What a difference a year makes

The 2017 review was a pleasure to write on the back of globally positive performance numbers.

2018 has been a tough one by comparison and requires a detailed analysis of ‘why?’

Apologies that this will not be a quick or jaunty read but at difficult times when confidence is shaken, it pays to reaffirm both how long-term wealth is built and that uncomfortable periods are not only inevitable but actually helpful. During such periods, knowing investors keep their nerve and stay true to the principles and actions that are proven winners; eventually profiting as others capitulate giving away prize assets at fractions of true worth.

When markets have violent downturns reasons are sought, often in large part they are sentiment-driven so these are unclear and many conclude the crowd must know something they don’t. We will explore this theme.

We will also get stuck into the problems facing economies and markets; both political and financial, and the realities of each.

Firstly though, it may be helpful in framing these to review a specific example:

Case Study – Brookfield Asset Management

I read a series of posts recently on the Seeking Alpha website concerning Brookfield Asset Management (BAM) and its commercial property investment arm Brookfield Property Partners which trades as BPY.

I know BAM well; over the last 30 years it has invested opportunistically into numerous infrastructure and Commercial Property projects becoming the largest asset manager globally, Blackstone is second.

It has a rock-solid A-rated balance sheet, multiple and growing streams of fee income, a reputation for integrity and stockholder friendly management owning 20% of the shares (‘eating their own cooking’).

It has a compound average growth rate (CAGR) of 30% plus and will conservatively grow by 15-20% for many years to come.

It’s an elite business.

In a recent talk given to Google employees (and available on YouTube) Bruce Flatt, the CEO outlined how Brookfield had achieved success and why they will continue to do so.

The reasons he gives (below) are simple in essence and he started by making the point that in his words there was no ‘secret sauce’. They have grown by methodically applying a sound long term strategy to consistency of implementation then letting the magic of compounding do its work.

The best Value assets to buy will be found in places where crowds aren’t gathered, better still if they’ve recently exited en masse
Know your subjects intimately and while constantly learning and improving, stay true to core principles and process
Employ the highest quality people and align their success to that of the company as a whole over the long term
Buy only the highest quality assets; paying a good price for a great asset, rather than a great price for a good one
Accept there will be periods of emotional discomfort even when owning the best assets
Be conservative with amounts borrowed and funding structures
Maximise the phenomenal power of compounding growth over the ‘fullness’ of time.

As an example, he explained Brookfield Property (BPY) purchased an office tower in Central Manhattan on Park Avenue in 1996 for $432m. It was a great asset in a prime location and acquired when the market was in distress so undoubtedly would increase in value over time. But he went on to say that it had not been easy to own with 4 subsequent property cycles, the 9/11 attack and the Financial Crisis of 2008.

BPY sold the building in 2017, by then the total rental income received was considerably in excess of the original price paid, so the $432m had been repaid to them and significantly more.

The sale price was $2.2 Billion.

Getting back to the investment posts I referred to on BAM and BPY.

BPY has just completed the full takeover of GGP (General Growth Properties) which is the second largest Class A mall operator in the US. It already owned around a third of GGP having participated in taking it out of a bankruptcy in 2010, investing $2.5Billion for a 35% stake. At the time of the full takeover offer in 2018 the value of Brookfield’s initial investment had risen to around $7.5billion.

Their investment thesis for wanting to acquire full ownership was:

GGP owns mostly ‘class A’ malls in prime positions in each city and they have about 100 in total
This is a purchase where the asset price is currently significantly depressed, the ‘crowd’ view being that Malls will perform badly as people increasingly shop online
The reality of what they are acquiring is 100 lots of around 110 acres per site in prime locations in the largest US cities
There is a huge movement back to city living globally
Redeveloping some of each property to build houses/condos will increase the value of the land utilised by a factor of 8-10 times. If additional live/work, office and small warehousing is also created the land values are greatly improved overall
A trend for technology/internet companies to open up bricks and mortar sites. Amazon buying Wholefoods or Tesla opening showrooms in Malls are examples
People want increasingly to be entertained when socialising, so significant parts of Malls can be repurposed to provide these types of venues in great locations and with lots of parking

So, given the successful track record of Brookfield Property (BPY) over the last 30 years, that they are acknowledged to have an elite property team of amongst the best people in the industry, that they already own a treasure trove of the highest quality offices, hotels, blocks of apartments and warehouses globally and they have more than sufficient capital to finance the projects with conservative debt levels:

What has happened to the share price of BPY over the last few months?

It’s fallen from the mid $20’s to just above $15 currently.

The investors posting on the BPY message board were all asking the same question.

