Thursday, December 15th, 2016
VALUE BASED INVESTING WILL RETURN IN 2017
Understanding the period that is coming to an end
One result of the sustained period of low interest rates, which has been the enduring policy response to the global financial crisis of 2008/09, has been elevated investment asset prices. High bond prices or low bonds yields have driven the price of both equities and income securities higher. Prices of many assets have risen faster than the forecast cash flows from those assets.
It is important to understand that neither declining yields nor the expansion of price earnings ratios (PERs) is an investor’s enemy if they occur in a sound economic framework. However, they become dangerous when investors are deluded by price rises and prices do not properly reflect the likelihood of cash flows flowing to them as owners.
The delusion of the paper wealth affect is captured brilliantly in this quote from a paper written by US fund manager John P. Hussman titled “When Paper Wealth Vanishes”,
“As in equal or lesser speculative bubbles across history, there’s a common delusion that elevated stock prices represent wealth to their holders. That is a fallacy, and we can hardly believe that given the collapses that followed the 2000 and 2007 extremes, investors (and even Fed policymakers) would again fall for that fallacy so readily. The actual wealth is in the cash flows that are ultimately delivered into the hands of shareholders over time. Individuals can realize their paper wealth by selling now to some other investor and receiving cash in return, but only a small proportion of investors can actually convert current paper wealth into cash by selling to other investors without disrupting the bubble. The new buyer then receives whatever cash flows the stock delivers into the hands of existing holders, and can eventually sell the claim to the remaining stream of future cash flows to yet another investor. Ultimately, a share of stock is nothing but a claim on the long-term stream of cash flows that will be delivered into the hands of its holders over time. The current price and the future cash flows are linked together by a rate of return: the higher the price you pay today for a given stream of future cash flows, the lower the rate of return you can expect achieve by holding that investment over the long-term.”
After 8 long years of brain numbing monetary policy, 2017 promises to be a year where the world economy emerges into a period of different (but not new) economic policy settings. The monetary policy experiments of quantitative easing (printing money) and sustained low or negative interest rates are not dead, but we believe they are well past their used by date. Importantly they cannot and will not work. The excessive focus on monetary policy as a solution will be ultimately reset and the world will revisit fiscal stimulation characterised by elevated government expenditure and large budget deficits.
The persistent use of monetary policy without success is evidence that incumbent political leadership and their bureaucratic advisors had become bereft of alternative thought process. As their policies became entrenched, they provided systematic support for financial markets and trading entities. Indeed the maintenance of zero cash rates and bond buying seemed to favour a select and influential few trading entities (major investment banks and affiliates). Meanwhile the real economy struggled to grow, an aging population grew increasingly concerned about their retirement and a younger generation struggled to find meaningful jobs. In Australia the issues were slightly different but they emanate from the same root cause. Here investment returns are stagnating with low interest rates and a younger generation cannot afford a home without accessing excessive (but at least for now, cheap) debt.
Enough of moribund leadership and enter a range of free thinkers, the entrepreneurs and business leaders with a mix of political extremists. All are promoted to replace the ineffective monetary policy strategies adopted by the evicted. In our view we will see in 2017 significant changes to economic policies driven by a groundswell of discontent amongst both the young and the old.
Our job in looking out through 2017 is to determine what these changes may be, whether they can work and to draw conclusions regarding the consequences for investment assets.
The future drawn from today’s charts
The election of President Donald Trump will definitely hasten the change of economic policy in the US and therefore across the world. His declared policies certainly suggest a massive fiscal blow torch to the US economy. These policies will lift both economic activity and growth. However, Trump inherits a government balance sheet that is already loaded with nearly US $20 trillion of debt equivalent to 110% of US GDP.
Figure 1. US GDP & Federal Debt ($m’s)
In our view either success or failure in Trump’s economic policies will result in higher interest rates. This is already being reflected in long term bond markets which have reacted immediately to Trump’s electoral success.
