“Sometimes a cigar is just a cigar.”
- Sigmund Freud
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CAN YOU SEE A VULTURE?
"The Virgin and Child with St. Anne" by Leonardo da Vinci (1503)
In a 1910 essay, Freud made a valiant attempt at divining an aspect of the painter Leonardo da Vinci’s personality through the above painting. Freud peered at the picture after tilting his head to the left, and noticed a vulture. Off went Freud on his psychoanalytic jet and concluded that the picture hid an insight into the painter’s life.
It seemed to speak volumes about da Vinci’s ‘homosexual’ childhood fantasy. Freud relied on a translation of da Vinci’s writings, apart from the painting, for his interpretation.
Only the unforgiving arrow of time would pass true judgment on Freud’s mental frolics. The great man had mistranslated the word for ‘vulture’. The edifice on which Freud’s theory of da Vinci’s sexual fantasies rested was an illusion. Freud apparently considered the essay to be the only beautiful thing that he ever wrote. Some loyalists even attempted to save Freud by imagining a vulture to validate the discredited theory.
I have since christened this behaviour, Freudian Vulture Fallacy.
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Decision making in financial markets is heavily influenced by the manner in which we receive and interpret information. Some gift-wrapped information packages are so ornately put together that they beguile the mind into decisions that betray Freudian Vulture Fallacy. But only with the benefit of hindsight.
Some charts to illustrate the point.
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| JUNK: 250-DAY WORST LOSS DISTRIBUTION. 5 YEAR HISTORY |
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| QUALITY: 250-DAY WORST LOSS DISTRIBUTION. 5 YEAR HISTORY |
The charts depict worst top-to-bottom loss profiles over the past 5 years for a basket of Junk and Quality Indian equities. Red notch depicts the present drawdown. 2018 has been harsh, but particularly severe on smaller and junkier companies. Some things stick out: Quality has better overall drawdown behaviour compared to Junk. Quality has held up well this year. Is it time to be long Quality?
Market chatter in recent times has been rife with ‘preference for quality’. Over the years, it is debatable if this narrative has been well invested. It certainly is well regurgitated, though. It is the weapon of choice of the learned in present times. And those of us that aspire for erudition.
Junk has fallen so far from the top, both on absolute basis and relative to Quality that it seems to represent relatively better value. Is it time to long Junk/short Quality? Or long Junk, in the very least?
Third, and final chart, for this edition.
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| WHAT REGIME ARE WE IN? |
Price behaviour has taken us back to a Quality regime. We are in QE unwind mode and increasing rates environment globally. Increasing rates trajectory domestically, too. Broad market conditions seem to favour Quality over Junk.
So, long Quality?
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NBFCs with little differentiation in product profile, or competitive edge, represent levered bonds paying a 12-15% coupon (‘ROE’); after throwing in 6-10 times leverage. Is it rational to pay more than 1x book value for a ‘levered’ bond return business, which is akin to picking up nickels in front of a bulldozer? If TBTF (too-big-to-fail), or growth, is the investment premise, what multiple of book is a ‘rational’ limit? 15x price-to-book? 20x?
‘Yielders’. Commercial real estate. A portfolio of commercial real estate assets is built on a 70:30 debt-to-equity capital mix. The debt costs 12-14%. Why would anyone want to lease this out for a 6-8% rental yield? Why would financial investors want a piece of this ‘action’? Negative carry is rational if one is cautiously optimistic of long-term capital appreciation. In the absence of this, why would anyone want to be in this business?
‘Renewables’. I get into a multi-decade agreement with governments to provide power at rates that have hit rock bottom in bidding auctions. My input costs have unfriended me. Cost of financing threatens to move higher; capital costs are steadfastly sticky on the way down. Wind and the sun have a mind of their own; in terms of the quantum of power they are willing to offer usefully for us. Yet, recent renewable energy deals for rock-bottom auction price projects command higher multiples than fixed rate agreements signed at higher prices.
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Freudian Vulture Fallacy at work.
Do you see any such instances? I’m curious to hear from you.
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