On Monday the 4th of November we heard from Peter Bell, a member of the Financial Framework Investment Committee, about the prospects for investors over the coming months and possibly even years. It was a very interesting discussion and we encourage anyone trying to understand the investment world, or how they might be able to beat the banks, to check it out here.
Peter started the conversation by looking into the past, the GFC. “The GFC was really caused by an excessive build up of debt in the global economy” he said. While debt crippled people during the GFC, when interest rates around the world were typically much higher, now the story is completely different. “In Europe there are countries that you can be paid to take on a mortgage (interest rates are negative)” said Peter.
“While reducing interest rates tends to be stimulatory, we’re getting to the lower bounds of where interest rates can go – while at the same time getting to the upper bounds of how much debt individuals can take on. Importantly, this build up in debt also means that any future increases in interest rates are likely to be more modest, given that debt levels are the ‘multiplier’ that determines the end impact of any interest rate rise. So it seems highly likely that low interest rates, and all the challenges that come with that, are quite possibly here to stay.”
Hearing Peter speak, it seems like there are some strange things happening in the economy right now. Peter touched on the non-accelerating inflation rate of unemployment (NAIRU). The NAIRU is the level of unemployment that an economy can reach before inflation pressures start to build. Historically, economists believed that the NAIRU in Australia was likely to be somewhere in the order of 5%. “But we’re roughly at 5% unemployment in Australia right now, yet wage growth is negligible, and inflation remains stubbornly below the RBA’s target range, leading to renewed calls from both the RBA and economists for the government to further stimulate the economy.”
The topic of inflation has been of interest to the entire advice team as of late, as inflation starts to outpace interest rates, meaning that the value of the everyday persons money in the bank can start to go backwards in real terms (interest minus inflation). As advisers, we become concerned about our clients who hold large sums of cash in low interest bank accounts when there is no need, or strategy behind the holding.
A lot of our mature clients, who may be in retirement, were once attracted to ‘safe’ investments, or cash alternatives, including term deposits, to help fund their retirement income. In this age of investing, it becomes very difficult to generate reasonable returns off these types of investments. We’ve prepared an article that covers our top 3 investment alternatives to cash and term deposits here if you’re looking to dig deeper on the topic.
The World Is Going ‘Long’
After a discussion about the strange economy we’re experiencing, locally and globally, the conversation then lead to some of the interesting businesses that are generating headlines and apparent ‘global success’. Businesses like wework, a co-working space that leases desks to start up and corporate businesses, are receiving massive valuations from private investors and they are trying to get access to share markets to reach public money as well.
Peter spoke to the point that, “wework is the largest lease holder in many major cities around the world. At their peak they had a massive $60 billion valuation, but this is a company that is generating revenue of $1.3b a year, yet losing $1.4b a year!” And this is a real estate business – not some sort of technology company that enjoys relatively fixed costs and enormous benefits from scale. Yet despite the serious questions regarding the sustainability of such a business, the liquidity in the global economy right now has enabled the company to raise billions of dollars from investors in the private markets. That makes no sense to Peter “call me old fashioned, but that doesn’t add up to me.” Fortunately their bid to go public was blocked which may save the average punter from the danger of investing in a business that doesn’t stack up by any traditional financial measurements.
Legendary investor, Ray Dalio, also shares some of Peter’s views on the world economy. In his recent article The World Has Gone Mad and the System Is Broken, Ray points out that investors are going ‘long’ on investments (placing large bets on long term returns, with little evidence of present performance), governments are racking up sizable debts. and central banks are printing money! It’s a mad world in Ray’s opinion. All of this activity is having the effect of forcing more money into the top of the system.which forces those who have money to either spend or invest. And in this case, they are choosing to invest – not spend! This means that most every day people don’t see the money in their pocket or in their pay check (indirectly) like they might have when people were more inclined to spend it.
This phenomenon has been trending as a result of the recent performance of stocks and investments since the GFC. People have been investing to ‘chase the gains’ and this means that the value of investments have been pushed upwards, not always in a logical manner.
Has Stock Prices Reached Their Limit?Z
On this point, Peter mentioned that “High valuations have the effect of making us all feel wealthier – because the value of our investments have been pushed up by this flood of cheap money. But at the same time, these higher valuations necessarily imply lower future returns – because earnings simply aren’t growing as fast as prices.” Yet while the market as a whole might look somewhat expensive relative to history, when we compare the returns that are available from the market to those available from cash and term deposits, it’s not at all apparent that it is at all overpriced – in fact potentially the opposite.
At the same time, the variation in returns has also been growing – with high performing, popular stocks enjoying rapid rises, while more out of favour companies have languished. One reason for this is the massive growth in passive investing, or ‘indexing’, where investors don’t attempt to buy undervalued stocks, but simply invest in ‘the market’ by putting their money into things like ETFs that track the largest companies on the market.
“The advent of index investing has definitely been a ‘net benefit’ for investors due to its relatively low cost. However, the trend has meant that inefficiencies in the market have been exacerbated – with expensive companies getting more expensive, and vice-versa. While challenging in the short term, this dynamic is actually ideal for active investors in the long term, creating opportunities for active managers to identify ‘out of favour’ or ‘overlooked’ companies that are relatively underpriced and offer the potential for stronger long term returns.” says Peter.
As Peter runs a managed investment portfolio, he made some special comments on what he looks for when picking businesses. “We love investing in businesses with moats. Capitalism is a brutal battle, where if you are earning strong profit margins, your competitors see that and are going to try and attack you, and take some of that business and profit from you. If you want to be able to sustain a high level of profitability, you need to have some element of your business that protects you from your competitors – that makes it hard for them to compete against you, and take your customers. As an example – Technology One (TNE), which we used to hold in the portfolio, has the enviable combination of recurring revenues, and a ‘trapdoor’ moat, whereby it is very, very inconvenient for their customers to leave them and go to a competitor. As a result, the business benefits from extremely steady, and reliable revenues and profits.”
While having a moat doesn’t mean they’re immune from experiencing losses in share value, it can provide an element of defensibility to your portfolio. These types of businesses (moat businesses) have been known to produce staying power, even during challenging times, and they are a crow favourite for intelligent investors like Warren Buffet also.
Final Thoughts
In summary, the team at Financial Framework agree that, while we’re in a very interesting time of history, we’re confident that the mechanisms we have in place position our clients favourably to any headwinds which may be approaching. We stick firmly to our proven investment philosophies during thick and thin and won’t waiver when conditions do eventually change.