The chart below shows the immediate lift in bond yields that followed the US election and it also highlights the “precarious” bond yields that exist in both Germany and Japan. We use the description “precarious” because they are unsustainable on any rationale assessment of the future. Both Japan and Germany have been badly corrupted by the application of ‘too low for too long’ monetary policy settings and their biggest challenge in 2017 will be this – will any (rational) long term investor buy long term bonds in Germany or Japan as US bond yields rise under a Trump Presidency?
Figure 2. 10-year Government Bond Yields (%)
However, the manipulation game will not end quickly for we suspect that both the European Central Bank and the Japanese Central Bank will carry on printing money and buying bonds until their political leaders are replaced. The longer this is continued, the higher the likelihood that, ultimately, the only way out for highly indebted governments funded by Central Banks will be to seek a compromise of their bond debt. We can foresee that Central banks will be compelled to roll much of their current bond holdings into 50 or even 100 year bonds that will never be repaid and which ultimately will be forgiven. Maybe President elect Trump has already planned for this to occur in the US?
Australia between China and the US
Donald Trump has pledged to label China as a “currency manipulator” on his first day as President. That may well happen and if he does it will destabilise the relationship between the two largest economies in the world.
The next few charts show why the relationship can become strained. First, the US has an intractable trade deficit with China and it peaked in 2015 at US$350 billion. This deficit has been created by US corporations domiciling their manufacturing base to China.
Figure 3. US Trade Balance with China
Source. US Census Bureau
The combined trade deficits over the last ten years exceed $3 trillion and US consumers have clearly helped grow the Chinese economy. Consequently for a period the Chinese Administration repatriated capital back to the US by way of US government bond purchases. However, about three years ago China became a net seller of US bonds and today they hold US$1.15 trillion of US government debt.
Figure 4. China’s Treasury Holdings
So if President Trump does label China a currency manipulator then he should also be sure that they won’t dump US bonds. It is always dangerous to argue with one of your biggest creditors.
Our point from the above is that Australia sits between the US (our major ally) and China (our largest trading partner). It is clearly not in our interest that these major economies have a major disagreement. If it does occur then the $A may well sharply weaken in the cross fire.
The next chart takes us to an unsavoury truth. The worlds major companies have been struggling to grow earnings for at least the last few years. A low growth developed world, with low interest rates, high unemployment and low inflation has clearly not been conducive to profit growth.
Figure 5. Sluggish growth of corporate profits (ex energy)
It is has been a tough few years where banks, resources, telcos and retailers have battled across the world to achieve growth and maintain margins. Indeed this takes us back to the beginning of this letter, where we noted that excessive prices have been paid for low growth opportunities.
The illusion of returns is exemplified in the following chart. From an Australian investor’s perspective, the apparent positive returns of some international equity markets (US and UK) have been lost in currency translation. In our view, and given high PER multiples, sharemarket indices will continue to struggle to deliver positive returns. It will be up to investors to stock select and discern growth opportunities at a fair price.
Figure 6. MSCI Standard Equity Total Return Indices (Rebased, 1st Jan 2016 = 100)
This is why the Trump Presidency becomes so important. His policies promote growth at a time of low growth and his rhetoric provides hope at a time of economic and social despair. He will be a President for US corporations with tax cuts and massive government expenditure proposed. We have no doubt that turbulence from his policies will shake the world and shake out markets.
Higher bond yields, lifting inflation, jobs returning to the US but with a debt load that grows higher actually suggests to us a more conducive environment for “value based” investing. We believe that in this environment, companies that generate real cash flows for reinvestment and distribution will be more fairly priced. We’re optimistic that this will be a feature of 2017. Higher bond yields give investors alternatives, and alternatives ensure better pricing for all assets. Inflated asset prices will deflate and opportunities will abound.
