The Valor Blog.
Investment News and Views, Direct from Our Team.

Investing in a low return world

We live in a low return world.

Asset prices are high across the board. Government bonds trade below 1%. Cash is effectively zero. Net residential property yields are low single digits. Stocks have earnings yields of around 3%. Obvious areas to allocate capital are scarce.

A large percentage of people still think they can retire comfortably with an approximate 5% net return. The vast majority of people have calculated their insurance needs on a 5% net return. There are still a number of pension funds which require 7% returns. The problem with these assumptions is that we live in a world where expecting these returns is like sticking your hand in a bag of snakes and trying to pull out an eel.  

Valor believes that intelligent investors have a few options on how to tackle the low return market conundrum.

  1. Attempt to Avoid Stupidity.
  2. Dynamic asset allocation
  3. Dry powder reserve
  4. Lower your expectations

Attempt to Avoid Stupidity

There have been lots of stupid areas to invest over the last decade. Valor has warned about a number of them.

The Iron ore bubble.

The LNG bubble.

The Aussie Banking bubble.

The disruption Fad.

Generally speaking, ignoring the crowds is often beneficial to your wealth.

In 2011, we spent a large amount of time dissecting the Chinese growth story. For those that looked, it was obvious that China was overconsuming steel and at some point, prices would revert closer to their long-term averages.

At the time, BHP was $48. We warned a number of clients who held the stock that our estimate of its fair value was closer to half its $48 price. BHP eventually fell over 50%.

China is still overconsuming iron ore.

We are confident that China will not permanently consume 50% of the worlds iron ore as they are only 15% of the world’s population.

Beginning around 2012, we observed the ridiculous Asian LNG prices of around $17 per million British thermal units. These prices were not congruent with the coming supply increase and likely arbitrage from Qatar gas prices (which were priced in cents not dollars) and US gas prices which had fallen precipitously down to around $2. It was quite obvious for those with a 5 to 10-year view that Asian LNG prices would trend closer to the $2 (plus transport and liquefaction costs) that existed in the US.

Woodside was $48. Origin was $14. Today Woodside is closer to $18 and Origin is closer to $4.

In 2015, we warned that the great Australian debt bubble would bring the Aussie bank shares down significantly from their elevated levels. The Aussie banks were trading at up to 3 times book value on solid Net Interest Margins (NIM’s). They were over-earning. We were confident that this was near top of cycle NIM’s and prices to book value.

Today, Westpac, NAB and ANZ are down around 50% to 60% from their highs.

We still expect that we will experience a full cycle in Australian property prices at some point, however the can has temporarily been kicked down the road. The can (household debt) will likely get bigger in the coming year or two and at some point, will break the foot.

Today, we live in a multi-bubble world.

Most assets trade at well above their long run valuations. Many believe that central bankers are omnipotent and it is becoming increasingly common to believe that deficits don’t matter. Whilst we agree that central banks are powerful, their magic works to a point and then stops working. Deficits don’t matter, until the point where they do.

The most egregious bubble of today is in the disruption fad stocks. That is, stocks that seemingly appear to be offering a new way of doing things and revenues are growing like wildfire. Some of these stocks will change the world. Many of them will come crashing back to earth like the Hindenburg airship.

The most obvious disruption fad stocks, in our opinion, are those that have structurally flawed business models. The food delivery companies, the buy now pay later stocks, the EV car makers and a number of the software as a service companies that offer difficult to differentiate services. Many of these companies are challenged businesses in highly competitive markets and yet trade at prices that require extreme levels of certainty of future outcomes.

The irony of the disruption stock fad is that a number of  the disruptors are easily disrupted themselves.

Business moves faster today than in any time in history. The ability to take market share due to modern technological changes has never been greater. Brands can spring up from no-where in a matter of months not years. The Instagram influencer phenomenon has changed marketing dynamics. Small brands can eat into big brands like never before.

The connectivity of the world has led to disintermediation. The old gateways are no longer barriers to entry. The brands of the 1960’s had to get their foot in the door with the department stores. Today, you can start a business selling online in the matter of a few hours and sell through Amazon, Shopify or Ebay.  

