REVIEW OF 'PRINCIPLES FOR NAVIGATING BIG DEBT CRISIS' BY RAY DALIO




Principles For Navigating Big Debt Crises is a series of 3 books by Ray Dalio, the founder of Bridgewater Associates, a global asset manager and the largest hedge fund in the world. My blog post would be reviewing the first book of the 3-part series. I was interested in this book because I felt that it would be good to learn from the lessons of the 2008 financial crisis (this is covered in detail in Part 2, which includes detailed case studies of the debt crises). I did not experience the 2008 crisis from the perspective of an investor, and the only market correction I’ve experience was during late 2015 and early 2016, due to fears of a hard landing for the Chinese economy, as well as crashing oil prices; and perhaps also early this year as well as the recent volatility in the markets. I believe that as even these relatively mild corrections can be rattling for many investors, I can’t help but to wonder how we would react in the event of a crash of similar magnitude to that of 2007 – 2009, when equity prices declined by more than 60%. It has only been about 10 years since the Great Recession, but it seems as though complacency has begun to set in again.

Today, people are still irrational as ever, as evident from the cryptocurrency hype last year, driving Bitcoin to $20,000 before the bubble burst. Greed and fear of missing out drives investors to pile money into ‘investments’, (or rather, speculation) in hope of making a quick buck. Undeniably, there are those who made huge returns through cryptocurrencies, and the underlying blockchain technology is set to bring about many practical benefits. However, as described in the book, bubbles form when the boom encourages new buyers who don’t want to miss out to enter the market (although the book is focused on debt fuelled bubbles, which wasn’t the case for crypto).

Given that we are still in the longest bull market since World War Two, many of us have questioned whether the next crisis would be approaching. This book describes how debt cycles are formed, and that by studying many cases, we would be able to see patterns that repeat itself over time.

The key points that the book covered were 1) the deflationary debt cycle, 2) the inflationary debt cycle (currency crises), and 3) the spiral to hyperinflation. The deflationary debt cycle is probably best characterised by the 2008 subprime mortgage crisis, while hyperinflation is what Venezuela is experiencing now.

The book begins by discussing how “debit” and “credit” underpins our entire economy, and that having too little growth in debt can be as bad as having too much debt, because of the forgone opportunities. Dalio includes a good analogy using the Monopoly game as a simplified example of how debt cycles are formed. Bubbles occur when unrealistic expectations and reckless lending results in high levels of bad loans, and when increasing amounts of money is borrowed to service debt payments.

Dalio listed seven measurable characteristics of bubbles as follows:

1) Prices are high relative to traditional measures

2) Prices are discounting future rapid price appreciation from these high levels

3) There is broad bullish sentiment

4) Purchases are being financed by high leverage

5) Buyers have made exceptionally extend forward purchases to speculate or protect themselves against future price gains

6) New buyers have entered the market

7) Stimulative monetary policy threatens to inflate the bubble even more, and tight policy to cause its popping

However, Dalio notes that debt ratios of the entire economy may not be adequate as compared to specific debt service abilities of the individual entities, which are often lost in the averages.

For policymakers to manage debt crises, Dalio notes that the following methods have been employed – the four levers:

1) Austerity – cutting government spending and raising taxes. Dalio believes that this is a mistake during depressions

2) ‘Printing’ money – guarantee liabilities, providing liquidity, supporting the solvency of systemically important institutions and recapitalising/nationalising systematically important financial institutions.

3) Debt defaults/restructuring – balance the benefits of allowing broke institutions to fail with the risks that failures can have detrimental effects on other creditworthy lenders and borrowers. Ensure that the pain is distributed across the population, and spread out over time.

4) Redistributing wealth – through taxes, politically attractive but rarely impactful.

Dalio notes that the four levers have to be moved in a balanced way to reduce intolerable shocks; balancing the inflationary forces against the deflationary ones. Additionally, it is much harder for policymakers to manage debt crises when the majority of the debt are denominated in foreign currency.

Overall, I picked this book because I believe we all want to be able to spot the peak of the bubble – and adjusting the position of our portfolios. Imagine shorting CDOs in 2008, as depicted in “The Big Short” movie. While Dalio described the typical indicators of spotting bubbles, the book didn’t exactly cover how investors should react during a debt crisis; instead, it was more about what policymakers could do to mitigate the effects of debt crises. 

However, I still feel that this was a worthy read, as it allowed me to understand more about the macroeconomic factors affecting our economy, as compared to the individual company level or industry level analysis that I have been familiar with. My blog post has mainly covered the deflationary debt cycle, as I had found it challenging to fully appreciate the chapters about inflationary depressions and currency crises, and I did not want to write any misinterpretations of what these chapters cover. I’ll be reading the detailed case studies in Part 2 of the series in the coming weeks.

I’d recommend anyone interested in understanding debt crises from a macroeconomic perspective to read this book. Lastly, if you have read a good book regarding investing or personal development in general, please leave a comment below and I’d be glad to check them out. Thanks in advance!

