Peter Doherty, manager of the Global Navigator fund at Tideway Investment Partners, explains how to create an engine of positive real return
We live in unprecedented times. For all intents and purposes, the available return after costs on five-year government bonds from the world’s largest economies is zero. After inflation, the return is negative. These bonds now offer ‘return-free risk’.
In short, savers are footing the enormous bills of the US housing crisis, the banking crisis and now the eurozone crisis, not to mention the UK’s own problems arising from an imbalanced economy, low tax receipts and zero growth.
A central pillar of my preferred strategy is to buy secure cash flow at yields well ahead of inflation in order to create a core ‘engine’ of positive real return.
We live in unprecedented times
Where is this secure cash flow?
It is widely accepted that banks generally became too large and complex in the 20 years prior to 2008 and that what they need to do now is simplify their business and have more equity (capital) to absorb losses than was previously assumed. So, as we have seen from recently reported figures (EBA, Federal Reserve), banks are shrinking their balance sheets and lending less.
In turn, this means many sound companies that previously might have borrowed everything from a bank are now issuing bonds for the first time or issuing more bonds.
The second, riskier part of the bond market is ‘hybrid capital’ where utilities, industrials, insurance companies and banks can raise a form of equity capital with bond-like features. Most public companies do not want to issue new shares to raise capital by diluting existing shareholders, so they issue hybrid bonds or ‘preference shares’, which generally have more risk and higher yields for investors.
Hybrid bonds should be bought only from the safest companies with household names that have both the ability and willingness to repay. There is a very high degree of certainty that this cash flow will actually be paid because, subject to the specific terms and conditions of the bond, paying the interest and principal is a contractual obligation of the borrower.
The usual safety-first guidelines apply: do not use leverage; only buy bonds from companies you know and trust; diversify across a number of bonds; and invest with a medium-term horizon, not for short-term gains.
The first objective of building an engine of cheap and secure cash flow is then met.
Creating multi-asset exposure
The principle of diversification into a larger number of asset classes is a good one and should be embraced. Too often though, investors and managers follow a fundamentally flawed process, whereby:
1 Expected returns are forecasts;
2 There is overconfidence in those forecasts;
3 Expected returns become an ‘anchor’;
4 Anchoring prevents adaptation to changing circumstances;
5 Expected returns disappoint.
Overconfidence in forecasting and in delivering return is endemic in the equity markets. In actual fact, following mantras of equity investing such as ‘equities outperform bonds in the long run’ have proven to be incredibly expensive errors, combining overconfidence and anchoring with devastating effect.
Many investors in equities have, for between five and ten years, suffered both heavy losses and significant volatility. Why might this be? Remember: equity is what is left over after everybody else has been paid.
Ideally, when well-run companies accumulate cash they either return it to shareholders efficiently or use it in new cash flow generating activities, in a positive upward spiral. However, too often chief executives go on an expensive M&A spending spree, squandering hard-earned money. Years later, ‘goodwill’ is written off and dismissed merely as an accounting issue.
Other things can go wrong: capital expenditure can turn out higher than anticipated to maintain current earnings, so available cash flow declines. In addition, corporate pension liabilities need funding, which periodically takes a big chunk out of company cash flow.
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