New Year blog
Background – the noble truth – the ignoble truth – asset bubbles – data – the investment outlook – rising interest rates – how to cope with rising interest rates – should we go into cash – the cost of insurance – the ghost of Christmas future
Short summary – there will be a time to go defensive, but in our view, it hasn’t come just yet
This article has been written for investors in TB Wise Multi-Asset Income. It describes how we see the world, and particularly the investment markets, as we go into the New Year of 2018. What are the opportunities, what are the threats, and how, if possible, can we take advantage of the former, while avoiding the latter?
We can’t forecast the level of any of the relevant indices at the end of the year, and we don’t waste time trying to do so.
But we are sure that the two Great Truths of investment will continue to hold good in 2018, and we hope that they will continue to serve us well as they have in the past. Let’s call these truths the Noble Truth and the Ignoble Truth.
The Noble Truth
The Noble Truth is that, in most of the markets in which we invest, people matter more than numbers, and in fact the people create the numbers, rather than the other way round. We have found that there is a certain type of manager who produces superior returns, whether we are investing in companies or in funds. These managers are dedicated, believing in the importance of the job rather than the personal rewards it brings. They tend to think long-term, tend to have few career moves, and to be considerate of everyone within the community in which they operate (staff, customers, suppliers, shareholders, regulators). Such individuals tend to be respected by their colleagues, who will tend to stay with the organisation for the longer term, and their great experience will be of benefit to all. Such a manager is a ‘good shepherd’ rather than ‘an hireling, whose own the sheep are not’. The Noble Truth is almost too obvious to be worth mentioning, and yet we have found it has helped our investment process. It is the source of our best long-term ideas.
We have also noticed that adversity tends to bring out the best in people. We sometimes find that companies which have got into difficulties through becoming too exuberant or acquisitive, come to realise the error of their ways, and start taking great care of the assets they are stewarding. The results can sometimes be spectacular.
The Ignoble Truth
The Ignoble Truth is that humans are fallible, and never more so than when we are investing money. This continues to be true despite the great strides made in the science of Behavioural Investment over the last decade. Many of us spend a lot of time trying to avoid repeating our most recent errors, and in trying to avoid our past mistakes we invariably commit new ones.
Of course, the financial markets are rational, and the price of any asset on any given day is by definition the right price, where a willing buyer meets a willing seller, but in hindsight it is clear to see that sometimes assets become completely mispriced, usually because investors have become too pessimistic, or too optimistic.
We find it helpful to look for the word ‘as’ in investment commentaries, found in phrases like ‘as the economy continues to deteriorate’ or ‘as the tide of populism continues to sweep the world’. The word ‘as’ in this context tells us that the author is so confident of the outcome that he or she is describing, that it becomes a foregone conclusion, making explanation or justification unnecessary. The word ‘as’ used in this way tells us to look for assets which have been mispriced (either too high or too low) in consequence of the assumed inevitability of a future outcome.
The Ignoble Truth is the source of many of our best short-term ideas.
If you read the financial press, you will know that there has been a period of extraordinary monetary stimulus, that there has been a long period of rising asset prices, and that asset prices in all markets are at dangerously high levels.
If you don’t read the financial press, the following quotations will give you an example of what is being said.
‘Bitcoin is only an appendage to what is already a bubble in everything’ – John Authers, respected Financial Times journalist.
‘The average valuation percentile across equities, bonds and credit is the highest since 1900’ – from a piece by Goldman Sachs analysts, quoted in The Week December 9th 2017.
‘There are so many bubbles that I’ve lost count of them’ – Neil Woodford, renowned fund manager.
One of the leading global investment banks, one of the UK’s best-known financial journalists, and its best-known fund manager, together with many other equally respected figures, can’t all be wrong. But let’s look at the facts. Is it really true that the prices of all assets are at record-high levels?
The price of crude oil is as good a place to start as any. Crude prices have risen from their low of two years ago, but the current price, $66 per barrel (a barrel is 42 gallons) is well below the $115 level at which it peaked in July 2014, and less than half the $147 level reached in July 2008. Perhaps crude oil is a bad example of a ‘bubble’ asset. For ten years the world was concerned at the possibility of oil running out, whereas now we have the opposite concern, that with the imminent arrival of the electric car, and following the advent of fracking, oil supply will permanently exceed demand, and many existing oil wells may become redundant.