“What were they missing and what did the sellers know that they didn’t?”

The situation as of now (22/12) is that the shares are valued at 51% of the book value of the properties it owns, and the dividend yield is 8.2%.

The market is offering a premium global property portfolio at 51% of its independently audited value so basically a half-price sale with 8% income on top.

Now assuming that Brookfield is not doing anything nefarious and there’s absolutely no hint of that, then this could well be an example of how untethered from logic and reality market prices can get when panic selling happens.

Portfolio returns over the last three years

	2016		2017		2018
	Benchmark	Portfolio	Benchmark	Portfolio	Benchmark	Portfolio
Defensive Portfolio	12.42%	10.14%	5.96%	7.83%	-3.03%	-6.29%
Cautious Risk 4 Portfolio	13.64%	11.73%	7.28%	10.43%	-3.66%	-2.99%
Cautious Risk 5 Portfolio	13.94%	12.42%	7.76%	11.81%	-3.96%	-5.88%
Balanced Portfolio	16.53%	13.76%	10.17%	18.24%	-5.42%	-6.99%
Moderately Adventurous Portfolio	20.12%	18.06%	11.59%	20.16%	-5.78%	-7.75%
Adventurous Portfolio	21.59%	19.65%	12.79%	21.89%	-5.93%	-7.99%

Average return (p.a.):

	3 years		5 years		Since launch
	Benchmark	Portfolio	Benchmark	Portfolio	Benchmark	Portfolio
Defensive Portfolio	4.93%	3.61%	5.28%	4.09%	4.98%	4.49%
Cautious Risk 4 Portfolio	5.51%	6.15%	5.59%	6.08%	6.81%	9.80%
Cautious Risk 5 Portfolio	5.65%	5.74%	5.70%	5.60%	6.94%	9.31%
Balanced Portfolio	6.68%	7.74%	6.05%	7.22%	7.44%	10.49%
Moderately Adventurous Portfolio	8.09%	9.37%	5.99%	7.49%	7.66%	10.79%
Adventurous Portfolio	8.86%	10.29%	6.24%	7.93%	7.77%	11.12%

You should note that past performance is not a reliable indicator of future returns and the value of your investments can fall as well as rise. The total return reflects performance without sales charges or the effects of taxation but is adjusted to reflect all on-going fund expenses and assumes reinvestment of dividends and capital gains. If adjusted for sales charges and the effects of taxation, the performance quoted would be reduced. Performance is up to 31 December 2018.

It is extremely tempting for fund managers and investment advisors to take laps of honour after years of outsized gains such as in 2016 and 2017, but it’s not necessarily deserved.

Markets will rise and fall and the minimum any client should expect is to match the overall market performance as index trackers do.

So, when markets go up the question should be, have actively managed investment portfolios created additional value or just mirrored market performance?

Known returns

We repeat this often, it’s the core reason for investing in risk assets.

*Investors can be fairly sure of the likely average returns from different asset classes over time periods sufficient for the averages to assert*

So, this is saying that over time gains will made (index returns) and these can be improved upon by investing in the best opportunities within each market (active).

That all asset prices will ebb and flow in price year on year but over the fullness of time market growth rates are fairly predictable and the best assets in each will inevitably rise to be the top performers.

Averaged asset returns

Cash: around zero after inflation

Bonds: 2-3%

Property: Inflation + 1-2% + rental yield less costs

Shares: 7-8% including dividends

**BUT INVESTORS MUST KNOW AND ACCEPT THESE RETURNS WON’T OCCUR IN STRAIGHT LINES**

Our ‘benchmark’ for any portfolio are the returns that will occur naturally as above (market return), that’s the minimum we must do, and our mission is to consistently add value above those by investing with a superior process in outstanding funds.

So, have the portfolios beaten their benchmark of market returns since we began?

	Since Launch
	Benchmark	Portfolio	Outperformance (p.a.)
Defensive Portfolio	4.98%	4.49%	-0.49%
Cautious Risk 4 Portfolio	6.81%	9.80%	2.99%
Cautious Risk 5 Portfolio	6.94%	9.31%	2.37%
Balanced Portfolio	7.44%	10.49%	3.05%
Moderately Adventurous Portfolio	7.66%	10.79%	3.13%
Adventurous Portfolio	7.66%	11.12%	3.46%

If Portfolios are able to add 2-3% pa annually above index returns, then this has a significant positive compounding effect over time.

