January Outperformance

It's that time of year again, with New Year's resolutions already seeming an impossible target and the cold winters nights setting in with no Christmas break to look forward to... However investors are traditionally very happy this month with December and January traditional outperformers. So I thought I would have a look to see whether I could explain how such a seemingly predictable phenomenon can persist.

Before we have a look at the data I’m going to analyse some of the potential explanations so we know what we’re patterns we’re looking for that could confirm or contradict them. The business year is cyclical with most trading being done in the fourth quarter thanks to the commercialisation of Christmas. However analysts are well aware of this, and their forecasts represent this and their predictions should be as accurate as every other time of the year, so what are the common explanations? A good example is the recent announcements of the quarterly results of various supermarkets with Tesco undershooting their forecast and rival Sainsbury’s over-performing causing their share prices to go through similar negative and positive shocks respectively.
A major reason often cited is that investment/fund managers report their end of year figures December/January time and like to show that they have been holding the big winners of the year. This could potentially lead an uplift in the best performing shares of the year and of the wider market stimulated by the increased buying activity (a similar but opposite and milder than the panic effect in market crash conditions). The knock-on effect I would expect to see if this did happen would be for February to be a poor month. Why? Because once the reporting window is past the fund managers need to redistribute their portfolio, taking positions for the new year and this should unwind any effects on the surge in December.

Another potential explanation, and in my opinion a more likely scenario, is that CEO’s of businesses downplaying expectations before Q4 comes around. It is in management’s interest to make sure that analysts and investors underestimate the value of their stock to help preserve their jobs and increase their potential bonuses when the upside surprise kicks in at the end of year. After all it’s much better to deliver bad news when people are just getting back from their holidays in the summer rather than the time that you are expected to be delivering your headline results. If this theory holds merit I would expect to see underperformance in the months preceding December as executive level management employ techniques to reduce expectations.

So now that we know what we’re looking for, let’s have a look at the data. I’ve selected some of  the world's most important indices to look at: DJIA, NASDAQ composite, ASX, FTSE 100, and the NIKKEI 225. I’ve taken the monthly performance data over the last 40 years to produce the graph below:

The graph clearly shows that December, January and surprisingly April have consistently outperformed over the last 40 years.

Revisiting my earlier predictions it is interesting to see that February is a very ‘average’ month performing at 0.57% compared to the average of 0.68% which indicates that investment managers window dressing their portfolio does not hold too much sway. November is a relatively strong month however the preceding months are typically poor performers with September being particularly bad. Which suggest that there is some merit to the lowering expectation theory.

Although the data agrees with the original predictions I made about performance I’m not entirely sure that’s the whole story. Firstly analysts compare like for like quarters, so it would be difficult to bamboozle through off their predictions with poor results in Q2/Q3. Secondly while this effect would make sense if you anticipate a small tenure at your company, it would be next to impossible to pull off year after year.

So the question still remains, why do we see out performance in the months of December, January and April but poor returns in the summer/late autumn? My answer is in two parts and perhaps controversial  for economists but I believe it is credible. Firstly, news flow is not random. This may fly in the face of the efficient market hypothesis which is accepted by many, however I believe companies’ management are much more likely to release bad news around the summer as there is weaker trading for most companies in the summer (obvious exceptions such as airlines aside). If such a cyclical company is struggling to stay afloat, it is much more likely to enter administration when cashflow is tight in the summer months.

Positive news flow is more likely in the winter. Management want to take credit for their good actions and results when the markets are paying full attention and not on their summer holidays! More exciting announcements/forecasts are reserved for year-end (both calendar and tax year).

Finally, significant negative events have a habit of occurring in the summer. Looking down the listof stock market crashes over the time period I examined these events have coincided with. Using the data to estimate this; I have calculated that this accounts for between 20 - 25% of the overall deviation so while not the full story it is definitely a contributing factor.

Diversifying the Portfolio: Lithium

Every month I'm going to be running a feature looking alternative investments called 'Diversifying the Portolio'. This first post I will be looking at the commodity lithium.

Background:

Why have I chosen to look into lithium? If you’re reading this article then you’re almost certainly using a device powered by a Li-ion battery on a daily basis. Often used in watches and calculators the digital age is proving to be very hungry for these power sources especially as laptop and cellphone usage has increased. The real potential growth market revolves around the adoption of  lithium as a major component in other types of battery such as in automobiles.

