Director's Cut: The safety bubble

Pessimism in investing prevents error and preserves capital. Over the past 12 years it has served us well.

Still, in rereading the ramblings of this column over the past 12 months, there exists an underlying patina of fear. The regular exposition of what might go wrong and how to prepare for it contrasts vividly with the handsome returns earned over a difficult period.

Recognising that it is in the preparation for the worst that these returns were secured, a reconciliation, of tone rather than substance, seems apposite.

Twelve years ago, there was a bubble in internet stocks. The bursting of that bubble, like the flag fall in a post-war taxi, set the meter ticking on the next one—an uproarious boom in bonds.

In an odd Carl Jacobi kind of way, one could not exist without the other. The rush to risk in dotcom stocks and the flight to safety is the yin and yang of investment markets, the bookend events to a crazy-weird period, utterly opposed but connected through time by cookie-cut foolishness.

If you were seduced by the dotcom boom, or even the resources supercycle, there’s a reasonable chance you’re now in term deposits, bank hybrids or bonds. Investors that piled thoughtlessly into stocks are now in ‘safe’ assets, with a similar measure of thoughtlessness, crowd-sourcing their investment strategy instead of thinking for themselves.

Bond bubble

The upshot is that from June 2008 to June 2010, the money being withdrawn from US equity funds totalled US$232bn. According to The Investment Company Institute, over the same period inflows into the bond market hit US$559bn.

The place where the distant ends of this continuum touch is in 1.65% paid on 10-year US Treasury bonds. In July, the annualised US inflation rate was 1.4%, making the real return from 10-year Treasuries 0.25%, and that's before tax. After tax interest receipts for most investors will be zero. Only capital gains can save these investors. And that can only occur if bond prices move lower still. Should they move higher, capital losses will make already woeful returns absolutely abysmal.

The last time we saw investment propositions of this ilk was in 1999. Speculative stocks can go to zero very quickly. Bonds get you there so slowly you won’t even notice how much you’ve lost.

The likes of LibertyOne and Solution 6 staked out greed’s territorial gain. Now the negative real return on government bonds carves a mark on fear’s Plimsoll line. The result is another Jacobi-like inversion: Where once bonds offered a risk-free return, now they’re loaded with a return-free risk.

Governments do default on their debt; they also have a nasty habit of inflating it away. Still investors rush into the welcoming hands of Ben Bernanke, paying him to look after their cash while he plots to erode its value. If the first rule of investing is to preserve capital, investors are breaking it everywhere, en masse.

Meanwhile, US companies are making record profits, paying dividends and buying back shares at a rate that mocks the idea of a recession. As this column regularly intones, there’s plenty to worry about but as the latest reporting season showed, the corporate sector—Twiggy excepted—is hardly stressed. And still the ASX All Ords remains 36% below the pre-GFC peak.

Thus begins the argument for stocks, a case we’ll make in greater detail in a special report to be released in early October. For added flavour, accompanying it will be a ‘recovery’ portfolio packed with companies research director Nathan Bell believes are ripe for the picking. The point is to offer you confidence to buy at a point where there isn’t much of it about.

Happy returns

The Case for Infrastructure, published in July 2009, made a compelling argument for four stocks that offered safety, yield and the prospect of capital growth. Including distributions, Spark Infrastructure has returned 71%, Sydney Airport (formerly MAp Group) 110%, Australian Infrastructure Fund 158% and Challenger Infrastructure 7%.

Over the same period, the ASX All Ordinaries Accumulation Index has returned 29%. This basket of stocks is up a collective 86%. The extent of the outperformance might be unusual but good all round performance isn’t. Table 1 shows the returns from our two model portfolios since the GFC.

It is the absence of enthusiasm for stocks that permits returns of this ilk. Don’t see in the safety bubble confirmation that everything is about to get worse. It may well be the opposite.

Next question: If everyone is rushing to safety, why doesn’t our Buy list, which had over 40 stocks on it in 2009, now have only 15.

Steve Johnson, managing director of Intelligent Investor Funds, might argue that maybe we’re not looking hard enough. Fresh from generating returns of 18.3% over the year to 30 Jun 12, we shouldn’t disparage his view, although note his predilection for stocks too small to recommend in these pages.

Research director Nathan Bell, a man who takes capital preservation to an almost religious plane, makes a compelling response: ‘The buy list isn't very long at the moment but as we've seen over many years, the list stretches in and out like an accordion.’

That’s true. So far this year we’ve upgraded 12 companies, one of which—Sonic—was on the list for just over a month. Buy recommendations aren’t London buses, which all turn up at once. Neither are they Sydney buses, which don’t turn up at all. There is no timetable for the arrival of cheap stocks.

Indeed, the prices of high quality and high yielding stocks have increased sharply of late due to the flight to safety. But that need not induce despondency. As Nathan says, ‘If you can't find the right opportunities, wait for the next fat pitch and hold on to your core holdings, which should be stocks like Woolworths, Sydney Airport, Cochlear, CSL, Origin Energy, QBE Insurance for more risk tolerant investors, Wesfarmers, ARB Corporation, Coca-Cola Amatil and ASX, for example. There’s enough opportunities in good quality companies without needing to fish more treacherous waters.’ His team’s record offers succour to that view.

What about portfolio allocation whilst waiting for ‘the fat pitch’?

Many members should have a bit more cash because several stocks have been downgraded this year for various reasons. It's ok to hold large amounts of cash if you're unable to find attractive opportunities that meet your return hurdles, but in a deflationary environment where interest rates are falling our return hurdles are not as high as they were. High annual single digit returns without taking large, unnecessary risks would be satisfactory. The key is not to make easily avoidable mistakes (like ignoring portfolio limits for speculative stocks), avoid reaching for yield, be patient and act decisively when opportunities present themselves.  

Watch your hybrids

What we don’t recommend is going boots n’ all into hybrids. Instead, consider shuffling a small part of your portfolio up the risk curve and into stocks, which should increase expected returns and, perhaps ironically, also lower real risk. If that doesn’t tempt you, we’d prefer the genuine safety of cash and term deposits over these offers.

All this and more will be discussed on our forthcoming roadshow, where you can meet Nathan Bell, Steve Johnson and Walnut Report managing director Richard Livingston, plus a special guest in most cities. The presentations kick off at 6pm in each state capital with details shown in Table 2. Keep your diary free—we’d love to see you there.

Finally, Intelligent Investor would like to offer our warm thanks and appreciation for the sterling work of James Greenhalgh over the past 12-odd years. James first worked on a now-defunct publication called the GTS Report, specialising in small growth stocks.

His gargantuan work ethic and sublime analytical skills earned him a spot with Intelligent Investor when the doors to that publication were closed. Many members have him to thank for some of the best performers in their portfolios over the past decade. We’re going to miss you James but you do deserve a mighty rest. Good luck and thank you.