	3 years		5 years		Since launch
	Benchmark	Portfolio	Benchmark	Portfolio	Benchmark	Portfolio
Defensive Portfolio	15.52%	11.21%	29.31%	22.20%	44.05%	39.00%
Cautious Risk 4 Portfolio	17.45%	19.60%	31.25%	34.31	92.20%	154.57%
Cautious Risk 5 Portfolio	17.91%	18.24%	31.93%	31.34%	95.60%	143.39%
Balanced Portfolio	21.42%	25.07%	34.16%	41.67%	105.02%	170.97%
Moderately Adventurous Portfolio	26.30%	30.85%	33.76%	43.48%	109.18%	178.52%
Adventurous Portfolio	29.02%	34.18%	35.35%	46.43%	111.28%	187.02%

We will do worse in down years

The portfolios WILL likely perform worse than indexes in down market years, especially when highly volatile.

Why?

The indexes are made up of lots of companies and a fair number are boringly predictable just chugging away doing their thing. These are not the companies or sectors that warrant active investment; far better to buy these in a passive index.

Active investment should identify and put money to work in assets, companies and sectors where future growth and profitability will exceed the market average.

However, when markets have a collective panic attack the assets that get hit hardest for short periods include these best long-term growth prospects.

Growth becomes doubted as the future seems far less full of promise for a time, with sentiment turning highly negative.

As an example, Apple over the last few months has lost around 35% of its value going from $225 to $150 per share. It now has a P/E of 12 with projected profits growth over 20% and ROE (return on equity) of over 50 when 15-20 is considered good.

What tends to be much more price-stable in these volatile periods are the boring chuggers like utilities, telco’s and consumer staples, not outperforming investments long term but the safer harbours in a storm. These lower volatility parts of the index fall less which is why the portfolios perform worse as they don’t own them.

Importantly though these down periods provide the opportunities for active fund managers to buy great assets at wonderful prices which will propel future outperformance. It’s the time of planting. As unpleasant as these periods feel, they are to be welcomed when the asset equivalent of a top of the range Ferrari or Bugatti can be acquired at a 30% plus discount.

Berkshire Hathaway

We often reference Warren Buffett who created and has run Berkshire from inception. He is a legendary investor, the third or fourth richest person in the world who from the late 1960’s to today has grown Berkshire purely by investing in shares and buying businesses. He started the company from a few million dollars to a current value of $475 Billion.

$10,000 invested at outset in Berkshire stock is worth $300 million today.

But over that time the share price of Berkshire has fallen by over 40% four times and by over 50% twice.

Mr Buffett has always stressed that a great deal of the success was fuelled in these downturns when he could buy prime assets at fractions of their true worth, but they were obviously traumatic periods for Berkshire shareholders.

They have certainly been handsomely rewarded though if they kept the faith.

What a difference a year makes

We wrote in the 2017 yearly review that it was notable how low volatility had been through the year and returns had been exceptional, probably borrowing in part from the future. The main driver identified for strong growth in ‘18 was the significant stimulus of US corporate tax cuts and repatriation and so this proved with US markets being the global leader until October when they succumbed to concerns and rolled over.

2017/2018 why the huge difference in volatility?

This demonstrates that markets can be profoundly sentiment driven over short periods. In 2017 markets weren’t in the mood to hear bad news so simply ignored it. This sounds crazy we know but emotion or sentiment is a huge factor however unscientific this seems.

But ALL the issues of 2018 were there in 2017.

US-China trade dispute

Interest rates tightening

QE unwinding

Brexit

So why then the change in sentiment from unworried to full-on panic?

Interest rates and liquidity

There is no investment that is unaffected by interest rates. It is the key component to calculating the comparative attraction of cash, debt (sovereigns and bonds), property, commodities and equities.

The global economy for the last 10 years, post crisis, has enjoyed the favourable conditions of real interest rates being negative (below inflation). This was engineered quite deliberately by Central Banks to encourage money out of cash to kickstart recover and prevent deflation.

So, the question is then, how much does a rising interest rates (only in the US) and reduction in liquidity (in the US and potentially starting next year in Europe) actually matter to economic growth and should markets be so worried?

Points to consider.

