. In an environment of falling home prices, consumer sentiment
is hard hit, and prices can fall significantly in very short periods of time - putting a severe
squeeze on many who may have counted on the recovery to maintain a bull market
lifestyle.
Deflation...
The decade of the 90’s (and much of the 80’s) was essentially a period of declining
interest rates and inflation. Globalization in the economy allowed manufacturing
companies to reduce the cost of labour and production by moving into developing
countries. Technology allowed even greater productivity gains for companies both in
administration, sales and production. Proof lies in the capacity (though questionable at
some technology firms) of the aggregate economy to continue to reduce inventory levels
as a function of sales.
However, these gains in general have been offset by price declines invited by the
increased competition that globalization brings with it. With little pricing power
companies have been hard pressed to turn these developments then into hard profits. As
the economy slows and prices adjust downward with demand the dis-inflationary trend
accelerates. At a certain point, dis-inflation becomes deflation, and unless productivity
continues to rise (and past adjustments continue to put its value into question), company’s
will become unable to cope. Add to this an uncertain dollar and the trend for US
companies may be forced to answer some tough questions should this recovery stall.
8
Copyright Forum Finance Group S.A.
January 2003
FORUM FINANCE GROUP S.A
Investment Perspectives 2003 - Outlook
Markets
Implied Equity Risk Premium
6.00%
#17
5.00%
4.00%
While 2003 will be a year of economic stabilization rather than growth, we think that
the markets may on the contrary provide positive returns in 2003. Profits are on the
rise, valuation is finally reasonable and many psychological issues are behind us. At a
time when no one wants to own stocks, it seems that now may be a good time to go
bargain hunting and we are finding a large number of attractively valued companies.
However current expectation for earnings growth, which we think are still too high,
remain troubling. More importantly, the implied risk premium has risen substantially
as risk aversion on the part of equity investors grew during the now 3 year old bear
market (chart #17).
Profit Outlook
3.00%
2.00%
1.00%
0.00%
Dec-95Jun-96Dec-96Jun-97Dec-97Jun-98Dec-98Jun-99Dec-99Jun-00Dec-00Jun-01Dec-01Jun-02Dec-02
After three years of economic malaise, the S&P 500 has registered 4 consecutive
quarters of earnings and importantly cash flow growth (and looks set to make it 5 in Q4
2002 - chart #18). While we believe that estimates for 2003 remain too high and
pension fund costs will likely eat up some of these profits, the growth trend is clear.
For the first time in this bear market we can point to positive bottom lines, and it is
improbable that stocks would fall in periods exiting a recession as earnings grow.
Valuation
S&P 500 EPS Quarterly
16.00
#18
15.00
14.00
13.00
12.00
11.00
10.00
Estimated
9.00
8.00
7.00
6.00
S&P 500 DDM Model
EARNINGS 35
36
37
38
39
40
41
Table #2
42 PRICE
EARNINGS
RATES
3.50%
18151867 1919 19702022 207421262178
52
3.60%
15811626 1671 17161761 180618521897
45
3.70%
14001440 1480 15201560 160016401680
40
3.80%
12561292 1328 13641400 143614721508
36
3.90%
11401172 1205 12371270 130213351367
33
4.00%
10431072 1102 11321162 1191 12211251
30
1016 10431071 109811251153
27
4.10%
961 988
4.20%
891 916
942
967 993 101810441069
25
4.30%
831 854
878
902 925 949 973 997
24
4.40%
778 800
822
844 867 889 911 933
22
Dividend discount model (DDM - table #2) - After 3 years of market losses, valuations
in the US and Europe have finally come back to historically reasonable levels. Our
dividend discount model shows the market undervalued by 10-20% based upon
consensus expected net earnings for the S&P500.
Return on Equity (ROE) - Importantly, return on equity for US companies appears to
have bottomed and is once again on the rise; having bottomed at near 8.5% in the Q2
2002, it should hit 11% in 2003 on its way to the long term historical average of 12%.
An important factor in determining normalized earnings potential this may drive
investors in the future to change their views on investing in stocks. In particular, many
stocks appear undervalued across many industries (including technology), where
balance sheet risk is being reduced and ROE looks set to increase. As earnings recover
we see opportunity in many stocks, once deemed growth that may be entering value
territory.
Yield - Historically, dividends represent 60% of the return on equity investments over
the long term. Dividend yields on the S&P 500 are now inching back up and are
currently above short term bond levels in the US - an important factor in today’s low
interest rate environment. Moreover, for the first time in many years, the EPS yield on
the S&P 500 (based on estimated consensus EPS) exceeds that of a 10 year investment
grade bond.
