An important point worth considering is that investing and the business of investing are not necessarily the same. Financial institutions, asset managers and most financial advisors may be in the business of investing, but are usually not investors. This differentiation is important to make for those placing money with asset managers and institutions.
This subtle difference was pointed out by Bill Gross, managing director of one of the largest bond managers in the world, US based Pacific Investment Management Company (Pimco).
The business of investing revolves around managing funds around an index, ensuring that results do not deviate too far from competitors for fear of loss of business and, given compliance restraints, managing to a restrictive mandate. Often the results are not in a client's best interests.
Unfortunately I come across this all the time and at a recent presentation of a fund, which has just been relaunched, the manager elaborated as to why they believed the portfolio construction should take into account the makeup of competitor portfolios.
The terminology used in the industry is "tracking error" - where risk is defined as too high a deviation from competitor returns, as opposed to actual capital loss. The question arises - is the investor concerned about a deviation in returns or loss of capital? I suggest the latter - investors are concerned about maximising returns and minimising downside loss to the absolute minimum and expect managers to do their best to achieve this.
When you start to recognize that investment opinions and actions are largely driven by those in the business of investing, who often prioritise their own business risk over their clients best interests, then you can start to take the appropriate action.
Pimco manages around $300 billion - making it one of the largest money managers in the world. Its speciality is bonds, and with US yields at record lows, managers such as Pimco have been propelled into the limelight as masters of the universe.
Erudite MD, Bill Gross, provides a very useful and thought provoking regular analysis on financial markets. In September 2002, he headed a report, "Dow 5000" reflecting his views that the US markets as represented by the Dow Jones Industrial index has probable further downside to around the 5000 level.
He conveyed that "The crux of the valuation argument is this: Stocks historically return more than almost all other alternative investments but only when priced right when the race begins. If you start from day one with P/E's too high or importantly, dividends too low, you will not obtain equity returns in excess of bonds.
The primary element in determining how a stock market is priced - whether it's cheap or expensive - is its yield. At 4.2% in 1900, the market needed an additional 2.0% annual push from a tripling of P/E ratios over the century to get near that 6.7% real return."
[the real return generated from equities in the US market].
This is all very well coming from a bond manager, talking down the equity market, but what does Bill Gross have to say about the outlook for US bonds, where the yield on the 10-year bond is hovering just under 4%.
One of the biggest risks to bonds is that of inflation. The ongoing debate in the US is whether the up to now benign inflation slides into deflation with massive consequences, or the monetary authorities managing to reflate and keep inflation on the cards for the foreseeable future - a far more palatable prospect.
In December 2002, after a further decline in US rates, and a speech by the Federal Reserve where they vowed to fight deflation, he pointed out that the cost of money (interest rates) can't go much lower and therefore at some time in future interest rates must start to move higher. He is also looking for some level of inflation, although concedes that it may be difficult for the Federal Reserve to engineer, notwithstanding their resolve.
The very important conclusion that he has carried through is that the "? the bond market's salad days are over. 4-5% annual total returns at best over the next several years should be expected. The Fed and the Congress will make sure of that by conquering deflation, promoting inflation, and perhaps in the process creating even more financial and economic instability than we have seen in recent years."
Remember that for a $300 billion bond manager to inform his clients that "the bond market's salad days are over" is very brave indeed. It's analogous to a landlord releasing his tenants from an onerous fixed lease for them to find alternative cheaper accommodation. His forthright opinion is that of an investor, as opposed to someone in the business of investing. I believe that it carries a lot of weight.
Again in April, he reiterates Pimco's assertions, stating "Although the global economy is wallowing in the aftermath of bubbles, trade deficit imbalances, and anaemic demand in Europe and Japan, government yields worldwide are close to rock bottom. The phrase, "the salad days are over" really means that capital gains that formed a goodly portion of the past two decades total returns, have run out of room to appreciate. Coupon clipping is for now the order of the day, and should current reflationary efforts take hold, price protection will be the order of tomorrow."
Remember that
The return from the asset comes from:
- the starting dividend yield - it stands to reason that the higher this initial yield, the greater the probability of a positive return.
- the real growth in the dividends, which should be in line with real earnings growth.
- any rerating of earnings. Returns increase when investors are prepared to pay a greater price for earnings, but the converse is also true.
The higher the initial dividend yield the greater the probability of a high return on your investment. Investors in property understand this concept well. When valuing a property for potential purchase, they look closely at the property's capitalisation rates, i.e. net rentals over price.
With substantial disappointment over the last few years, equity investors have tired. Astute investors will understand that wonderful opportunities will present themselves when equities in the main are shunned.
The disappointment has resulted in large outflows, causing equity prices to drop, but value to increase. I for one am looking for good-value entry levels, and will accordingly be rebalancing client's holdings from existing relatively lower equity weightings.
Conclusion:
Be wary of opinions of those in the business of investing. Institutions and advisors that continue to recommend offshore equities just because they have fallen some 50% and therefore appear cheap, don't understand the inherent risks still present.
I don't believe that it's too late to dramatically reduce offshore equity exposure.
Offshore bonds are expensive, but remain a better bet than offshore equities. Take opportunities to lighten exposure where possible.
Local bonds have been expensive for some time now, but with the inflation falling, retain your allocation to this asset class. Also commercial property, while having an extraordinary run, should continue to provide steady returns.
With the appetite for local equities drying, institutions have scrambled to offer different forms of absolute return funds, which limit downside and upside. I firmly believe that there is a place for them, but have the nasty suspicion that the institutions marketing these "products" are acting to limit their own business risk - being in the business of investing.
Such product launches typically come at the wrong time for investors. As one example recall the launch of the Financial Services funds in 1998, just when financial shares were peaking - Investors clambered to invest - wonderful for the institutions, but disastrous for investors.
In these volatile times, its important to preserve capital, so that when equities possibly reach the 8% dividend yield level, that you have the capacity and the enthusiasm to be a buyer and not a seller.
One of Warren Buffett's famous quotes is to "be fearful when others are greedy and greedy only when others are fearful." Discerning investors will look for the opportunities.
Optimising your investment strategy in challenging times
I help high net worth clients to optimise their investments and investment strategy. If you would like to find out more about how I can remodel and refine your investment planning, then please feel free to contact me.
For a copy of my Business and Investment Beliefs, send an email to ian@sharenet.co.za.
Best Regards
Ian de Lange CA (SA)
25th April 2003
ian@sharenet.co.za
021 710 5700
This investment newsletter is published for general information. While every effort has been taken in the production of it, Sharenet (Pty) Ltd and/or Ian de Lange bear/s no responsibility for any loss or damage that may be result from any person's reliance on the information contained in the newsletter.
Posted: 2003/04/25 14:57 View Archive