Gold might be a better example, but again, the price of an ounce of gold, currently $1,320, is nowhere near its peak level of $1,920 attained in September 2011. The price of gold is almost exactly where it was nine years ago, and, adjusted for inflation, lower than the level it reached in 1980. Perhaps gold is also not a good example, because people are saying that it no longer has any investment value in the new era of crypto-currencies such as Bitcoin.
The prices of most industrial metals, such as iron ore, copper and zinc, are also not anywhere near all-time highs, and many of them are below where they were ten years ago.
The relatively low prices of commodities are reflected in the prices of the shares of mining companies. Rio Tinto, for example, at £39.80, is below the level it was over a decade ago, in July 2007, and only just over half its peak above £70 the following year. The Baltic Dry Index, a measure of the cost of bulk shipping, now 1230, is at roughly its level at the start of 2003, 15 years ago, having peaked at almost 12,000 in the meanwhile.
There are without question large areas of over-valuation in the world’s stock markets, and we would argue that there are areas of undervaluation as well. The following three companies are all household names in the UK, and it would be hard to describe any of them as expensive, never mind ‘in bubble territory’. These are by no means the only cheap or fairly-valued shares in the market. There are many others.
Legal & General
L&G is one of the UK’s genuinely world-class companies. It is the world’s tenth largest investment manager, with over £1 trillion of assets under management. It is comfortably the UK’s market leader in pension de-risking, where an insurance company takes over the management of another company’s final-salary pension scheme, and is on the way to becoming the market leader in the US as well.
Legal & General is undoubtedly a growth company. Its profits and dividends have risen impressively over the last decade, but the rating is grudging – the shares are on a price/earnings multiple of 10.4x, where a long-term average across all markets is around 14, and yield an attractive 5.3% dividend, which is well covered by earnings.
Lloyds appears to be emerging from the disaster of the Financial Crisis. The Government has sold the last of its Lloyds shares, and the company is once again paying a dividend. Lloyds has made strenuous efforts to de-risk itself over the last decade, becoming in the process a UK-focussed bank which spends most of its time taking deposits, and then lending the deposited money out, as banks have always done. It hasn’t quite put the PPI scandal behind it, and there are one or two smaller scandals to be dealt with, and some new competition, but you could hardly argue that the shares are expensive. At 67p, and yielding 4% in dividends, they are around 25% below where they were in the middle of 2015, and less than half their peak level, reached in 2007.
National Grid is one of only seven utility companies with a listing on the UK stock market. The company owns and manages the electricity grid in England, runs the grid in Scotland, and has a dominant position in electricity supply in New York and New England. The company would be hard to renationalise, as it could not be compelled to sell the grid, which it owns. Its charges comprise just 3% of a standard electricity bill, making them less politically sensitive than those of other providers.
Traditionally, the utilities have been excellent assets to own in challenging times, because of the reliability of their cash-flows. National Grid’s shares hugely out-performed the UK stock market during the Lehman Brothers crisis of 2008, and more recently during the Euro crisis of 2011. In an environment where many investors are expecting imminent Armageddon, you might expect National Grid shares, which come with a dividend yield of 5.2%, to be at an all-time high. In fact, the shares are 25% below the high they reached in the middle of 2016, and just 2.7% above their level of ten years ago.
A bubble in everything?
We can see plenty of bubbles, but not in everything.
Above all, Quantitative Easing (QE) has distorted the markets in government bonds. UK government bonds, known as gilts, are still prohibitively expensive, though not as expensive as they were in the summer of 2016. We have not owned gilts in the fund for many years, or any other sovereign debt.
Investment-grade corporate bonds, the fixed-interest debt of the companies with the highest credit ratings, look very expensive too, as they are an obvious substitute for sovereign bonds. Companies like Unilever can borrow money at 1.0% fixed for ten years. With UK inflation running at 3.1%, this arrangement would appear to favour the borrower very much more than the lender, who receives a real return of minus 2.1% on his or her investment, which doesn’t look attractive to us.