Market Confidence
The all important factor in 2002. Many of the troubling issues are now behind us. We
have come to terms with Enron and other large bankruptcies, accounting scandals are
no longer front page news, investment banks are paying their penance and the pension
fund issue, while tough on earnings, is probably well understood. The crucial issues
remaining are the economy and the war. Barring a melt down in the US economy (and
the risk still remains - see page 8) if the war issue can be put behind us, the markets
should enjoy their first rise in 3 years.
9
Copyright Forum Finance Group S.A.
January 2003
FORUM FINANCE GROUP S.A
Investment Perspectives 2003 - Outlook
Allocation
After three years of market declines and significant volatility, we have come to the conclusion that we
must to a degree adjust our investment philosophy to a new more volatile reality. Extreme volatility
and a need to expand our offerings to include exposure to more modern investment tools drives us to
make some fundamental changes in the way we allocate our funds.
We are expanding our offering of asset classes to include both country and theme specific funds as
well as alternative investments (hedge funds and structured products) to our investment allocation.
The goal of these funds and other specialized investment vehicles are:
•To expand the diversification across asset classes for our clients,
•To provide access to specialized geographic and theme based investments
•To reduce the volatility of portfolios while targeting absolute returns.
•To reduce correlation to volatile market movements
Direct investments remain the cornerstone of the Forum Finance philosophy however, and a such we
will continue to focus upon growth stock investing with allocations across sectors with high growth
opportunities. This core of investments will then by augmented by the addition of Equity funds in
regions and sectors where we cannot offer in house the same high quality of exposure. In addition,
where possible alternative investments including structured products and hedge funds will be used to
enhance return and reduce portfolio volatility.
1
Cash
0- 20%
Fixed Income
- Direct investments
- Fund Products
- High Yield
- Hedge
- Structured Products
Equities
- Direct investments (above average beta)
-Tech
-Biotech/Pharma
-Cons. Discretionary
-Energy
-Financials
-Other
-Equity Funds
-Value
-Emerging Mkts
-Opportunity
Alternative investments
-Hedge fund products
-Multi manager
20-40%
Copyright Forum Finance Group S.A.
20-40%
0-20%
January 2003
FORUM FINANCE GROUP S.A
Investment Perspectives 2003 - Outlook
Alternative investments: Hedge funds
What is a hedge fund?
A hedge fund is an investment that can use one or more “alternative” investment strategies to protect or “hedge” against market downturns.
There are several common strategies used to hedge, such as selling stocks short, investing in assets such as currencies, distressed securities,
and using leveraged tools such as derivatives and arbitrage. Traditional funds and investments are often called “long only” products and are
highly correlated to market movements, with little or no downside protection.
Unlike regulated Mutual funds however, hedge funds are much less scrutinized by regulatory agencies around the world and as such require
sufficient due diligence in their selection and allocation.
This allocation will be limited to up to a maximum of 20% of any client portfolio, and will be in accordance with the directives laid out by
the Association of Swiss Bankers and the Association of Swiss of private Asset Managers. The directives of the association require that any
investment in alternative class of funds respond to the following criteria:
1. They must be structured along the principles of a fund of funds.
2. They must provide liquidity a minimum of 4 times per year.
Our use of hedge funds will in most cases be limited to the use of Multi-funds or Fund of Funds(FoF), where a fund manager specialized in
selecting and investing in various hedge fund strategies manages a group of fund investments. We apply a strict set of investment criteria in
evaluating these FoF’s and constantly review managers in an effort to maintain a wide range of investment opportunities for our clientele.
Our criteria are based upon:
1. Meaningful historic track record - consistency of returns
2. No consideration of pro-forma performance
3. Risk profile
•Maximise the Sharpe1 ratio
•Minimize Annual Volatility
•Minimize draw-downs and fat tail risk
4. Quality of Manager
5. Rigorous Risk control
For new clients this fundamental change - the inclusion of various fund and structured products will represent the objective for asset
allocation. For existing clients, given the fundamental nature of the change, only after consultation will any changes be made taking
advantage of the right opportunities to move existing portfolios in the right direction.
What Are Hedge Fund of Funds:
Fund of Funds*:
The manager invests in other hedge funds (or managed accounts programs) rather than directly investing in securities such as stocks, bonds,
etc. These underlying hedge funds may follow a variety of investment strategies or may all employ similar approaches. Because investor
capital is diversified among a number of different hedge fund managers, funds of funds generally exhibit lower risk than do single-manager
hedge funds. Funds of funds are also referred to as multi-manager funds
Strategy and Sector Definitions
Aggressive Growth:
The manager invests in companies experiencing or expected to experience strong growth in earnings per share. The manager may consider a
company's business fundamentals when investing and/or may invest in stocks on the basis of technical factors, such as stock price
momentum. Companies in which the manager invests tend to be micro, small, or mid-capitalization in size rather than mature largecapitalization companies. These companies are often listed on (but are not limited to) the NASDAQ. Managers employing this strategy
generally utilize short selling to some degree, although a substantial long bias is common.
