• Angus Crennan

Our end June 2019 conservative positioning

Updated: Nov 17, 2020

At end June 2019 we had 70% of our Fund in cash. That is unusual and deserves explanation so below I have provided the main reasons for that conservative positioning.

The summary is:

1. Avoiding losses is as critical to our purpose as capturing investment gains,

2. Investor uncertainty is high because the US is changing global trade rules,

3. Global equity markets are filled with confidence meaning opportunities are limited,

4. Global bond markets in contrast are telling us to be very cautious, and

5. We will continue only taking on the risks we want.

Growth and avoiding losses are both important

The 11.3% per year compounding rate our Fund has delivered from inception till end June 2019, after fees, is a tremendous outcome. With consumer inflation in Australia currently only 1.3% this equates to a 10% ‘real’ or after-inflation gain in the value of our investment capital.

If the Fund maintains a 10% rate of return applied to our investment capital each year it would grow by 61% over 5 years and by 17.4 times over 30 years. The effects of compounding get exponentially more powerful the more time we allow.

The rate of compounding is very important. If we reduced the rate of compounding from 10% per year to 8% per year over 30 years growth reduces from 17.4x to a little over 10.0x. It is imperative for me to work hard seeking the highest returns for our invested capital.

There is a complimentary point to targeting attractive returns over time and that point is to avoid losses through good risk management. The reason good risk management is vital is because of the asymmetry in investment losses. If our portfolio lost 10% then we would need to make 11.1% to return our portfolio to where it was before the loss. If we lose 50% then we need to make 100% to get back to square one.

This is the foundation of Warren Buffett’s famous quote: “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”

Each of the lines in this graph start at $10,000 in value with various scenarios plotted over the next 30 years:

  • The blue line compounds at 10% per year without fail to end up worth $174,494,

  • The green line compounds at 6% per year without fail to end up worth $57,434, a 67% reduction relative to the blue line,

  • The red line compounds at 10% per year for 6 consecutive years but then suffers a 20% loss each 7th year to end up valued at $48,817, and

  • The yellow line compounds at 10% per year for 4 consecutive years but then suffers a 10% loss each 5th year to end up valued at $52,346.

Given losses matter so much over time, we need to understand the real probability and the severity of impacts which markets suffer sell-offs so we can align our actions accordingly.

Below is actual data for global, US, European and Australian share markets. All returns here have been converted into Australian Dollar terms and so capture currency as well as equity market moves and are thus reflective what we as Australian investors would have experienced:

  • The MSCI World Index incorporates over 1600 companies across 23 developed market countries. There is 24 calendar years of data and over those years this index has delivered negative returns to Australian investors 9 times or roughly an average loss of 9.5% each 2.7 years.

  • The US S&P500 is the mostly widely quoted US equity index and has data going back to 1972. Over those 47 calendar years the S&P500 has delivered negative returns 16 times, an average loss of 11% each 2.9 years.

  • The STOXX Europe 600 Price Index represents large companies across the 17 countries in the European Region. Over the 19 years of data available Australian investors have experienced 7 negative years or an average loss of 15.8% each 2.7 years.

  • The S&P/ASX All Ordinaries Index captures listed Australian companies. Looking at the last 50 years we have had 17 negative years which delivered an average loss of 14.5% each 2.9 years.

These data tell us that broadly expecting a negative result of 10-15% occurring every three or so years is consistent with history.

Even a 10% loss each 3 years is worse than any of the lines on our graph above and will significantly impact the ending value of our investment capital. It is therefore clear that any actions we can take to avoid or significantly lessen the impact of these periodic downturns would be a very powerful outcome for us over long periods of time.

It is this logic, mixed with understanding clients want to grow wealth over time, that is at the heart of the Balmoral Fund seeking to deliver a positive return every year where markets make that possible.

US changing trade rules and how that uncertainty ripples through markets

Geopolitical risk does not often produce major issues for diversified investors but when it does it can be a very nasty risk indeed. World Wars illustrate that point. Geopolitical risk at present is elevated mostly because the most powerful country in history feels threatened and is changing global trade rules.

Global trade is slowing due artificial barriers introduced for political reasons. The Trump administration has openly discussed tariffs even on strategic allies like core European countries and Japan and we have seen mixed first round reactions to this approach – Mexico for example seemingly came to a new trade agreement while India imposed steep tariffs on a range of US goods.

At the time of writing this letter the US just introduced 400% tariffs on Vietnam steel with accusations Vietnam was routing Chinese products into the US and so avoiding their tariffs. Its not a market we invest in however in an instant the long-term investment appeal of multiple Vietnamese companies changed significantly. The very next anxious thought investors would have had – who is next?

It’s worth noting over a quarter of US economic activity derives from foreign trade so there is certainly some US sensitivity to trade. The awareness in countries like Germany, Japan, Korea and China is greater. Because the sensitivities are high the incentives for politicians to react to changed trade rules which don’t work for their constituents is high. This means countries which have tariffs erected against them will likely react in a negative way.

The complexity of geopolitical actions and reactions is high. Index Funds and ETFs will blindly eat whatever is served however how active investors react to this increased complexity matters as I explain below.

When investors are uncertain, they use larger margins of error. Less optimistic forecasts, higher discount rates and reduced concentrations are examples of increased margins of error being applied. All of these represent less conviction and therefore less aggressive investing and lower prices for assets.