Demand:

Lithium has a very wide range of applications, according to the USGS global end-use markets are estimated as follows: ceramics and glass, 31%; batteries, 23%; lubricating greases, 9%; air treatment, 6%; primary aluminum production, 6%; continuous casting, 4%; rubber and thermoplastics, 4%; pharmaceuticals, 2%; and other uses, 15%. It’s interesting to note that batteries are not yet the main use for lithium and it has many suitable substitutes in these other applications. Examples are calcium and aluminum soaps as substitutes for stearates in greases and sodic / potassic fluxes in ceramics and glass manufacture. Lithium carbonate is not considered to be an essential ingredient in aluminum potlines.

Although there are alternatives in the battery market, the properties of Li-ion batteries make them by far the most attractive for secondary (rechargeable) applications. Their high energy density makes them by far the most attractive option despite a premium price. See a comprehensive list of their pros and cons here. Despite this the growth in battery use is frequently touted to be around 20-25% per annum  mostly from the growth in laptops and smartphones. What makes lithium particularly exciting is its prospects to be adopted as the energy storage medium of choice for electric/hybrid vehicles. Researching into what the car manufacturing companies shows a clear bias towards Li-ion technology: General Motors have used it for their ‘Volt’ line, Nissan for their ‘Leaf’ vehicle. Now the Toyota Prius, which initially was using a Nickel-hydride battery has adopted the Li-ion battery.

Here is an interesting piece demonstrating the amount of Lithium actually required to produce a car battery. Combing through the detail I believe the author has been overly conservative and is overestimating how much lithium is required. For example they state that; ‘EV batteries will be 25% larger than the nominal or useable stated capacity to allow for capacity fade’. However the 16kWh assumption is based on the Chevrolet Volt which already includes this 25% over capacity in the 16kWh figure (the cell actually delivers 10.4kWh).

Supply:

There are two main methods to extract lithium from the Earth. The first method is hard rock mining. This method has declined significantly over the last 15 years as a cheaper alternative developed: Brine production. The world’s lithium production is focused in South America as it is one of the few places that has a high enough density of Lithium for economic extraction. With global production concentrated in a relatively small part of the globe.

There are reports that China may emerge as a significant producer of brine-sourced Lithium carbonate. There are brine production facilities in the Qinghai province and Tibet, however it is difficult to procure reliable up-to-date estimates on the figures behind these projects. Overall it seems they contribute around 25% of the global supply, however it is difficult to gauge whether this will be made available to the market with China’s propensity to hoard its resources.

Overall, the various sources I’ve used to investigate lithium supply conclude that feasibly extractable Lithium is not plentiful relative to the potentially increasing industrial appetite.

Forecast:

In summary it is safe to conclude that there will be no significant downward movements in the price of lithium. The price has been increasing consistently over the last few years  and I believe it holds solid potential. The question remaining is whether the growth in supply can keep up with the demand to keep prices relatively stable (and probably nominally above inflation), or whether demand outstrips supply causing a large increase in the price over the medium term?

The prices are likely to take quickly if hybrid/electric cars become a hit as it appears they are becoming so (2million Prius sales worldwide over the last 3 years) although it may take a few years for the latest models to be price competitive with their petrol powered alternatives.

How and where to invest in Lithium:

The key players in the Lithium market are Chemetall (owned by Rockwood Holdings Inc.) , SQM in Chile and FMC Lithium in Argentina. The most obvious is to invest directly in the equity of these companies but both are diversified and would require a significant amount more research before I would be happy to recommend them.

A more direct way would be to invest in a Lithium ETF such as: Global X Lithium ETF (NYSE:LIT). Conveniently our friends over at Seeking Alpha have done the due diligence on this equity based ETF so for the details take a look here.

Another option would be to look at exploration companies. Possible include: Canada Lithium Corp. (TSE:CLQ), Galaxy Resources (ASX:GXY), Lithium Americas Corp. (TSE:LAC), Orocobre Limited (ASX:ORE) and Western Lithium USA (TSE:WLC). My pick of them would be Lithium Americas Corp. for its very economically feasible discoveries in Argentina. Close second Western Lithium USA after its recent news in on its (slightly less economical) prospects in Nevada given the US is likely to be the largest market and its development is less prone to political barriers.

One final note. Linking back to what I said at the beginning of the article, the thought has occurred to me that there are perhaps better ways to tap into the potentially explosive market of electric vehicles by investing in small companies that stand to profit. This has the advantages of less incidental diversification and potentially higher returns however, it also carries out a significantly more downside. Unfortunately a more detailed analysis will take considerable time so that will have to a post for the future!