An interview with Constantine Lycos, President of Lycos Asset Management, a registered investment management firm based in Vancouver, Canada
Bio: Prior to founding Lycos Asset Management , Constantine Lycos was a partner, portfolio manager, investment advisor, compliance officer and head of the investment committee at Chartwell Asset Management, where he was the lead manager of the Magna hedge funds and also managed portfolios of high net worth individuals. Before Chartwell he was employed by CIBC World Markets as a Research Associate. Attached to the Private Client Division of CIBC World Markets, he conducted research focused on individual investors' needs and constraints. That research was primarily on equity investments but included asset allocation, hedging and other more sophisticated strategies. Mr. Lycos graduated top of his class in Mathematics from the University of London (B.Sc.), and earned a master's degree in Mathematical Finance from Oxford University. At Oxford he conducted research under world-renowned derivatives specialists Drs. S. Howison and P. Willmott on stock market volatility. Mr. Lycos has completed most courses offered by the Canadian Securities Institute, including the Options Licensing, Futures Licensing, Technical Analysis, Options Strategies and Financial Markets Risk Management courses. He holds the Canadian Investment Manager (CIM) and Derivatives Market Specialist (DMS) designations as well as that of the Chartered Financial Analyst (CFA), the highest designation for investment professionals. Mr. Lycos is a fully registered portfolio manager (meaning he is licensed to advise on any kind of investment (stocks, bonds, GICs, commodities, futures, options, etc), unlike some "advisors" or financial planners that can only advise on mutual funds or insurance products). He is also the fund manager of the Lycos Canadian Hedge Funds. He is a member of the CFA Institute (formerly the Association for Investment Management and Research), CFA Vancouver (formerly the Vancouver Society of Financial Analysts.) and the Social Investment Organization, the Canadian association for socially responsible investment.
Q: Mr. Lycos, in the face of the recent volatility in the stock market, a number of commentators are citing the over-valued nature of the markets based on the economic realities – what would be you’re view of the market right now?
A: Since you started your question with talking about volatility, let’s start by asking ourselves, does stock market volatility (a rather technical term) have anything to do with concepts such as fair value, over-valued stocks and under-valued stocks? The answer is not necessarily an obvious one, but yes, stock market volatility can have an impact on the fair value of stocks: the higher the volatility, the higher the rate of return investors require to own stocks, i.e. the higher the discount rate, and the lower the fair value for stocks. Is volatility the most important determinant of fair value? Obviously not. Stocks are all about profits or earnings, future earnings to be precise. Let’s examine the S&P 500 Index. It is a good proxy for the world stock market as it is made up of large global corporations. On 2nd November 2009, I calculated the book value of the S&P 500 to be approximately 486 index points and trailing 2 quarter plus estimated next 2 quarter earnings to be about 61 points, implying a return on equity (ROE) of about 12.5%. (The index was at 1042 when I performed the calculation.) It’s very tempting to apply a something like a 15x PE multiple on these earnings to come up with a fair value number of 915, but that would be wrong. We seem to be coming out of a cyclical bottom so the earnings are likely to improve a bit faster than normal, so we must rely on the concept of “normalized earnings”, meaning using a projected average ROE number over several years out, rather than just a couple of quarters, of let’s say 15%. 15% of 500 is 73, which is a reasonable “normalized earnings” number to use. Again, an average P/E multiple of about 15 could be used to come up with a fair value estimate for the index of about 1100. At 1042 the market doesn’t look overvalued. However, there are a number of things that bother me with this analysis. I am not convinced that the economic recovery will as strong as one might expect given the magnitude of the decline primarily due to the decreased leverage in the economy, when compared to levels prior to the financial crisis. So if appetite for borrowing doesn’t come back for a number of years perhaps the projected average ROE is lower in the future making the market too expensive or over-valued. Another thing that bothers me is that about half of the book value of the S&P 500 is made up of intangible assets such as goodwill. Goodwill doesn’t deserve a multiple.
Q: What is your near and long term outlook for the Canadian Dollar with respect to its fundamental value and its impact on the Canadian economy?
A: CAD is a currency used by speculators (as well as some other currencies such as AUD and NZD) as a vehicle of choice on betting on the global growth, reflation story. CAD almost never trades on fundamentals, i.e. things such as Purchasing Power Parity (PPP), meaning fair value based on what a basket of goods should cost in Canada versus in other countries, so it almost a waste of time even bothering to calculate the fair value for CAD. As far as making a call on CAD, the call would be pretty much the same as the call for oil and commodities in general, a “game” which I don’t play. Speculating on commodities and currencies is zero-sum game, better left to fools and “sharks”. I am neither.
Q: With the US GDP data coming in better than expected last week and today’s ISM Index rising more than expected in addition to positive construction spending and pending home sales data, what is your read on the US economy going forward and its place in the global economic landscape?
A: I tend to be a bottom up stock investor, not paying too much attention to the economy as a whole. A great bottom up investor, Peter Lynch, said something like “If all the economists in the world were laid end to end, it wouldn't be a bad thing.” The US economy is in trouble now but long term it’s probably about the best place in the world to bet on. Why? It possesses the basic necessary ingredients that are required for optimal wealth creation, first identified by Adam Smith: economic and political freedom for its citizens, respect for property rights and the rule of low. Unfortunately since 9/11 some of the freedoms have disappeared and also the respect for civil rights by governments has gone down a bit, so things could be better, but on a relative basis it is still about the best place in the world. Canada is also pretty good. By the way, all other factors, such as availability of resources (be it human like in China, or natural, like in Russia, Brazil and Canada) are secondary in the quest for wealth creation. Innovation, new ideas, new technologies create wealth and the economies that foster the right conditions to promote innovation will do the best in the long run.
Q: Given that cyclical stocks have outperformed defensives in this rally since March 2009, can you please highlight one sector among Canadian stocks (e.g. can be financials, energy stocks, technology, resources etc.) that you believe to be overbought and due for a correction and one sector that you believe to be oversold and due for a bounce and why?
A: Yes, cyclicals outperform when markets go up, they underperform when they go down, etc. Deep cyclicals are too hard to value – you can’t predict their earnings, can’t put a multiple on them, can’t analyze them. I do not take positions in things I can’t value, neither short nor long. But tied to question number one, if the market is overvalued and corrects, then the cyclicals will correct more. The market is not overvalued and it is not undervalued either. So large moves in either direction are not likely to happen based on fundamentals.
Q: Lastly, can you please highlight 1 stock/theme that you think offers the best value moving forward and your reasons for liking it?
A: The world needs energy and ideally clean energy. We have been talking about hybrid cars and now plug in electric cars for a while. If we all switched to driving plug in electric cars tomorrow all we’ll be doing is substituting burning refined oil (gasoline and diesel) with burning coal to produce electricity. Yes, electric cars are more efficient but burning more coal is not a good idea. Hydro, wind and solar are good but we don’t have anywhere near enough capacity from these sources. As much as I don’t like the only viable alternative is nuclear. A good pure play nuclear electric utility is Exelon (EXC). Stable earnings, a safe bet on growth, a good undervalued stock. It’s fair value is about $68 and will probably get there in 12 to 18 months and it’s only trading at about $47 now. Go long the stock, sell the $65 calls and buy the $35 puts, to have protection in case the unthinkable happens.
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