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FRASERS PROPERTY



With property companies in Singapore being hit by both the recent property cooling measures and the prospect of rising interest rates, many property companies listed here have fallen greatly from their January highs. I've began to take interest in property companies recently, as a number of them are trading close to their 52-week lows. Another proxy for our local residential property market would be APAC Realty, which has seen its share price performing poorly of late. As interest rates increases, home buyers face higher financing costs for their property, which may result in them scaling back on their purchases.

In July, when the latest property cooling measures were implemented, property developers here sold off sharply during the next few days. However, it would be important to note that many property companies here aren't merely residential property developers - some have assets diversified geographically across numerous sectors. Hence, I believe that the recent selloff in property companies has been overdone, and bargains have started to surface.

A company that got me interested was Frasers Property (FPL), a company that operates across Singapore, Australia, Europe, Thailand and China. FPL's 2017 annual report provides a breakdown of their assets geographically.

Source: FPL Annual Report 2017


Company Overview


Frasers Property has stakes in various REITs, including Frasers Commercial Trust, Frasers Centerpoint Trust, Frasers Logistics & Industrial Trust and Frasers Hospitality Trust. I feel that owing FPL would be a more diversified option rather than selecting the individual REITs.

Investors should note that only approximately 12% of FPL's shares are held by the public. The remaining shares are held by TCC Assets Limited (59%) and InterBev Investment Limited (28%). This results in FPL shares being less liquid relative to other developers.

Why I like Frasers Property


High Percentage of Recurring Income


This factor is of high importance to me as property developers tend to have lumpy earnings - depending on when the development properties are completed. With a high percentage of recurring income, it gives the company a more predictable revenue stream, thus the company would be less affected by a slowdown in the property market. 67% of FPL's PBIT are derived from recurring income sources (Figure 1), while 80% of FPL's assets are generating recurring income. FPL's recurring income base is derived from its fee income as a REIT manager, dividends received from it's stake in the REITs, as well as from rental income from its investment properties. In the latest annual report, FPL's management has stated that its strategy would be to continue to grow its recurring income base, while ensuring that its sources are diversified geographically. 

FPL's 3Q 2018 presentation shows how FPL has managed to grow its recurring income base:

Source: FPL Results Presentation, Q3 2018


High Dividend Yield relative to other developers


FPL has been paying out a constant dividend of 8.6 cents for the past 4 years. Looking at their dividend payout ratio, I believe that it is reasonable to expect a similar rate of dividends going forward. When looking at whether the dividends are sustainable, I look at the dividends paid as a percentage of FPL's net attributable income before fair value adjustments. The net attributable income to shareholders before fair value adjustments gives us a more accurate perspective of earnings, as it does not include revaluation gains on investment properties, which are non-cash gains and boosts earnings per share.

Here's a table which compares FPL's dividend payout against its net income attributable to shareholders before and after fair value adjustments.

AlpacaInvestments Estimates


From the table above, it is evident that FPL's payout ratio is healthy, and we can reasonably expect FPL to maintain or even increase its dividends going forward.

Investment Risks


High Debt to Equity Ratio

A key concern for me would be FPL's high net debt to equity ratio, which currently stands at 89.3%.  I also noticed that FPL's net interest cover ratio declined from 10x for 9M 2017 to 4x for 9M 2018. This was due to the double whammy of falling earnings per share and higher interest expense following its increased borrowings to fund acquisitions, as well as the completions of investment properties. During construction of investment properties, interest on the borrowings funding these properties can be capitalised, which reduces overall interest expense. Once they are completed, the subsequent interest expense cannot be capitalised, increasing interest expense.  However, FPL noted that there is a timing difference between the completion of these properties and the revenue contributions from them. Hence, we should expect FPL's interest cover ratio to show some improvements in the next quarter.

With interest rates expected to continue rising, this would increase FPL's interest expense. When FPL refinances their debt, it would likely have to borrow at a higher rate. However, property companies tend to have higher debt to equity ratios due to the nature of their operations. 

As of 30 Jun 2018, FPL had a fixed debt percentage of 74.8%, with an average debt maturity of 3 years. Their average cost of debt stands at 3%. 

Geographical Exposure to Australia

FPL has significant exposure to Australia, with 26% of their assets based there. Australia's residential property prices have fallen for 12 months straight, and FPL's management has flagged out challenging market conditions in Sydney, Melbourne and Perth in their quarterly earnings report. In addtion to Australia's recent political challenges, Australia has also been affected by the US-China trade war, as the Australian economy is heavily dependent on exports to China. Weakness in the Australian Dollar may affect FPL's earnings going forward, although FPL has some currency hedges (e.g FLT hedges its Australian currency risk) in place to mitigate this.

Conclusion


With FPL's exposure to the Singapore property market estimated to be approximately 5%, FPL's exposure to the Singapore property market is significantly lower than most other developers. I believe that FPL may have been irrationally sold off together with most of the Singapore property developers, due to fears over further residential property cooling measures. Nonetheless, some risks remain, including rising interest rates and a weak Australian Dollar. Ultimately, I believe that FPL at a range of ~$1.50 is probably a good time for investors to consider.

Note: As of writing, I do not have a position in FPL.



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