In the stock markets, there are a number of areas we would prefer to avoid at the moment. We see a number of behavioural trends in play, which appear to have caused over-valuation.
Investors believe that there is no growth in the world, so they tend to over-pay for companies offering genuine growth prospects.
Investors foresee a new technological revolution, in which robotics will cut a swathe through the middle-class jobs market, autonomous electric cars will replace petrol powered human-driven ones, and nearly all business transactions will be conducted through apps on smartphones. Investors will pay almost anything for companies which they believe will benefit from these trends, while avoiding ones which they expect will be disrupted.
We are not Luddites. We are not saying that none of these things will come to pass, but we remember the wisdom of Bill Gates’ remark that people over-estimate the amount of change that will happen in the next two years, while under-estimating the amount of change that will happen in the next ten. In investment terms, ten years is a long time. We also remember the tech-boom of the late 1990s, which from an investment point of view had much in common with today’s markets. Many of the exciting growth companies crashed and burned, while in many cases it was the ‘old economy’ dinosaurs who came along in the wake of the crash, and adopted the new technology at a slow but steady pace.
Investors don’t like losing money, so they buy shares which have been going up. This style, known as ‘momentum investing’ has been particularly fashionable since the 2008 crisis.
Many investors dislike certain sectors, including banks, miners and utilities, and avoid investing in them.
We respond to these trends by making sure that we don’t overpay for growth companies, however good they may be, and by doing all we can to invest in assets we like when they are as cheap as possible. We take care to come to our own conclusions about things rather than joining in with the consensus view, and are prepared to admit our mistakes as soon as we come to see them as mistakes.
Conclusion on bubbles
We don’t agree with those who would tell you that all assets are at bubble valuations. We agree that the fixed interest markets have been distorted by QE. In the stock markets, some sectors are very expensive, so much so that they make the market indices look expensive in the aggregate, but within the markets we look at, there are assets which are not only reasonably valued, but cheap.
To us this makes a crucial difference. It means that in the current environment we are able to manage the fund in the way we have been doing, being fully invested in good-value assets across a wide spectrum of sectors and markets. During 2017, many assets became more expensive, but others became cheaper, so that the opportunity-set, though different from a year ago, isn’t significantly smaller.
Should our universe of opportunities shrink to the point where we are no longer able to invest in the normal way, our flexible remit would allow us to take a highly defensive position, and we would expect to do so. We would make sure that all concerned were fully briefed should such a situation arise.
Apparently, of all the data that has been produced in the history of the world, half has appeared in the last two years. Even if this fact isn’t literally true, there is certainly more and more data, nowhere more so than in the investment markets, and there isn’t any more time to digest it, and put it to good use.
We all respond by buying data-analysing tools, which allow us to process huge amounts of data quickly, but in doing so, we become reliant on the software, on the assumptions of the software-writers, and the accuracy of the data input. We are at risk of all using the same tools, which analyse the data in the same way, and thereby of coming to the same conclusions. We need to be aware of this risk.
The investment outlook
The world looks a riskier place today than it did a couple of years ago. Politics has become more angry and unstable, and there are major unknowns such the growing tensions in the Middle East, Brexit, and potential conflict with North Korea. We watch these developments nervously, and without knowing how they will be resolved.
On the economic front, we agree with the consensus view. World economic growth is strong, and continuing to get stronger. We don’t feel it so much here in the UK, where the pound’s weakness following the 2016 referendum has caused inflation to pick up, leaving the consumer economy weaker.
Rising interest rates
Meanwhile, the policies of Quantitative Easing (QE) and the zero interest-rate policy (ZIRP) are coming to an end. The US is at the forefront of this movement, having already stopped QE, the policy of buying government and company bonds to support their prices, and begun to raise interest rates. Japan, which is continuing to buy bonds in great quantity, is at the rear. However, it looks likely that the US authorities will continue to raise interest rates, and will begin to sell the Federal Reserve’s huge stockpile of bonds back into the market, and that eventually, the UK, Europe and Japan will follow suit.