It is true that QE pumped huge amounts of liquidity into the economic system but it’s also true that lots of it didn’t really go anywhere. Banks due to the trauma of ‘08 and the resultant stress testing were hyper careful with loaning it out so much of it just stayed with them
Economics 101 says that this increased money supply should have caused inflation, but this just hasn’t happened. Certainly, in part this is due to changes brought about by technology, the very limited growth of loans, no wage inflation with so many jobs being insecure and general cautiousness after 08
QE was very important psychologically for markets, indicating that Central Banks had their back, but these were crisis era measures never intended or needing to last indefinitely
So now telling markets this is no longer needed or desirable withdraws a perceived security blanket. It is a little like asking people to walk along 4 by 2 planks laid end to end on the ground. Not a problem, everyone does it easily. Put them 4 feet in the air, fear of consequence kicks in and people wobble a lot more. Same thing, no greater actual danger but different perception
Interest rates have risen in the US which is negative for assets, this is true, but they are only now par to inflation so the return on cash is still zero and they will not rise much further in 2019 if at all
The US is at pretty much full employment, wages are increasing, companies have strong profits growth, consumers are spending, and confident and tax cuts are still to come through into the economy
In reality the only thing which drives asset prices higher permanently, especially shares, is economic growth and increased profits. This averages around 2.5% plus inflation so about 5% nominal, the projected growth rate in 2019 for the Global economy
Investment cycles in essence are the ebbs and flows of economic confidence and leverage levels (how much is being borrowed)

The Journey of a Cycle

Risinglevels of leverage (borrowing) and confidence over time push up economic growth and asset prices
Prices become overinflated with overconfidence and excess lending. Peaking of the cycle
There is at some point for some reason a collective realisation that things have become excessive. This has often been when Central Banks raise interest rates aggressively because of rising inflation
Business activity then starts to slow, and confidence is shaken
Profits start to fall
Banks reduce lending and start calling in loans
Bad loans become evident, defaults happen, confidence evaporates, asset prices decline everywhere
Everyone feels horrible for a time
Slowly the process begins all over again

So economic growth averages out over the whole cycle at the above 5% nominal rate and for shares add dividends so they give 7-8% total returns. In some years it’s above these and in some years below but it just all averages out. The wobbly nature of the upward trajectory is uncomfortable but basically pretty predictable and actually irrelevant if you are invested for the whole time period (though not if you are trading in and out)

Are we at a peak?

The situation as of now is that Bank lending is certainly not elevated. Companies are hoarding cash and appear to much prefer buying back their own shares to making major capital investments or engaging in mergers and acquisitions.

Markets are not exuberant, they are super vigilant about any hint of excess preferring to fire first and ask questions second exactly as now (certainly not drinking any Kool-Aid).

Technology is destroying inflationary pressures in a way we’ve never seen before.

Interest rates may go up a little bit more in the US, but they are not rising in Europe or Japan.

So, this has absolutely none of the hallmarks of a peaking cycle.

Rick Reider, head of Blackstone global fixed income investment (a properly bright man) has recently spoken on the subject of economic cycles and has questioned whether they’re naturally occurring or rather the previously repeating product of excessive behaviours.

If someone goes on binges, drinking too much and then gets hangovers consistently they can talk of the cycle of feeling dreadful but if they stopped drinking excessively it would stop happening. It’s the excess behaviour that’s the catalyst.

So, if as now borrowing is muted, asset prices are at or below average levels generally and there are no animal spirits of overconfidence. Why then are we at the end of a cycle or in the above analogy, about to get a hangover?

So, what is happening and why are markets freaking out?

The US stock markets, and they set the general tone for the others, are it appears ‘spitting their dummy’ that the ‘blankey’ of QE and negative rates are now being slowly removed.

But is it not right that gradual removal is exactly what should be happening to keep the economy moving upward on a sustainable path? If the Fed in the US doesn’t moderate liquidity, make cash returns at least worth zero by carefully raising rates and instead lets the market party upwards then they’ll ultimately surely just come right back down again and hard. Is this therefore the ‘tough love’ the US needs to guard against a sugar high of cheap money coupled with the new fiscal tax cut stimulus and a now decade old belief the Fed will rush in to help if/when it goes wrong so there is no consequence.

If this is correct, then current volatility is not speaking to any significant economic structural issues but rather of tantrums. The market is being told it can’t have as much of what it likes anymore and it’s showing displeasure.

If so then they will calm down soon enough and refocus on the fundamentals of earnings and profits, actually all that matters, and which look decent enough going forward.

Global interest rates

As referenced above interest rates remain low and my thought for a time has been, they would normalise back to more historic levels and why we’ve been holding fewer Bonds in the portfolios.

I now think they are likely to stay low-ish for the foreseeable future.

It is quite possible that the US doesn’t raise rates at all next year having reached the neutral level with QT (Quantitative Tightening) ongoing. If so, this will help Emerging markets and moderate any further Dollar strength. The Dollar may even start to weaken, another positive for EM’s.

European economic activity is sluggish, so they are not likely to move up, Japan the same.

China is stimulating not tightening to offset economic weakness and the effects of tariffs.

The U.K. is an outlier, it’s totally Brexit dependent but probably more likely that rates reduce if anything.