Due to the world changing Amazon’s of this world, many are projecting their success onto the next generation of disruptors. With history as a guide, the odds of success for many of these disruptors are likely low. The premium that many of them trade at is likely irrational. The few that do become “platforms” for growth are probably cheap today.

A number of the disrupters are likely frauds. As Jim Chanos recently stated:

            “We are in the golden age of fraud”

If you are to buy into any of these loss-making disruption fad stocks, it is probably wise to diversify significantly.

Dynamic asset allocation

The 60/40 or 70/30 allocation portfolio has worked for many decades. Will it work for the next decade?

Source: Hussman Funds

In a world of expensive stocks and bond yields below 1%, the expected return for a 60/40 portfolio is probably below what most are expecting.

Markets have been volatile this year. One way to manage risk is to use a dynamic asset allocation philosophy.

“Be fearful when others are greedy and greedy when others are fearful.” (Warren Buffett)

When the market rises significantly, trim. When it falls significantly, add to the portfolio.

Very few do this well, so I caution you to think that this will work for most.

Valor successfully trimmed and added back to the portfolio a number of times over the years which has reduced our down periods when compared to diversified portfolios. Notably, in 2018 calendar year, we had a 6% return in a down market due to this strategy. In March this year, we were more active than usual and had an over 30% market outperformance on the downside due to our caution. Admittedly, we have missed out on some of the recently rally, however our caution will once again be rewarded.

Beyond dynamic asset allocation between the asset classes is a more nuanced approach, which uses individual investment valuations. A company like Berkshire Hathaway, due to its diversification, has relatively predictive operating cash-flows. It trades within a fairly narrow band of its valuation. Buying when it trades at the lower end and trimming when it trades at the upper end of its valuation range has been highly successful for our firm.

Dry powder reserve

The dry powder reserve is an extension of the dynamic asset allocation.

Valor believes that you should always have an amount of cash or short-term government bonds as a dry powder reserve. The amount is predominantly determined by your age, spending habits and your assets levels. It is also influenced by market levels compared to their long-term ranges.

If you are in retirement, then you need a larger dry powder reserve.

If you have high fixed spending needs, then you need a larger dry powder reserve. Someone who regularly spends $100k per annum, however under compulsion, could live off $30k per annum needs less than someone who regularly spends $100k but could only live off only $70k in less than desirable market conditions. The lower number is determined by your fixed spending needs.

Generally, the wealthier your become, the less dry powder reserve you need as a percentage of your asset levels. Warren Buffett needs a lower amount of cash on hand as a percentage of his wealth than you do.

Market levels over a long-term range should influence your dry powder reserve number. At the upper end of the range, you should have more dry powder as it can take longer for markets to recover to their previous levels from these peaks. Remember that it took 25 years for the market to recover from the 1929 peak. Japan in 1989, the US in 2000 and Australia in 2007 are notable peaks. We are likely at another peak for a number of markets.

Lower your Expectations

The last thing someone who has worked 40 years to generate a significant lump sum for retirement wants to hear is that they need to lower their expectations.  

Unfortunately, there is no obvious way to materially increase investment returns on defensive assets. If cash is 1%, cash is 1%. If bonds are 1%, bonds are 1%. You can’t change that.

Source: Bloomberg

I’m bald. I have accepted that my hair is not going to grow back again. You need to accept that cash rates are not going back to 5% again soon.

Once you accept the reality of the situation, you can plan for the future with confidence. Those that attempt to reach for yield may be disappointed with a future that is less than what they need.

There are a number of “high yield” offerings popping up in the market place. Many of these are lending to distressed or subprime borrowers. When you realise that a good corporation can borrow for between 1.5% to 3% and mortgage rates are around 2.5%, the quality of a company that is forced to borrow for 7-9% is likely not where you want to be allocating capital.

Lending at high yields is done well by a few specialists, however most are not adept at the task. The best specialists in these areas take large amounts of equity or control of assets under distressed situations. If you are down the pecking order behind these specialists, then you are the patsy.

Summary

These are difficult times for investors. Those that have decades left of productive years of employment can dollar cost average over a number of cycles. Those that are nearing or in retirement have a number of headwinds.

Always have a safety-first attitude to capital allocation. With a primary focus on avoiding permanently losing capital and then calculating the upside, it is possible to sidestep much of the current market folly.