As a result of higher interest rates, there could come a time when savers, who have been forced to invest in the financial markets, by the need to earn some interest on their cash, would return to the safe haven of deposit funds. The income-paying assets they sell would fall in value. There has been an insatiable appetite for income-paying funds, investing in infrastructure, clean energy, high-yielding bonds, peer-to-peer lending, social housing, student accommodation, and much else. One question we need to ask of all our existing and potential investments is ‘If interest rates were 3-4%, would this asset still be worth investing in?’ We can only guess the answer to this question, but a guess may be better than nothing.
As well as prompting a dash to cash, higher interest rates would make borrowing more expensive. Indebted companies and individuals would pay more to service their debt, leaving less available cash to spend on anything else. The effect would not be immediate, as many people have fixed-rate debt, but gradually the debt will mature, and will be re-set at higher rates. This growing cost pressure would apply to the Government as well. The result might be an outright recession, though central banks would attempt to avoid such an outcome, by reversing their policies only gradually.
How to cope with rising interest rates
Most money managers expect interest rates to rise, and most of them appear to believe that all strategies will fail in that environment, apart from the one that they have chosen to pursue themselves.
TB Wise Multi-Asset Income pursues a relatively high-yield strategy. The fund currently pays around 5.0% per annum. In theory, higher-yielding assets should hold up better in a rising interest rate environment than lower-yielding ones. To give an example, at present, the Bank of England Base Rate is 0.5%, UK Government stock pays around 1.0%, and TB Wise Multi-Asset Income pays 5.0%. Government stock pays a ‘yield premium’ of 0.5% to cash, while TB Wise MAI pays a premium of 4.5%. If the Bank rate goes up to 0.75%, Government stock’s yield premium drops by half to 0.25%, while TB Wise’s yield premium drops by a mere 5% to 4.25%. Thus higher-yielding assets, in theory, have a bigger cushion against rising rates.
Theory is all very well, but what will happen in practice? The short answer is, we don’t know. It will depend on how much interest rates rise, and how quickly, and on what else is happening. However, it’s pretty clear that the ‘normalisation’ of interest rates poses a threat to financial markets, and, by increasing the cost of borrowing, to the growth of the economy.
Should we go into cash and wait for this process to work through?
The gradual reversal of ZIRP and QE across the world is likely to take place over several, if not many years, and central banks are likely to stop the normalisation process if they see it having a significantly dampening effect on their economies. While we continue to see attractive income-paying opportunities, we prefer to remain invested. When investing in shares, we prefer companies which provide the goods and services people need, rather than ones which they might like. The three companies mentioned above all pass this test. We try to spread our investment portfolio over as wide an area as possible. And we try not to take anything for granted.
We accept that setbacks in financial markets are both normal and necessary. They don’t feel pleasant at the time, but they refresh our investable universe. There is a long list of assets in which we’d love to invest if only their prices were a bit (or in some cases, quite a lot) cheaper. Sell-offs bring these delicious grapes nearer to the mouth of the waiting fox. And as fund managers, experience tells us that our best years nearly always follow our worst ones.
The cost of insurance
For many investors, the prospect of a significant financial loss is the paramount consideration. But is this right? If we are investing for the long-term, our over-riding consideration should be the overall return after all charges and taxes, provided that we have the determination to ride out the humps and bumps along the way.
We believe that many of the funds which offer you the prospect of only a limited drawdown in the event of a financial market slump are superficially attractive, but may cost investors a fortune over the longer term in lost returns. Is the insurance premium really worth paying?
The Ghost of Christmas Future
As we enter 2018, the question is whether to invest our money in the financial markets, which have given generous returns over all longer-term periods, or whether to put our money in funds which offer to reduce our risk, but with only limited potential returns.
Which of these selections leads to Bob Cratchit and his family sitting rosy-cheeked in front of a roaring fire, and which to them huddling, ashen-faced and shivering, in front of an empty grate? Investor, the choice is yours…
Our aim in 2018, as in all other years, will be to leave our investors as comfortable and rosy-cheeked as possible, and we wish you a Happy New Year.
January 3rd 2018
PLEASE NOTE – this blog contains the personal opinions of Tony Yarrow as at January 2nd 2018, and is not intended as financial or investment advice. Prices and dividend yields can fall as well as rise, and past returns are no guide to the future.
All performance figures in this article have been taken from Financial Express