Distressed Securities:
The manager invests in the debt and/or equity of companies having financial difficulty. Such companies are generally in bankruptcy
reorganization or are emerging from bankruptcy or appear likely to declare bankruptcy in the near future. Because of their distressed
situations, the manager can buy such companies' securities at deeply discounted prices. The manager stands to make money on such a
position should the company successfully reorganize and return to profitability.
1The
Sharpe ratio provides a measure of return above a risk free rate, per unit of risk (volatility). It is calculated as follows: (annualized return-risk free
rate)/annualized volatility. While it is often used as a guide to hedge fund selection, it should only be viewed as one tool among many in analyzing fund
characteristics.
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Copyright Forum Finance Group S.A.
January 2003
FORUM FINANCE GROUP S.A
Investment Perspectives 2003 - Outlook
Hedge Fund Strategies*
Income:
The manager invests primarily in yield-producing securities, such as bonds, with a focus on current income. Other strategies (e.g.
distressed securities, market neutral arbitrage, macro) may heavily involve fixed-income securities trading as well; this category does
not include those managers whose portfolios are best described by one of those other strategies.
Macro:
The manager constructs his portfolio based on a top-down view of global economic trends, considering factors such as interest rates,
economic policies, inflation, etc. Rather than considering how individual corporate securities may fare, the manager seeks to profit
from changes in the value of entire asset classes. For example, the manager may hold long positions in the U.S. dollar and Japanese
equity indices while shorting the Euro and U.S. treasury bills.
Market Neutral - Arbitrage:
The manager seeks to exploit specific inefficiencies in the market by trading a carefully hedged portfolio of offsetting long and short
positions. By pairing individual long positions with related short positions, market-level risk is greatly reduced, resulting in a portfolio
that bears a low correlation and low beta to the market. The manager may focus on one or several kinds of arbitrage, such as
convertible arbitrage, risk (merger) arbitrage and fixed income arbitrage. The manager attempts to take advantage of pricing
discrepancies and/or projected price volatility involving the paired long and short security.
Market Neutral - Securities Hedging:
The manager invests similar amounts of capital in securities both long and short, maintaining a portfolio with low net market exposure.
Long positions are taken in securities expected to rise in value while short positions are taken in securities expected to fall in value.
These securities may be identified on various bases, such as the underlying company's fundamental value, its rate of growth, or the
security's pattern of price movement. Due to the portfolio's low net market exposure, performance is insulated from market volatility.
Market Timing:
The manager attempts to predict the short-term movements of various markets (or market segments) and, based on those predictions,
moves capital from one asset class to another in order to capture market gains and avoid market losses. While a variety of asset classes
may be used, the most typical ones are mutual funds and money market funds. Market timing managers focusing on these asset classes
are sometimes referred to as mutual fund switchers.
Opportunistic:
Rather than consistently selecting securities according to the same strategy, the manager's investment approach changes over time to
better take advantage of current market conditions and investment opportunities. Characteristics of the portfolio, such as asset classes,
market capitalization, etc., are likely to vary significantly from time to time. The manager may also employ a combination of different
approaches at a given time.
Short Selling:
The manager maintains a consistent net short exposure in his portfolio, meaning that significantly more capital supports short positions
than is invested in long positions (if any is invested in long positions at all). Unlike long positions, which one expects to rise in value,
short positions are taken in those securities the manager anticipates will decrease in value. In order to short sell, the manager borrows
securities from a prime broker and immediately sells them on the market. The manager later repurchases these securities, ideally at a
lower price than he sold them for, and returns them to the broker. In this way, the manager is able to profit from a fall in a security's
value. Short selling managers typically target overvalued stocks, characterized by prices they believe are too high given the
fundamentals of the underlying companies.
Special Situations:
The manager invests, both long and short, in stocks and/or bonds which are expected to change in price over a short period of time due
to an unusual event. Such events include corporate restructuring (e.g. spin-offs, acquisitions), stock buybacks, bond upgrades, and
earnings surprises. This strategy is also known as event-driven investing.
Value:
A primarily equity-based strategy whereby the manager focuses on the price of a security relative to the intrinsic worth of the
underlying business. The manager takes long positions in stocks that he believes are undervalued, i.e. the stock price is low given
company fundamentals such as high earnings per share, good cash flow, strong management, etc. The manager takes short positions in
stocks he believes are overvalued, i.e. the stock price is too high given the level of the company's fundamentals. As the market comes
to better understand the true value of these companies, the manager anticipates, the prices of undervalued stocks in his portfolio will
rise while the prices of an overvalued stocks will fall.
*Basic
1
definitions as outlined by Vanhedge funds, http://www.hedgefund.com. An Authoritative guide to investing in hedge funds
Copyright Forum Finance Group S.A.
January 2003