As I am in the US for the next ten days it seems appropriate to take a look at the various asset classes and their relative values and prospects.
Interest bearing securities
This includes Sovereign debt and bonds from high grade to high yield.
The Market is distorted and artificial at present as the driving down of interest rates to near zero and the current second QE from the Bank of England and Operation Twist from the Fed attest.
The main policy response from Governments has been to counteract the deleveraging (paying down of debt) by making the holding of cash or cash equivalent assets as unrewarding as possible. This, it is hoped, will encourage investment in economies through asset purchases and new borrowing, thus keeping economies from shrinking.
The effect of the hyper low interest rates has been to push up the capital values of debt instruments (if originally issued yielding a fixed 7% and current interest rates are 3.5% then the cap value rises making the yield relative to the increased value 3.5%).
In uncertain times there is an additional driver towards quality (the perceived safest) which has meant that the higher rated bonds of Countries and Companies have been the most sought after and the riskier, higher yielding bonds have been sold off.
Low interest rates will be with us for some time but the key with all public officials either political or financial, is to study the walk not the talk. Plainly the easiest way to reduce a debt burden is to allow inflation; this is called monetizing the debt. If inflation runs at 5% and the debt level stays constant effectively 5% is written off each year. The talk will be of guarding against inflation; it is unlikely the walk will match the talk.
As an aside this is why house purchases can be very rewarding in times of higher inflation, if a house is bought for £200,000 with a mortgage of £150,000 and over twenty years inflation is 100%, the value of the house will be £400,000 (£200,000 profit on £50,000 initial investment) and the cost of repaying the debt in real terms will equate to £75,000, half the original debt value, so big win!
As long as interest rates stay at current levels the bond markets are ok but and there is a J-LO here (a big but!) there is only one way interest rates can go from where they are and this will be negative for the cap value of fixed interest assets, again – it’s not an ‘if’ it’s a ‘when’.
The main drivers for property are growing economies and cheap money. Although interest rates are low economies are stagnant and unemployment is high (and job insecurity is high) commercial property provides a yield well above cash but there is a significant overhang of non performing property on bank balance sheets and rents are falling in many cases if property is not prime.
If interest rates stay low then property will bump along at current (ish) valuations, inflation will probably exceed cap value growth so in real terms values will decrease but this avoids a decline in actual prices and negative equity.
The biggest issue with commodities is knowing what a correct value is.
To explain: with a company the value is effectively the total of all future profits a company makes (this will increase the asset price as profits increase but the key is that it creates free cash, it makes money and pays dividends).
A commodity does not do this; a commodity such as gold, oil or wheat has a cost of production and a price each day it can be sold at but as an example gold itself does not make a profit.
As Warren Buffett said in relation to Gold “it costs a fortune to dig it up and then another fortune to put it back in a hole and guard it”.
Gold is an extreme case, it has very little utility unlike silver, copper or palladium – it has negligible economic use, it yields no dividend (this is ok when cash is yielding next to nothing but increasingly uncomfortable when cash yields are rising).
So what is the correct price, it’s possible to calculate the value for a company but not for gold.
When it’s bought the purchaser is ultimately hoping that someone will buy it for more than he or she paid, this in certain cases is known as the “greater fool” approach to investing.
With commodities which are central to manufacturing or daily life such as copper or potash then the driver for prices will be economic activity and scarcity.
This is why in part commodity prices are tending to move in tandem with Emerging markets.
If 3 plus billion people are wanting first world lifestyles then demand will be strong and commodity prices will go up, this is the likely scenario over the medium term.
However the prices are also effected by commodity traders, often far more of a commodity is notionally traded as futures than physically exists and this leads to heightened price volatility.
We have researched the commodities sector in detail and have concluded that the more we learn the less we understand. Its opaque nature can be illustrated by an extensive review undertaken by an international research firm after oil spiked to $150 dollars a barrel. The remit of the research firm was to establish the causes of the price spike, after a number of months they reported that they couldn’t.
The one area that would appear to have the most predictable and obvious metrics is food and its production, with billions wanting to eat better and with finite resources to grow food (and irrigate) pressure will mount and prices will rise (we think investments can be made in to farm equipment manufacturers, farm land, fertiliser companies and food producers which are profitable in the medium term).
I have been reading a number of equity investment books recently as we are putting together some presentations on the theory and psychology of investing.
The aim has been to try to distill down the key elements that make the difference and to define the practices common to the majority of the best.
What we have found consistently is that the key is in understanding the concept of Value Joel Greenblatt, a hugely successful fund manager and Ivy League professor has written several books explaining his method (“the little book that beats the Market”).
The method involves in simple terms (spoiler alert!) buying fundamentally good companies who have hit a rocky patch (importantly they must be fundamentally sound).
His method over the years has consistently and significantly outperformed the index.
The snag however is that it does not work all the time, the method works over longer periods but the returns come in bursts when markets focus on fundamentals, if they are preoccupied with other macro issues the method can appear unsuccessful (for several years at a time).
In a recent interview he was asked why tell people about his way of investing when they would surely copy it and he would lose his advantage.
He replied that few would copy it as to do so required patience and commitment.
Successful Equity investing absolutely requires (as core skills):
- Emotional control
- Understanding value is not the same as price
- Patience and commitment
The best advantage that an investor has today is the requirement of professional investors to produce results over short periods, this forces focus on the short term movements of stocks and away from longer term opportunities (as they can’t wait for these to play out), their focus is mostly less than a year (often only a few months), the result of this trading is that stocks are driven too high as momentum is chased up and too low as momentum is chased down which produces short term volatility!
The investor with a longer term time horizon and a basic understanding of value is therefore handed the opportunity to buy stocks at prices well below intrinsic book value (known as a high margin of safety) when they have been overly punished by excessive downward momentum, the invested need only know that in time the Market will correct and that commitment and patience will be required as it may take some time.
We select fund managers in the LWM Portfolios who are value orientated with longer holding periods and a willingness to be contrarian simply because over the medium term this is what produces the highest returns.
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. This is not a recommendation to buy any product or service including any share or fund mentioned. 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.