Many will claim that Trump and a likely range of new leaders across Europe will take the world into uncharted waters. We believe we have been in uncharted waters for many years already and it is time to move on. We forsee that a proper response based on commercial grounds and common sense will deal with the issues that many governments could not deal with. It will be a rocky road, but it presents a good one for investors whom are patient and can value companies correctly.
Harnessing volatility with purposeful portfolios
‘Having purpose’ is an inherently simple concept. It’s the reason something is done or why it exists. When it comes to investing, it’s insightful to consider this concept. Simply put, why am I making this investment?
We believe the fundamental reason behind making an investment comes down to one or more of the below three objectives. To;
- Grow your invested capital;
- Guard your invested capital;
- Generate meaningful income on invested capital;
Give me growth
Growing your invested capital over time is often a primary reason for making an investment. The compounding of growth over time is a powerful engine to meaningfully increase capital value.
Guard my assets
The variability of invested capital is another relevant consideration. Of particular concern is a decline in capital during an unfavourable or uncertain market environment. The reason some investments are made is to reduce the variability of capital movements over time, or more directly lessen the drawdown (decline in capital) in an unfavourable / uncertain market environment.
Investing capital to receive some form of regular distribution in the future is another key reason for making an investment. Whether it is paid as interest (term deposit), a coupon (bond), rent (property) or a dividend (shares), the certainty of regular income is an appealing driver of investment.
The importance of setting clear goals
Having considered the key reasons for making an investment. The next logical step is to set clear goals to achieve them. Some examples might include
- I want my investments to achieve an annual return of inflation +6%.
- I want my equity return variability to be no greater than 12% p.a.
- My income portfolio’s objective is to achieve 3% p.a. above the cash rate
These goals are examples of objective based investing, which refers to investing with a specific absolute return, risk and/or income target. Setting investment goals in this way aligns key objectives with the underlying reasons for making the investment.
Note that when set in this way, none of these goals refer to outperforming traditional market indices or tracking established benchmarks.
Having established clearly defined objectives, the next stage is to build out the investment portfolio to achieve them. We employ a clear decision framework in building portfolios to ensure risks taken are appropriately compensated. This framework is
- Capital deployed
- At what risk
- For what likely outcome
- (And over what expected time horizon)
Within Australian equities we utilise the following sub-portfolio approach
- The large cap allocation (ASX50) seeks to deliver solid yield with some capital growth;
- The mid cap allocation (ASX200 ex ASX50) seeks to deliver a balance of some yield and solid capital growth;
- The small cap allocation (ex ASX200) seeks to deliver strong long-term capital growth;
- The cash allocation seeks to preserve capital and pursue selective opportunities across the investment universe.
Each sub-portfolio has a specific objective and purpose within the broader investment portfolio.
Harnessing opportunity in market volatility
Clime is a value based investor. We have a clear framework to assess what we believe a company is worth based on rigorous investment analysis. Our investment approach requires an appropriate ‘margin of safety’ when entering into a position and our team-based approach ensures both discipline and conviction in pursuing those most attractive opportunities. Equally important is applying this discipline in selling positions where the investment thesis has played out or, as is sometimes the case, where things don’t play out as expected and the investment thesis changes. Regular portfolio review, discussion and debate in Investment Committee meetings add further rigour to this process.
We encourage investors to use the opportunity created by volatility to selectively build positions in quality businesses trading at attractive valuations. Markets hate uncertainty. It is this uncertainty that can create the opportunity to find value in great businesses. Those businesses able to consistently generate real cash flows for reinvestment and distribution.
We believe key ingredients to do this successfully are:
- Investing with discipline based on a clear valuation framework;
- In what we see as quality companies; and
- Where the risk we are taking is appropriately compensated.
It is often said ‘with change comes opportunity’. Change is clearly on the horizon. Strap in for the considerable adjustment in financial markets, which will naturally bring with it significant volatility. We advocate using this volatility within a purposeful framework of portfolio design and are optimistic for the coming year ahead.