Living in extraordinary times
Living in extraordinary times
How to generate attractive returns in a very uncertain world.
‘May you live in interesting times’ is often referred to as the Chinese curse. Whilst the actual origins of the phrase are uncertain the meaning is clear to all investors. If something is interesting it tends to be unusual, unusual events create uncertainty and uncertainty gives rise to investor unease which manifests itself in falling prices of risky assets such as equities.
But what is it about the world currently that is interesting? Just reading a newspaper and watching the news provides us with many examples. However there are certain investment ‘events’ occurring now, which don’t occur once a decade, or once a lifetime, but once since records began!
Nowhere is this better illustrated than when looking at interest rates. In the UK the Bank of England sets Bank Rate (which is the rate that the Bank lends to financial institutions) and the chart illustrates that it is at its lowest level ever. At 0.5% it has never been cheaper for a bank or financial institution to borrow from the Bank of England and this in turn affects a range of different interest rates set between commercial banks and their corporate and individual borrowers. Ultimately the Bank of England’s objective is to make it cheap for individuals and companies to borrow cash (and spend or invest it) thus stimulating economic growth.
However the Bank of England is fighting a difficult battle with some severe economic forces. Consumers don’t want to borrow as they have too much debt and are uncertain about their jobs and future wage growth. In addition, banks don’t want to lend as they try to reduce a decade of over-lending and are instead seeking to rebuild their financial strength. Lastly, corporations (who do have cash) are worried about investing in new plant or equipment (and generating a sufficiently high level of return on them) in the current extremely uncertain environment.
Of course low interest rates affect savers and investors a well as borrowers. A low rate for borrowers also means a low rate for savers. In addition, when current inflation rates are taken into account the real return (after inflation) for savers is often significantly negative. By way of illustration, if the nominal return from cash is 0.5% and inflation is running at 4% this gives a negative real return of 3.5%.
This low or negative return from cash sets a framework for valuing other low risk assets. For example UK government bond yields are the lowest on record making them appear very expensive from a historic perspective. And of course the corollary of something being expensive is that it has more valuation risk i.e. the price could fall substantially. The frustration for investors is that they look for safe havens and buy government bonds which forces the price higher and increases the riskiness of the investment.
For charities which require both long term capital growth (to protect against inflation) and a reasonable income (to fund their charitable activities) neither gilts nor cash are suitable over the long term. The income they produce is insufficient and the real value can be easily eroded. Therefore the answer for many charities is to adopt a longer term time horizon and take additional risk in order to generate the higher returns they need. Corporate bonds, equities and commercial property are all examples of investments which offer the prospect of higher returns.
Unfortunately, over the shorter term, these sorts of asset classes also offer the potential for far greater volatility. However, with a long enough time horizon this additional volatility should not be that concerning. Warren Buffett, perhaps the world’s most successful investor, is quoted as saying: ‘I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for 5 years’. We agree with this advice that long term investments such as equities should be judged over the long term and that much of the short term gyrations of stock markets are largely irrelevant.
Instead we think that long term investors should view risk, not as volatility or maximum drawdown (the largest peak to tough fall in the value of an asset) but as the potential for any individual investment to exhibit a permanent loss of value. In its simplest form a permanent loss of capital is most commonly derived from three principal sources being business risk, financial risk and price risk. If investors can avoid or minimise these risk then a portfolio should be better equipped to exploit the opportunities provided by the compounding of returns. Over the long term the compounding of returns is massively influential and is probably the most powerful driver of both portfolio values and, crucially for many charities, distributable income. In fact, at a rate of 7% per annum an investor will double his or her money in just 10 years.
From a very simplistic perspective, investors are currently more focused on the multitude of existing risks – many of which they have never faced before – than the potential rewards. Another quote from Mr Buffet, in his role managing his investment vehicle Berkshire Hathaway, is as follows: ‘we simply attempt to be fearful when others are greedy and greedy when others are fearful.’ Despite a good end to 2011 and start to 2012, the relative valuation of ‘risky’ and ‘safe’ assets certainly suggests that fear is in the ascendancy. Therefore charities should at least consider whether they should follow the advice of the Sage of Omaha, close their eyes and buy equities.