Wholesale Client BRIEFING Understanding ‘How we think’€¦ · Prerequisite Capital Management Pty Ltd (ABN 27 141 060 933) is a Corporate Authorised Representative of AIW Dealer

Wholesale Client BRIEFING

14th April 2016, by Daniel J. Want

Understanding ‘How we think’

www.prerequisite.com.au/research

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www.prerequisite.com.au/research Restricted Use: for Wholesale Clients Only

Copyright © 2016 Prerequisite Capital Management Pty Ltd, Australia. All rights reserved. Past performance is not indicative of future results. The views expressed are the views of Prerequisite Capital Management Pty Ltd through the period ending at the date of

publication and are subject to change at any time based on market and other conditions. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.

Copyright © 2016 Prerequisite Capital Management Pty Ltd, Australia. All rights reserved. Past

performance is not indicative of future results. Neither Prerequisite Capital Management Pty Ltd nor

any of its employees, or any person(s) or firm who is represented within this publication shall have

any liability for any direct or consequential loss sustained by anyone who has relied on the

information contained in this publication. At no time does Prerequisite Capital Management Pty Ltd

make specific recommendations for any specific person, and at no time may a reader, caller or

viewer be justified in inferring that any such advice is intended. This publication has been prepared

by Prerequisite Capital Management Pty Ltd on behalf of itself and its affiliated companies solely for

the general information of clients or potential clients of Prerequisite Capital Management Pty

Ltd. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument.

The views expressed are the views of Prerequisite Capital Management Pty Ltd through the period

ending at the date of publication and are subject to change at any time based on market and other

conditions. References to specific securities and issuers are for illustrative purposes only and are not

intended to be, and should not be interpreted as, recommendations to purchase or sell such

securities. Prerequisite Capital Management Pty Ltd (ABN 27 141 060 933) is a Corporate

Authorised Representative of AIW Dealer Services Pty Ltd (ABN 59 153 322 420) AFSL 414256.

Disclaimer

General Information

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Guiding Principles

PCM’s key beliefs (with practical examples to follow)

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“Good analysis comes from good understanding.

And good understanding is provided by a conceptual framework that helps

you organize your thinking… A conceptual framework guides you in using

information intelligently – to turn the information into knowledge.”

“Concepts and frameworks are only important if they lead to analysis tools.”

…Stephen H. Penman(Financial Statement Analysis & Security Valuation, 2001 edition, preface pg. vii)




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Markets are made at the margin (but should always be viewed in the context of valuations)... therefore:

1. We look at capital flows and liquidity dynamics (not just liquidity supply, but also demand [velocity] and the disequilibria often found in liquidity pricing)

2. We are attentive to what is and isn’t “in the price” – thus we pay attention to “consensus” – noting that when everyone is thinking alike, no one is thinking

3. We focus on where profits come from in an economy (& around the world) and watch these sources like a hawk.

4. We pay attention to the Wicksellian logic of available risk premia vs. funding costs in driving cycles of capital flows and investment (we especially pay attention to distorted dynamics that can give rise to unproductive investment and capital misallocation)

5. We pay attention to Hazlitt’s maxim – re: 2nd, 3rd order unrecognised effects – hence we are mindful of paradox in fiscal and monetary policy.

6. We pay attention to the fallacy of composition in global affairs – if everyone does the same thing then that which they wish to avoid comes upon them




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7. We pay attention to the logic of capital structure (i.e. seniority of credit to equity) – especially with regards to interpreting signal from noise. We also note that real rate and credit growth dynamics tend to lead volatility.

8. We look at the world at a global level as a ‘closed system’ – one subsystem’s imbalance has or forces another subsystem’s counterbalance – so we spend probably too much time thinking about balance of payments issues in addition to savings/investment disequilibria issues at a global level.

9. We seek to attune ourselves to the epidemiology of ideas (or memes) amongst market participants

10. When looking at markets we see price also as a fingerprint of psychology – hence we are attuned to inflection points (and lines in the sand) that represent decisive behaviour shifts in the participants. As a sub-tenet to this, it is not the event itself but the perception of the event is key on a tactical basis – it’s the flaw to the perception that’s key on a structural basis

11. When analysing companies, we seek to truly grasp the fundamental PATTERNS of ecological strength, success and resiliency

12. We seek always to be able to objectively recognise the difference between a cyclical drawdown in a thesis vs. a structural breakdown in a thesis.