Whole market P/E ratios

	Forward P/E Ratios
Emerging Markets	10.5
Europe	11.6
Japan	11.6
UK	11.2
US	14.6

We think these are an interesting set of numbers.

The long-term Price to Earnings of markets is the average multiple of profits investors are generally willing to pay to own shares, which is around 15-16.

Current multiples are much lower, especially for Emerging Markets, the U.K. and Europe.

This means one of two things.

The low P/E ratios are because markets have sniffed out a looming recession and sold down markets prior to any actual evidence of such. The E (earnings) will fall in the future so the P (price) will then be correct.

Or: Sentiment is currently very poor. Earnings will not reduce and therefore markets are cheap. Companies are certainly talking of a slowing rate of increasing profits in 2019 but this is not the same as a recession where profits fall from previous levels.

US vs China

We have a pretty basic take on this.

China behaves terribly and has done so for decades
Calling them on it is way overdue, the rest of the world should be united on this
China have a much longer time horizon and pain threshold than the US, Trump has an election to fight in 18 months
China will do something in 2019 to appease the US but probably not that much in reality
Trump will grab it and claim victory

BREXIT

Firstly, this is not a glorious new dawn for ‘Great Britain’.

If it matters most to the majority that we have complete control of immigration, an independent tax and legal system and we are members in a club of 1 then that’s fine and that’s what Brexit gives.

But the economic turmoil and resulting loss of business investment and skilled people will be damaging.

The nightmare is if we leave with no deal, if we just quit. It will be carnage for a time and people will realise that anyone who said it wouldn’t, has been wilfully wrong.

There is a nationalist element in Parliament whose agenda is complete independence, the costs whatever they are, seen as acceptable collateral damage.

It could be that longer term leaving turns out ok but over the next few years at least, especially if unstructured, it will be destructive.

The sensible protection to take is to hold assets globally in alternate currencies because the Pound is likely to be trounced in a no deal outcome.

What has happened and where will it end?

The UK asked for a divorce from an unwilling partner who has not been accommodating with the terms of the split. Predictable
The absolute nightmare is creating a new Irish border, which isn’t a border, satisfying both Republicans and Unionists. A trifle tricky to do. Highly predictable
The U.K. government knew that the draft settlement would be unpopular, and they adopted the ‘brace’ position; extreme turbulence was bound to occur when received by Parliament. Obvious
They then must let the realities of the alternatives sink in and the pressures from big business and the public to come to bear as everyone becomes increasingly scared of a hard Brexit. Absolutely

Going forward:

Parliament votes in mid Jan and the deal will likely be rejected. Probably
If so, the anxiety ramps up further and the EU equally will be panicky, Britain is a huge trade partner. Definitely

This then is where it gets really tricky because time will be short, and anxiety will be sky high. It becomes a multi-player game of chicken to decide the future direction of a nation.

Possibilities:

There is an agreement on the Irish border question and with a few other tweaks an 11th hour salvation for the deal as a whole to go through. Possible but not likely
Parliament can’t agree and ultimately Article 50 is withdrawn as the European Court of Justice has said the U.K. can do unilaterally. Quite possible and the classic political ‘kick the can’ option. It’s then announced PM T-May is stepping down; a new Prime Minister takes weeks to appoint followed by a new deal, second referendum or general election acting as a quasi-second referendum
The nuclear option of a hard Brexit actually happens, and nobody knows what this means in practice. Possible but only if a collective bout of insanity prevails

A MEA CULPA

I was discussing investments with one of our founding clients recently, a really lovely man, very successful in property and a great supporter. We were talking about the Standard Life Global Absolute Return fund and he said “look, it’s just been bad for a while”. He’s absolutely right, it has.

What it has shown me is there really is no way of avoiding the basic investment rules.

It just isn’t possible to create something to consistently harvest most of the markets’ profits without taking on the volatility risk that comes with it. It looked for a time that it was, but alas no.

So, although our initial thesis seemed correct (and many benefited from investing in the Fund), the last three years have shown it is almost impossible to consistently achieve this desired outcome without taking on volatility risk. In the portfolio review we will be looking to reduce the exposure to this fund to reflect this.

Conclusions

We are totally committed to what we do. Our focus is on providing the highest quality financial planning, the best service levels and creating great outcomes. We are all proud of what LWM stands for and that it walks the paths less travelled, it only succeeds in our eyes if our clients do. Our clients are central to everything.

This has been a tough period and they will happen from time to time (2011 springs to mind) but really nothing that ends up great is easily achieved. There’s just always going to be some pain along the way.

But if it was easy then everyone would do it! We look forward to seeing you in 2019.

Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.