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…