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EUR / USD

Relative Liquidity Model


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Quantity of Liquidity (YOY%)

Velocity of Liquidity (YOY%)

Total System Liquidity (Quantity + Velocity, %YOY)

US 10yr Bond

USA




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US 10yr Bond




CNY / USD China



Above blue band = structural BullMarket in Gold

Below blue band = structural BearMarket in Gold

Bear market signal given by collapse of tactical valuations

Overvaluedwithin a bear

market context


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1. We look at capital flows and liquidity dynamics (not just liquidity supply, but also demand [velocity] and the disequilibria in liquidity pricing)



Undervaluedwithin a bull market context


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Results as 2014 progressed:Bond yields ‘surprisingly’ lower (bond prices higher)…




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Results as 2014 progressed:US Profits ‘surprisingly’ down (but blamed conveniently on ‘the weather’)…




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4. We pay attention to the Wicksellian logic of available risk premia vs. funding costs in driving cycles of capital flows and investment (we especially pay attention to distorted dynamics that can give rise to unproductive investment and capital misallocation)

[Example next slide]




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Pricing. S&P 500 Implied 10 Year Annualised Future Price Returns

Expected 10yr Equity Returns LESS THAN ‘Risk Free’ 10 Yr Bond Yield

Source: (Data) Macrobond Financial; analysis uses frameworks developed by Jesse Livermore of Philosophical Economics blog; Prerequisite Capital Management Pty Ltd.

“One reason that risk premiums may be low is precisely because the environment is less risky… The Fed has long focused on ensuring that banks hold adequate capital and that they carefully monitor and manage risks. As a consequence, banks are well-positioned to weather the financial turmoil.”- Janet Yellen, July-September 2007




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“The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not

merely for one group but for all groups.”

...Henry Hazlitt (1894-1993)




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PCM Research from 19th May 2014...




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PCM Research from 19th May 2014...(please let us know if you would like to request the full research document)

[QE as we are currently experiencing it]




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6. We pay attention to the fallacy of composition in global affairs – if everyone does the same thing then that which they wish to avoid comes upon them

PCM Research from 20th Jan 2014...(please let us know if you would like to request the full research document)




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[Examples next two slides]




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Tactical. Capital Structure Concerns...

HYG / TLT ratio(HYG iShares iBoxx USD High Yield Corporate Bond Fund ETF)(TLT iShares Barclays 20+ Year Treasury Bond ETF)




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Real Rates pushed forward 18months




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8. We look at the world at a global level as a ‘closed system’ – one subsystem’s imbalance has or forces another subsystem’s counterbalance – so we spend probably too much time thinking about balance of payments issues in addition to savings/investment disequilibria issues at a global level.




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9. We seek to attune ourselves to the epidemiology of ideas (or memes) amongst market participants

Everett Rogers’ work on the diffusion of innovation [an idea]: • When 3% of a total population accept an idea, it won’t go away. • When that number rises to 15-20 percent, it cannot be stopped.

The thread of an idea entering the awareness/consciousness of & then taking grip of society/markets?...

Time

Awareness(% of Population)

15%

3%




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10. When looking at markets we see price also as a fingerprint of psychology – hence we are attuned to inflection points (and lines in the sand) that represent decisive behaviour shifts in the participants. As a sub-tenet to this, it is not the event itself but the perception of the event is key on a tactical basis – it’s the flaw to the perception that’s key on a structural basis

“People are disturbed not by things, but by their perception of things.”...Epictetus (AD 55–AD 135)

“...financial bubbles are not a purely psychological phenomenon. They have two components: a trend that prevails in reality and a misinterpretation of that trend. A bubble can develop when the feedback is initially positive in the sense that both the

trend and its biased interpretation are mutually reinforced. Eventually the gap between the trend and its biased interpretation grows so wide that it becomes unsustainable.