Live within your means and keep your fixed costs down.

Despite generally difficult investment conditions, there are still a number of assets that are more than reasonably priced and have many years of growth left.

Be careful out there…

Emergency Procedures Training

All pilots routinely perform emergency procedures training. When we have an emergency that was unexpected, but well trained for, we perform that task as if it were a normal task. It becomes like a habit.

If a pilot experiences a near mid-air collision, you have a 2.5 second reaction time under a reversal procedure for a TCAS event (traffic collision and avoidance system). There is no thinking time. There is no room for error.

Not all emergencies are that simple and many require multiple tasks and time. Not all emergencies follow a script. A large component of emergency procedures is training methods to handle various types of emergencies without prescribed actions. We use first principles such as Aviate, Navigate then Communicate. We follow acronyms such as GRADE (Gather, Review, Analyse, Decide and Evaluate) and NITS (Nature, Intention, Time, Special instructions)

If untrained for an emergency, humans tend to get startle effect, panic, or mental overload. Many are unable to make rational decisions in a crisis. The human mind can only concentrate on about 7 items in the conscious part of the brain. During a crisis, there are often dozens of permutations and combinations. Without training to manage these situations, most cannot act or think rationally.

In the corporate world, there is little to no emergency procedures training. Yet corporate crashes are common.

In the last 20 years, there has been the Tech Wreck, the GFC and Covid-19. Within companies there are improper acts from managers that require action. Continual allocation of capital into loss making ventures. Emergencies happen regularly. Over the last 100 years, the stock market has fallen approximately 37% every 3.5 years.

So why do we not train managers in emergency procedures?

I believe we should.

CEO’s, board members, professional investors and others making key decisions during a crisis should have emergency procedures training. They should have an emergency procedures manual. They should do regular simulations on various scenarios to ensure they are up to date with the latest procedures.

The delay in raising capital by Rolls-Royce and Unibail have caused far lower share prices than otherwise needed to be if the leaders of these businesses acted decisively. The CEO’s of Rolls and Unibail got startle effect and their inaction has caused billions in losses for shareholders. Would emergency procedures training have reduced the losses? Possibly.

Valor continues to build our emergency procedures for investing through crises. Our emergency procedures manual includes when to realise a loss, how to handle various economic conditions (deflation, inflation, stagflation), poor management decisions. We are constantly learning how to evaluate company management in a crisis. Having these procedures allows us to make more informed rational decisions with less emotion during a crisis. The greatest organisations that have ever existed are continual learning machines. Valor strives to continually improve and learn from not only our mistakes, however from mistakes of others.

Melting Ice Cubes

A number of companies with the highest dividends are likely melting ice cubes.

A dividend yield of 6% may look attractive, however if this dividend is being paid by a declining company with large debts, it may not last very long.

This is the most common mistake I see with dividend investors.

It is often far better to buy a slightly lower, yet growing dividend.

Valor strongly believes that the “best time to buy is the point of maximum pessimism”, as per Sir John Templeton’s investment thesis. The only issue with this thesis is that the pessimism is often warranted.

It takes considerable training and independent thinking to work out which businesses are in terminal decline and which are temporarily depressed.  

AGL

After recent significant price falls, we recently attempted to analyse AGL. AGL has grown revenues at roughly double every decade for 20 years. If history were to go by, you would consider this a very good investment. The issue we found with AGL is the future is likely less rosy. Their reliance on coal fired power stations in a world of ever increasing renewables leaves them at risk of disruption.

New power technologies (wind and solar) are already cheaper than old generation coal and gas. The main issue with renewables is that when the sun is not shining or the wind is not blowing, they can’t provide base load power without storage. During peak renewables periods, that is, bright sunlight and good winds, increased supply reduces pricing levels. Whilst renewables have historically been a relatively small part of grid power, this wasn’t a problem. As renewables increase, they will eat away at AGL’s profits during these periods.

Over the coming decade, we expect an s-curve adoption of battery storage (both home storage and grid storage). When this happens, traditional electricity companies may have their profit margins further compressed.

Source: Eikon

Telstra

For many years, Telstra was the perennial dividend favourite for retirees. Telstra is likely a melting ice cube.