In short additional complexity changes investor behaviours and that does not support bond and equity markets remaining at all-time highs.

Changing rules brings two headwinds to equity markets

America became the world’s dominant economy by becoming the world’s dominant producer…But then, America changed its policy from promoting development in America — in, in, in America — to promoting development in other nations… Today, we import nearly $800 billion more in goods than we export. We can’t continue to do that. This is not some natural disaster, it’s a political and politician-made disaster. Very simple. And it can be corrected and we can correct it fast when we have people with the right thinking. Right up here. It is the consequence… It is the consequence of a leadership class that worships globalism over Americanism.

Donald Trump, June 2016

The quote above is from 2016 and we have now seen that the Trump administration is following through with its campaign rhetoric.

By strongly encouraging US companies, which harness and direct the bulk of America’s people and capital resources, to source more of their inputs and complete their production processes domestically the Trump administration is turning away from classical economics and the mutual benefits of national specialisation.

As Adam Smith wrote in The Wealth of Nations back in 1776:

By means of glasses, hotbeds, and hot walls, very good grapes can be raised in Scotland, and very good wine too can be made of them at about thirty times the expense for which at least equally good can be bought from foreign countries. Would it be a reasonable law to prohibit the importation of all foreign wines merely to encourage the making of claret and Burgundy in Scotland?

This is directly relevant to us because classical economics has at its heart a focus on the most productive use of accumulated capital. Maximising the return on our collective investment capital is my primary focus and the reason the Balmoral Fund exists.

Leaving aside the arguments for and against domestic manufacturing in any developed economy, I want to just focus on what forcing companies back to use more local counterparties means for investors.

If a company’s profit margin declines then the value of the company declines. To demonstrate: If an investor requires 8% and a company earns $8 then the price the investor will pay is $100. If profit is instead $5 the price required to earn 8% is $62.50.

Lower returns on capital investments change share prices. So if a US company was sourcing steel from China and it now has to source steel domestically and that results in the business becomes less profitable then its value changes accordingly.

However there are additional impacts to reduced corporate valuation from falling profitability.

  • If an executive team seeks to find savings to maintain existing profitability despite higher input costs that might change decisions such as whether to commit to new plant and equipment or the hiring of new employees.

  • If plant and equipment companies get the sense their customers are not buying and ‘we are in for some tough times’ then they respond by increasing their own caution which in turn might see them change their expansion or hiring plans.

  • When employees become fearful for their employment they respond by increasing their own caution.

If enough people get cautious at the same time then total economic activity slows. Political decisions impact many businesses concurrently and thus risk of changing overall business activity along these lines.

When economic activity is declining Governments conventionally spend more than the taxes they collect to counteract this. However the global backdrop to these new trade disputes is elevated government debt levels across most developed world countries with the main Central Banks already utilising very low interest rates to stimulate activity. If economic activity slows in countries like the US and Europe how will activity be stimulated if meaningful monetary and fiscal capacity is already expended?

This is not a forecast on my part but rather a risk framework I am monitoring. Fear and uncertainty do change investor behaviours and when enough peoples’ behaviour have changed of course markets are impacted.

Bond markets tell us there is already a lot of fear

Investor appetite for the safest assets, highly rated government bonds, is currently ravenous.

At 30 June 2019 the Australian Government could borrow from the investing public for 10 years at around 1.3%. The RBA’s inflation target is 2-3% meaning this yield is almost certainly going to deliver reduced purchasing power in real, or after inflation, terms to an investor. At the Swiss company I used to work for investors in other countries regularly reminded me that Australian interest rates are attractive simply because they are positive. Switzerland and Germany don’t pay interest of their sovereign debt, they currently get paid to borrow money.

Let me illustrate this increased demand for super safe assets like highly rated sovereign bonds over the last few months:

  1. The US 10-year bond was offering a yield of 3.14% at end October 2018. By the end of June 2019 the price of US Treasury bonds had risen so much that yields had fallen to 2.01%, and

  2. In September 2018 the yield on Switzerland’s 15-year Government Bonds was 0.4%. By 30 June the price of the Swiss Government’s bonds increased so much that the yield has become -0.27%.

Leaving aside specific mandates and traders why would professional investors be purchasing long dated low and negative yielding government bonds and holding them for long periods of time knowing the investment outcome is almost certain to be poor? The only logic would be if they expected worse outcomes in other asset classes, or inflation over coming years to validate the yields received, both of which are very negative expectations.

Its time for cautious positioning

Having generated strong returns till this point my analysis of market conditions and the importance of avoiding investment losses have directed we de-risk our portfolio at this time and I have incrementally done so over 2019.

This is only a tactical conservative positioning. Opportunities are regularly thrown up by investment markets so as the picture becomes more positive, I will reinvest our capital into great assets.

In the interim there are good and bad elements to this positioning:

  1. If global share markets continue to rise from current all-time highs we will only capture some of the returns we would have otherwise captured.

  2. The inverse is true and if markets sell-off our capital will be less impacted. As importantly any sell-off would allow us to buy the assets we want at better prices and that is a key part of setting us up for strong returns in the future.

Let’s finish on a positive note and remind ourselves we are doing great and are in front of the Blue Line!

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