After a twilight period both the bias and the trend are reversed and reinforce each other in the opposite direction.”

…George Soros, June 2nd, 2012




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“The great strategists of the past kept forests as well as trees in views. They were generalists, and the

operated from an ecological perspective. They understood the world is a web, in which adjustments made

here are bound to have effects over there – that everything is interconnected. Where might one find

generalists today? The dominant trend within universities and the think tanks is towards ever-narrower

specialization: a high premium is placed on functioning deeply within a single field than broadly across several.

And yet without some awareness of the whole – without some sense of how means converge to accomplish

or to frustrate ends – there can be no strategy. And without strategy, there is only drift.”

…Tom Friedman (noted author in the field of International Relations, emphasis added)

Ecological// definition:

The study of the interaction of living systems with their environments.




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“To understand is to perceive patterns.”

…Isaiah Berlin (1909-1997)

“Given the fast-changing and ever increasing complex nature of the world, gaining insight into how patterns are forming and structures are developing represents the most powerful

way of managing in the new economy” …Winslow Farrell




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The Systems Thinking Approach

The approach of systems thinking is fundamentally different from that of traditional

forms of analysis. Traditional analysis focuses on the separating the individual pieces of

what is being studied; in fact, the word “analysis” actually comes from the root meaning “to

break into constituent parts.” Systems thinking, in contrast, focuses on how the thing being

studied interacts with the other constituents of the system – a set of elements that interact

to produce behaviour – of which it is part. This means that instead of isolating smaller and

smaller parts of the system being studied, systems thinking works by expanding its view to

take into account larger and larger numbers of interactions as an issue is being studied.

This results in sometimes strikingly different conclusions than those generated by

traditional forms of analysis, especially when what is being studied is dynamically complex

or has a great deal of feedback from other sources, internal or external....Daniel Aronson,

Copyright 1996-8 (www.thinking.net/systems_thinking/overviewSTarticale.pdf)



http://www.thinking.net/systems_thinking/overviewSTarticale.pdf


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TESTIMONIAL: WORLD RENOWNED EXPERT ON ‘SYSTEMS THINKING’

H. WILLIAM DETTMER

Senior Partner, Goal Systems International (USA)

www.goalsys.com

Author of the following books:

“The Logical Thinking Process: A Systems Approach to Complex Problem Solving”(http://www.amazon.com/Logical-Thinking-Process-Systems-

Approach/dp/0873897234/ref=sr_1_1?ie=UTF8&s=books&qid=1286929732&sr=8-1)

“Strategic Navigation: A Systems Approach to Business Strategy” (http://www.amazon.com/Strategic-Navigation-Approach-Business-

Strategy/dp/0873896033/ref=sr_1_4?ie=UTF8&s=books&qid=1286929732&sr=8-4)

among many other books he has authored & co-authored.

• Since retiring from the US Air Force over 20 years ago, he has been much sought after internationally by International Fortune 500 Companies, primarily as a corporate problem solver & strategist; but also directing large-scale business process and highly-successful performance improvement projects.

Partial list of clients include: BHP Billiton, Bosch, Bayer, Deloitte, United Health Group, Raytheon Missile Systems, U.S. Air Force Software Technology Center, Seagate Technology, U.S. Navy Sea Systems Command, Tellabs, Lucent Technologies (Europe & US), Western Digital Corporation, NEC America, Kendall Healthcare Products, Ericsson Cellular, Weyerhaeuser, Boeing, Siemens Medical (Germany), Siemens Energy Generation (USA).

• Former 23 year career in US Air Force where he started as a B52 Bomber Pilot during the cold war. As Chief of War Plans Division, Headquarters Air Force Logistics Command, he prepared and updated wartime mobilisation, deployment, and survival/recovery plans for the entire Air Force logistics support structure. He was deputy Chief of Staff, Logistics, Headquarters 13th Air Force (Philippines), responsible for all maintenance, supply, equipment, and contracting for the largest American base outside the U.S.