With increased competition forcing pricing for internet and mobiles to fall, Telstra has been squeezed with rising costs. Their profit decline over the last 5 years tells the story:

A 5% dividend yield today may not compensate for profit declines of this magnitude.

Source: Eikon

Banks

The European banking index recently traded below 1988 prices. This extraordinary level of poor performance by a sector highlights the risks in investing.

In 2015, we took over a balanced portfolio that was well approximately 60% invested in banks and bank hybrids. This portfolio would have had enormous losses over the following years. This type of portfolio was not uncommon.

The direction of interest rates over the coming years has never been more uncertain. It is likely in the short-term that they stay lower. If the RBA pushes rates further lower, this compresses bank margins. Aussie dividend investors who have profited handsomely from ever rising bank dividends over the last few decades may be disappointed.

Source: Eikon

If we have even moderately higher rates in Australia, our extreme household debt levels would be tested, which may be a worse scenario for the banks. It is this bind, that lead me to describe the Aussie economy being in coffins corner:

Source: Flightdotcom

“Simplicity is the ultimate sophistication” (Da Vinci)

We live in interesting times.

It is very easy to get caught up in the hullabaloo of markets and forget the basics.

The genius of Warren Buffett is his method is so simple. He has a four filter model and sticks to it.

  1. Understand the business
  2. Moat around the business
  3. Exceptional management
  4. Reasonable price

As much as Trump’s antics are theatre redefined, they have very little to do with investing.

Over a 100 year chart, with no dates, it would be difficult to pinpoint the exact periods of most US presidents. Major market crashes may make certain periods more obvious, but the effect that presidents have on markets over the long-term is usually negligible.

The geniuses at Alphabet are not sitting at their desks thinking, “Donald Trump is president, let’s not invent driverless cars”.

I had a client who recently planted a mushroom crop. His expected return on invested capital is approximately 100% per annum. I can assure you that he is not thinking “If labor gets elected, I won’t plant my mushrooms”.

The decision to invest in an asset should solely rely on the expected return of cash over the life of that investment discounted at a reasonable rate. Short-term factors such as politics, a recession or a failed product of a well diversified company should be factored into the price, but over a 20 year period will likely have little influence on whether to buy that asset.

“Time is the friend of a wonderful company and the enemy of a poor one”. (Warren Buffett)

Source: Eikon

The last piece of Buffetts four filters is price. It is the least important of the four filters when purchasing an asset, however it still matters.

A business that earns $1 trading for $35 requires a perfect future. Businesses rarely have perfect futures.

The market seems to be ignoring price for a number of companies. Paying multiples of the value of a business can lead to a number of years of anaemic returns. There is much of this folly in todays markets:

“Fools rush in where angels fear to tread” (Alexander Pope)

Despite the lofty levels of markets, we recently added to our position in Ambev. Ambev is a wonderful company at a reasonable price.

Ambev is easily understood, has a wide moat, is run by outstanding management and is below our estimate of intrinsic value.

Source: Eikon

Disruption Fad

Disruption is the word of the day.

There are numerous funds that only invest in disruptive companies.

I think it is a fad.

The issue with most of the disruptive companies that I analyse is that they are selling their services or items at below cost. This is not disruption, it is destruction (of capital).

If potatoes cost $1 kilo to grow, selling them for 50c is not disruption, it is destruction.

A company selling potatoes at 50c will be a very fast growing company. The demand for their services will certainly be there as they steal market share.

Investing in loss making “growth” companies is fraught with danger when they are selling their items or services at below what it costs to produce.

Many of these companies are playing the “Adjusted EBITDA” game. I can make almost any company look profitable if I adjust the earnings for just about anything that actually costs the company money.

Caveat emptor.

Why Rolls-Royce should call Berkshire

Rolls-Royce is about to embark on an enormously dilutive capital raise. I think it may be a mistake.

They probably should be calling Berkshire Hathaway to discuss a preference share.

Berkshire is highly unlikely to have been considered due to the very unusual position Berkshire Hathaway is in to do large deals, very quickly. Most companies cannot provide $10 billion dollars within 24 hours from a simple phone call. Berkshire Hathaway can. They may be the only company in the world that can do deals of this magnitude and many still do not think of them during situations like this.

