can turkey's economic situation recover?

Invast Insights

Week Commencing January 28, 2014

www.invast.com.au | 1800 468 278

This week we look at the following topics:

1.0 Can Turkey’s economic situation recover?

2.0 Monthly portfolio review and changes

3.0 Forge Group (FGE) – example of fragility

4.0 Educational trading video – Nassim Taleb


1.0 Can Turkey’s economic situation recover?

There has been lot of press coverage over the fall in the Turkish currency over

the past few weeks and the knee jerk reaction of the Turkish Central Bank to

boost rates above 12% last week. The decline in the currency is due to a

number of factors including political instability and a widening graft probe, a

worsening fiscal situation and the flight of cash away from emerging markets

as the US Federal Reserve expands its tapering efforts. The real reason for the

currency decline is hard to pinpoint and this isn’t really our main focus.

Instead we are more interested in where the currency goes and if there are

further trading opportunities should the Turkish Lira completely collapse.

How likely is this?

This isn’t the first time a central bank has intervened to stem a currency

collapse. There is a long history of markets shifting capital outside of

economies when certain political forces take power. France in the early 1980s

is a perfect example. Efforts were made to stem the currency collapse by


lifting short term interest rates. There are other examples though of

unsuccessful efforts. Indonesia comes to mind during the Asian Financial

Crisis. The Indonesian Rupiah depreciated from Rp2436 in mid 1997 to around

Rp7900 in the space of two years despite the Indonesian Central Bank

boosting interest rates to as high as 70-80% range for overnight money.


Investors were clearly shaken and since the depreciation, the Indonesian

currency is yet to recover. Our point here is that when a currency starts to

collapse, it is very unlikely for it to recover ground. Central bank action to

temporarily prop up the value of currency is a short term solution. Turkish

businesses have experienced a large fall in their purchasing power and now a

huge rise in the cost of borrowing to finance their operations. This will start to

flow through the domestic economy, driving down economic growth and

plunging the country further into a financial mess.

The sudden increase in Turkish interest rates will only temporarily halt the

flood of cash leaving the economy. The Indonesian example, coupled with

many others globally, will no doubt resonate among the capital elite. There is

a fine balance between depreciating your currency to help improve export

competitiveness and a certain currency being sold off on fear that the central

bank and government situation will lead to hyper inflation. Turkey is on the

verge of spilling over into the later unlike the United States which has bank


and government situation will lead to hyper inflation. Turkey is on the verge

of spilling over into the later unlike the United States which has benefited

from the former. Below is a chart taken from Invast’s MT4 platform, which

shows the US Dollar rising against the Turkish Lira over the past few months.


Image: USDTRY hourly chart via Invast MT4 platform


Turkey’s economy cannot be fairly compared to Indonesia in the late 1990s. Turkey is diverse - a gateway between Asia and Europe. The economy is worth around US$800bn annually which is significantly larger than Iran at around US$500bn and more than three times the size of Greece. Turkey is the 17th largest economy in the world. GDP growth has been running at a respectable rate of 2.2% but this is likely to drastically slow as monetary policy tightens. The 74m population has generally benefited from economic prosperity over the past decade or so as trade ties and capital flows helped double GDP per capita to around US$10,665, on the most recent measure.

Unemployment is high at around 9.8% and public debt to GDP is at 35.5% which isn’t large on face value but has been steadily rising. Turkey needs to turn a corner in its domestic politics if it wants to stem the economic fallout. This will be the most pivotal point. The fiscal situation has the capacity to change but only if government confidence returns. As a democracy the next few months will be crucial. Fiscal expenses are quickly exceeding revenues and while Turkey can fund this through issuing more debt there will come a point where the market completely loses trust. We will continue to monitor the situation over the next few months to see if any European intervention helps stave off a complete government and fiscal collapse.


The reason we started this week’s publication with comments on Turkey is

because very rarely in history have investors been able to trade the potential

collapse of a currency. Usually this luxury has been afforded to only large

institutional investors. Usually the individual investor is left with a currency

that continues to depreciate and their purchasing power diminished. Invast

has added the Turkish currency to its list of available markets due to strong

client demand. We feel iIt’s worth keeping the USDTRY or EURTRY on your

watch list.