http://www.goalsys.com/

http://www.amazon.com/Logical-Thinking-Process-Systems-Approach/dp/0873897234/ref=sr_1_1?ie=UTF8&s=books&qid=1286929732&sr=8-1

http://www.amazon.com/Strategic-Navigation-Approach-Business-Strategy/dp/0873896033/ref=sr_1_4?ie=UTF8&s=books&qid=1286929732&sr=8-4


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William H. Dettmer:

“Daniel Want’s talents and skills extend well beyond the financial world. He possesses an ability that all too few do in today’s world—a systems perspective. In our world of international global business, the interdependencies among companies, markets, cultures and regulatory environments, the capacity

to understand complex interactions and their effects requires an innate understanding of cause-and-effect. Daniel demonstrates that capacity daily. He is one of the most skilled at this I’ve ever seen.

“My personal forte is not finance, international or otherwise. It’s in the realm of analyzing and predicting the behavior of complex systems. I’ve made a career out of doing that in Fortune 500

companies, and I can instantly recognize systems thinkers when I see them. Daniel is the equal (or better) of any that I’ve encountered in any of those companies.

“His understanding of systems complements his integrity, self-discipline, and ethical foundation. The net result is an individual of the utmost capability, reliability and dependability—someone whose judgment can be relied upon in the most critical of circumstances. As a former pilot in the United

States Air Force, I can truthfully say that I would be honored and comforted to go into combat with Daniel Want on my wing. I can think of no higher praise than that.”

William H. Dettmer:




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Rio Tinto (RIO, ASX)

Was a small holding in the

Strategic Opportunities Portfolio,

but exited early 2014 as indicated...

Actual Example:

PCM EXIT REPORT, 26th Feb 2014: “Continued issues pertaining to global capital & liquidity flows, in addition to escalating latent risks presented in China towards iron-ore pricing, and a degree of fundamental weakening shown in Rio’s most recent half yearly financial results suggests that the risks to maintaining further exposure to RIO are unacceptable. We therefore propose to exit the position & capture open profits.”

Citi Research, 16th January 2014: “We move our 12-month sector stance to Bullish, from Neutral, our first bullish call in three years... our move to bullish reflects better bottom-up fundamentals, particularly from the major miners.”“Citi is broadly forecasting a flat commodity price environment and, with commodity prices into cost curves, a reduction in volatility. Improvements in European and US growth are supportive for commodities and weakening commodity currencies are providing a fillip for the miners.”

Institutions enter

PCM exits




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“For they shall be like a tree planted by the waters,Which spreads out its roots by the river,And will not fear when heat comes;

But its leaf will be green,

And will not be anxious in the year of drought,Nor will cease from yielding fruit.”

…Jeremiah (627BC – 586BC)




Copyright © 2016 Prerequisite Capital Management Pty Ltd, Australia. All rights reserved. Past

performance is not indicative of future results. Neither Prerequisite Capital Management Pty Ltd nor

any of its employees, or any person(s) or firm who is represented within this publication shall have

any liability for any direct or consequential loss sustained by anyone who has relied on the

information contained in this publication. At no time does Prerequisite Capital Management Pty Ltd

make specific recommendations for any specific person, and at no time may a reader, caller or

viewer be justified in inferring that any such advice is intended. This publication has been prepared

by Prerequisite Capital Management Pty Ltd on behalf of itself and its affiliated companies solely for

the general information of clients or potential clients of Prerequisite Capital Management Pty

Ltd. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument.

The views expressed are the views of Prerequisite Capital Management Pty Ltd through the period

ending at the date of publication and are subject to change at any time based on market and other

conditions. References to specific securities and issuers are for illustrative purposes only and are not

intended to be, and should not be interpreted as, recommendations to purchase or sell such

securities. Prerequisite Capital Management Pty Ltd (ABN 27 141 060 933) is a Corporate

Authorised Representative of AIW Dealer Services Pty Ltd (ABN 59 153 322 420) AFSL 414256.

Disclaimer

General Information

33

Contact: Darren Brind (Director)[email protected]

+614 98 671 505



Documents

Wholesale Client BRIEFING Understanding ‘How we think’€¦ · Prerequisite Capital Management Pty Ltd (ABN 27 141 060 933) is a Corporate Authorised Representative of AIW Dealer