Berkshire Hathaway owns Precision CastParts, Flight Safety and NetJets. They have in-depth knowledge of the aviation industry. As a long-term shareholder in Berkshire Hathaway and an expert on the company, I am confident I am able to suggest this alternative avenue to source capital. I have confirmed with other experts on Berkshire Hathaway that Warren may be amenable to a potential deal such as this. Berkshire Hathaway currently has approximately $147 billion USD in cash. They certainly have the ability to do a large deal.

I am also very aware of commitment bias. It is human nature to want to follow a path that you have committed to, despite evidence that there may be a better path. It is very difficult to be able to change course, regardless of whether changing course may potentially be the most rational decision. The Rolls-Royce team has likely put in long hours organising the capital raise and deals with investment banks. No one likes to be told that their work is to be discarded for a different decision. 

So, what is the potential cost to Rolls-Royce shareholders with the proposed capital raise? A 10 for 3 capital raise roughly destroys 2/3 of shareholders ownership in Rolls-Royce. Giving away two thirds of the pie is a decision that wipes away decades worth of equity creation. It is not unreasonable to assume a conservative £1 billion of free cash flow in 2025, and a modest free cash flow multiple of around 12 times, Rolls-Royce could be worth approximately £12 billion. Shaving two thirds off this could be an £8 billion decision. 

The cost of the preference share would also have a higher interest rate than the debt Rolls plans to raise. Let’s assume another £300 million off the free cash flow amount, bringing the number down to £700 million per annum in 2025. At 12 times £700 million Rolls could be worth £9 billion. 

Obviously, Berkshire would require an element of equity stake in Rolls for a preference share. Let’s assume that this is around £3 billion in the form of a warrant.

This still leaves a disconnect of around £3 billion of potential market capitalisation that will effectively be wiped away with this enormously dilutive capital raise. 

A secondary, yet potentially important consideration is the increased market confidence that an investment by Berkshire would attract. A seal of approval by Berkshire Hathaway would likely garner market support around Rolls-Royce and make any further dealings with bankers a less arduous task. 

I have deliberately left these calculations very rough. An in-depth analysis would be less than helpful as the accuracy of the free cash flow forecast for 2025 is itself liable to be within a wide range of outcomes.

I am well aware that there may be factors behind the scenes that may preclude a deal of this magnitude being done with Berkshire Hathaway. A phone call to Warren may only take 5 to 10 minutes of their time as Warren is extremely direct. He will say yes or no relatively quickly.   I am unable to know whether a deal with Berkshire is possible or not, however, if possible, I am confident that a preference share could save Rolls-Royce shareholders somewhere in the vicinity of £3 billion over the coming years. This is not a decision Warren East should take lightly.

What “Can” Happen vs What “Will” happen

There are lots of market commentators who promote absolute certainty. Many of them have reasons to pretend that they are absolutely certain about a subject, because their lively hood depends on a specific outcome.

            Never ask your barber if you need a haircut

A far more rational way to view the world is to be less certain, but position your views toward risk weighted outcomes. When you realise you don’t know what is going to happen, you can start to attempt to correctly price risk.  

This is where we find ourselves today in the middle of the corona virus.

Be very careful of those that promote absolute certainty and listen more to those that allocate capital with skin in the game in a probabilistic manner.

The beautiful position of being asset agnostic means that we can allocate to where we believe we know much of the range of what “can” happen and we are getting paid to take the risk.

Tail risk outcomes are becoming more likely in this environment. We have a strong view on Australian property and the Australian banking system. Our view is that property is multiples of its fair value in Australia and if it reverts closer to its fair value, the banking system requires large recapitalisations. We have had this view for a number of years, although we have never known when the risk might materialise. We are now seeing that risk increase. We know what “can” happen to the Australian property market, but we certainly don’t know what “will” happen. We are very confident you aren’t being paid a premium to take the risk to find out.

By using what “can” happen to avoid risk, we believe we are protecting capital better than many.

Conversely, when we see opportunities that have significant upside versus potential downside, we take a very assertive position. We certainly don’t know exactly what will happen, however we generally know what “can” happen which means that we will likely be far more right than we are wrong over time.