Taking care

The loss of asset classes

For most of the post-1945 years, it was hard for investors to see the losses made on gilts. Inflation combined with high yields sheltered capital losses when markets yo-yoed, and for the past 30 years and more bonds have been in a bull phase. But those holding or buying bonds now, with inflation low and deflation threatening, are simply hoping that central bankers know what they are doing.

Monetary policy cannot forever shelter politicians from the electoral consequences of necessary fiscal actions, nor their failure to address supply side problems, from education to transportation to land taxes. With some European bonds now offering negative yields – we are paying governments to take our money – the only justification for holding bonds is the greater fool theory of investment, that when the time comes to bail out, there will be a greater fool out there to buy us out.

And when this bond bubble does crack, the losses will be significant. There will be neither yield nor rising prices to hide the reality that the long-term cost of money is some 2 to 3 per cent a year, and the capital adjustment of bond prices to this recognition will be savage. This is the explanation for the timid tinkering of the US Federal Reserve and the Bank of England to the ending of quantitative easing, and the freeing of interest rate adjustments. The ‘trickle-down’ theory of economic growth has not worked, and neither bankers nor politicians can agree on what to do next.

The equity alternative

Cash remains as an alternative to bonds, and smaller sums can obtain some 3 per cent a year interest from banks, but larger sums are unlikely to find equally attractive returns in today’s low inflation environment. The very rich have already accepted the degradation of money, and are putting their cash into artworks. But for the majority of investors, holding cash must be regarded as an immediate yield sacrifice, to be used when equity markets have a setback.

For although the equity market is now the only long-term asset class available – commodities and gold are suffering from low worldwide demand, just as in the 1930s –

market levels are high. The best recognised of the two long-term valuation methods are either the Q ratio of Nobel laureate James Tobin, or the Cape calculation of another Nobel laureate, Professor Robert Shiller.

Tobin’s Q compares the market value of companies to their replacement cost, and has its roots in Keynes’s General Theory of Employment, Interest and Money in which he writes, “there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased”. Cape or the cyclically adjusted P/E is the price of the market (S&P 500) relative to the 10-year moving average earnings adjusted for inflation.

On both these measures markets are hopelessly optimistic. James Montier in his paper ‘GMO 7 A Cape Crusader – A Defence Against the Dark Arts [of stockbroker economics] February 2014’ concludes, “As a general rule we average across the various models we use to generate our best forecast as to where real returns are likely to head, rather than relying upon one signal model (without exceptionally good reason). Doing so currently results in our expectation of a minus 1.1 per cent real return for the S&P 500 over the next seven years. We continue to believe that the weight of valuation evidence suggests the S&P 500 is significantly overvalued at its current levels. Some call us “valuation bears”; we argue that we are simply valuation realists!”

Equity investment in hard times

The beauty of all markets is that valuations vary; more often than not too high, as fashion catches one mood or another, but sometimes too low, especially when a company looks boring, or is overlooked by market fashion. Identifying which is which is the art of the analyst, and one of the best of these was Terry Smith. He was the top-rated bank analyst in the late 1980s, famously issuing “sell” advice on Barclays when working for BZW, Barclays’ own investment bank, and was fired as head of research at UBS in 1992 after the publication of “Accounting for Growth”. This exposed dubious but legal accounting practices used by some of the UK’s biggest companies – including UBS clients.

Smith’s outspoken style was a hallmark of his time as analyst. He has not changed and, on his Straight Talking blog, he writes, “I believe that one of the reasons we have got into the difficult and dangerous situation which afflicts our economy and society is that too many people followed the herd. There was too little high-quality independent analysis, and we have been, and still are, dominated by ‘spin’ rather than reality.”

What he believes are the realities are explained in his question and answer session with fund holders of his equity fund at www.fundsmith.co.uk/video.

This is well worth listening to, whether professional adviser or private investor, since it identifies what an analyst should be looking for in a company, and how a manager decides what and when to buy and sell. More to the point, it shows why Fundsmith has been successful in obtaining greater returns on invested capital than the market as a whole, and why those greater returns should turn into cash and dividends.

The need for diversification

The skills which Smith outlines are more likely to be found within the investment trust world than that of unit trusts, while ETCs and the like are simply index trackers; these are simply not good enough if Montier is right about future returns. Fundsmith has an investment philosophy equivalent to the best of the international investment trusts. However with the Western world facing serious demographic problems, let alone political and economic paralysis, as well as dangerous international concerns with the rise of radical Islam, investors need to consider geographical and style diversification.

The AIC and Numis Securities websites both offer many choices, and certainly both Asia and North America are key to a diversified portfolio. So, also, is the ability to say no to current fashion, such as Venture Capital Trusts and Private Equity; US experience suggests that, however good the returns, in the end the costs outweigh the benefits and investors would have done better in the S&P.

And style is important, especially small companies and income specialists, property investors and infrastructure funders. Managers of such trusts cannot afford to take their eye off the ball, which Smith identified in his speech to fundholders. Such careful planning will not keep investors safe when markets do crack, but will ensure that their portfolios – and their dividend incomes – thrive as panic subsides.