2.0 Monthly portfolio review and changes

Our portfolios have held up relatively well over the holiday period. We haven’t

seen the types of gains which we booked late last year but given the global

market turbulence and falling indices as the US Federal Reserve tapers, our

portfolios have not seen any significant losses either. Keep in mind that our

main focus is to beat our modest targets.


We started the portfolios off with modest $50,000 balances in each and we

purposely said that we won’t be benchmarking against an index but investing

according to stated goals. The most disappointing portfolio has been our

Wealth Preservation – not because we have suffered losses but because our

gains have evaporated. Nevertheless, our primary focus is to hold a wide

range of diversified securities that allow us to sleep overnight and this hasn’t

changed.


The Wealth Creation portfolio continues to hold up well, we’re pleased with

the 14% return since inception. The short S&P500 index position has worked

against us since inception but we continue to hang on and it is encouraging

to see markets starting to pull back. Unfortunately the depreciation in the A$

has helped offset any gains but we’re sticking to our conviction and see this

as a nice hedge against falling markets. We have just under $9500 in cash and

we continue to shop around for some small cap opportunities. We are likely to

announce these in the next review before making new acquisitions. Any

pullback in markets will create even great opportunities to enter.


Westfield continues to be a disappointment for the Wealth Preservation

portfolio, mainly around its split into two difference vehicles. The fact that the

US Federal Reserve is starting to taper suggests that the US economy is

improving and Westfield is a major beneficiary of this, with its vast portfolio

of real estate assets. We’re digging in and holding on for at least the next year,

Westfield has strong income certainty and at the very least we will be picking

up a solid dividend yield in the order of 4-4.5% which helps contain any

temporary losses. The IJP ETF position has also performed nicely as the

Japanese market holds onto its gains and the Australian dollar declines

slightly against the Yen.


The Drawdown Phase portfolio continues to trade above our target. We sold

our AMP position as previously advised and subscribed to the AMP

Subordinated Notes issue – basically taking the income component without

worrying about further capital downside. We wouldn’t be surprised if AMP

shares actually rise following their result next month but this is a conservative

portfolio and we don’t want to have any type of volatility, so future losses will

also be quickly cut. The realised loss is large but the rest of the portfolio is

performing strongly. We have recognised the upcoming dividends from the


TAHHA and GMPPA securities that we are holding and these are sitting nicely

in the cash balance now at $1139.

3.0 Forge Group (FGE) – example of fragility

Forge Group (FGE) shares have fallen from a yearly high of $6.98 to around

$0.76 as of the time of writing. They have touched a low of $0.28. This isn’t the

most important stock on the market by any means but the reason we are

writing about it this week is to use it as a case study for assessing other

stocks. This is a perfect example of how the market can like a business for a

long time and then suddenly the value can evaporate overnight. We analyse

the situation below.

Forge is an engineering, procurement and construction business focused on

mining regions in Western Australia. It managed to grow earnings steadily

over the years by winning large contracts. The market loved the stock as work

continued to pile in but what many missed was the composition of earnings.


There is a big difference in the way mining construction businesses earn

revenue compared to a supermarket or telecommunications provider.

Contracting businesses rely on a few, large contracts. It’s all very well to win a

$100m construction project but the risk of underperforming is large.

Sometimes it’s better to have 10 million transactions at $10 each. The fragility

of a business is often overlooked by the market – and many analysts for that

matter – with too much emphasis on actual earnings in isolation.


Forge’s glory run eventually came to an end, it blew up basically overnight on

a few key contracts. The main problem projects have been the Diamantina

Power Station and West Angelas Power Station projects which have seen large

losses. Earnings have evaporated and caused the business to move into a loss

making position for the 2014 financial year in the order of $20-25m. What

makes matters worse is that Forge has used debt to fund its growth and

lenders are now sitting cautiously on the sideline to see how key risks play

out.

When cash starts flowing through the door and your business is reliant on

debt funding this usually creates a cocktail for disaster. That’s why the value of

Forge shares – the equity value – has almost completely diminished over the

past few months. When buying shares, you need to look beyond the actual

‘Price to Earnings ratio’ or earnings growth numbers and actually stress test

the quality of earnings themselves. Sometimes it is better to buy a robust

business with little earnings than buying a business which appears to be

making strong earnings but with poor composition. This is how we think

about stocks at Invast, particularly smaller companies.


Investors should never cease to educate themselves, there are lessons in the

market every single day. The market will always continue to teach and

educate you regardless of your level of experience. If success was attained

through experience, no fund manager would ever lose money. We know that

many do and when markets tumble it is usually the experts that suffer the

largest losses. The lesson here is to never be complacent. The misfortune of

Forge shareholders should remind in your mind, as an investor, for the rest of

your life. Many investors and traders focus on the businesses that book huge

returns but we should equally spend time studying the businesses that blow

up.

Usually we learn more from the blow ups than we do from the success stories.

Ask yourself this question, how many success stories have you read where the

CEO or founder takes credit for all the success themselves and gives little

appreciation to luck. Now ask yourself how many disaster stories you read

where the CEO or founder ponders on external circumstances – the economy,

interest rates, the currency, politics, consumer sentiment etc – and gives little

criticism of their own mismanagement.


We as humans like to pat ourselves on the back when luck goes our way and

criticise others and blame misfortune when we make mistakes. This won’t get

you anywhere as an investor or trader.

From the Forge group experience, we learn the following points:

• Contracting businesses usually don’t make money over the life of the

business cycle. There will come a time in the future where the financial

community will try to convince you otherwise. Don’t believe them. Keep

this written on a piece of paper and tuck it under a draw somewhere.

Revisit in 5-10 years time when the next mining investment boom is

around.

• Contracting businesses do make large profits at the top of the cycle. There

might be a few years where they win large contracts and everybody

jumps on-board, sold the message that there is a huge abundance of work

out there, but then growth usually leads to a blow up. It only takes one or

two large contract losses to completely wipe out the value of a business.


• Shareholders usually take the largest losses. Lenders tend to cover

themselves against assets to fund business growth. Ordinary shareholders

are always the last to know when things go bad and by the time the news

is out there in the market, shares have probably already collapsed.

• Earnings are not all the same. The earnings quality of a supermarket or a

construction business is very different. One has more fragility while the

other. A supermarket’s earnings growth may not be as attractive at certain

times, earnings may even fall in some cases, but selling 10 million

transactions at $10 each might be much better than completing one

single $100m contract. You are less likely to blow up with 10 million

transactions then you are with one large contract.

• There is a reason why mining companies, property developers,

governments and companies generally outsource construction or

procurement – it is because they don’t want to take the risk. If contracting

was so successful over the long term, governments, property developers,

companies like BHP and Rio Tinto would all internalise the function rather

than outsourcing it.


4.0 Educational trading video – Nassim Taleb

With the above section in mind, we thought we would bring you an

interesting video that caught our eye over the past few days. The whole issue

of quantifying risk and being able to measure probabilities against stumbling

blocks is core to our ideology. Nassim Taleb is an author which we first

mentioned in our book review of the Black Swan. Taleb’s name is synonymous

with risk taking and more recently being able to measure what is fragile and

what is anti-fragile. There are certain ways to position you as a trade to

benefit from rare events like Black Swans, but these are difficult to predict.

Taleb in this video instead focuses on being able to see what is fragile – like

Forge Group (FGE) for example – and then adjusting your circumstances or

investment portfolio accordingly. We end this publication with this video

because it is really relevant to all of the above sections. If you watch the video

you can see which parts of our portfolios are fragile and how we have tried to


build robustness (particularly with the deep diversification in the Wealth

Preservation portfolio) and lastly the Forge example. Taleb presents his

findings at the Digital Life Design conference, click on the image below to go

directly to the link with will play the short video. On his Twitter page, Taleb

wrote that this is the “one thing I want to convey before I die”. Take a look.

Image: Author Nassim Taleb presenting at the DLD conference

Drop by our site to access other trading videos relevant to this topic.

http://www.businessinsider.com.au/nassim-taleb-measuring-fragility-2014-1

http://www.invast.com.au/resources/video-centre.aspx


7.0 Disclaimer

Please note that you are receiving this report complimentary from Invast Financial Services Pty Ltd (AFSL 438 283). Invast staff members may from time to time purchase securities which are included in this or future reports. The authors of this report may or may not be holding a position in the securities mentioned. Please note that the information contained in this report and Invast's website is of a general nature only, and does not take into account your personal circumstances, financial situation or needs. You are strongly recommended to seek professional advice before opening an account with us.

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can turkey's economic situation recover?

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