Download Investing in the desert

NEWSLETTER SEPTEMBER 2013
Investing in the
desert
While not the largest desert in Australia, the Simpson Desert is probably the
best known. It stretches across SA, Queensland and NT and is equivalent in
size to a 400km square. It is the largest sand dune desert in the world.
The Simpson Desert is also the home of the
Simpson Desert Ultra Marathon, a 630km
footrace held in September and run over 11
days.
Ken Marshman
Chairman
Ken is Chair of the JANA Board of
Directors. Prior to this he was also
Head of Investment Outcomes, which
involved him focusing on the delivery of
superior investment returns for clients,
particularly the next wave of investment
opportunities and how good investment
ideas can be implemented effectively.
Ken was JANA’s Managing Director from
1995 to 2008. Before joining JANA, he
held the position of Director of Finance
for the State Electricity Commission of
Victoria, and held a number of positions,
including CEO, within that organisation.
He has specialised in financial markets
and corporate strategy for over 30 years
and has been intensively involved in
investments for superannuation funds
since 1986.
Ken has a Bachelor of Arts (Honours)
degree in Mathematics and Economics
from the University of Melbourne, and
a Masters of Economics (Econometrics)
from Monash University.
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As runners train for this gruelling event, they
will of course be considering what special
preparations they need before the event and
what additional precautions they need to take
while out on the course. And it goes without
saying that their expectations in terms of their
race times and results will be very different
from those they’d expect to achieve in more
temperate conditions.
But why all this talk about running in deserts?
Over the past 100 years, investors who have
invested in equities have been well rewarded.
In Australia, the returns from equities since
1900 (as calculated by Credit Suisse) have
been just over 6% in excess of the cash rate.
This is equivalent to a real (after inflation)
returns of between 7% and 8% pa. At these
rates of returns, and with the power of
compounding, disciplined long-term investors
have enjoyed a massive increase in their
wealth.
This is good news for most of the funds advised
by JANA. These returns form the basis of how
we build portfolios. We recall that there was
talk only about two or three years ago about
the death of equity investing. But fortunately
and contrary to that view, equity returns have
had an extremely strong recovery since then,
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Investing in the desert
is now around 4% - 5% pa (after inflation).
Based on these assumptions, most JANA
advised funds will still achieve their stated
investment return objectives, but the margin
for error is much slighter than it has been for
decades.
This is the desert we are embarking our Ultra
Marathon into: a desert of real interest rates.
But, just like the marathon runners, we need
to adjust not only our times (ie our investment
objectives) but also our preparation (ie our
investment strategies).
with returns in the order of 25% to 30% in most
markets around the world over the past 12
months.
But what about other asset classes? Over
the very long term (50 years +), investing in
government bonds has also generated positive
real returns, but typically 3 – 5% pa lower than
that of investing in equities. Returns from
government bonds of course haven’t been
as volatile as equity investing, and it might
be fairly concluded that the lower return is a
reasonable give-up for a more even ride.
But, it’s the last 30 years that are very
interesting here. Since 1980, the returns from
investing in equities and the returns from
investing in government bonds over this 30
year period have been remarkably close. This
has led some public figures to conclude that
investing in shares is an unnecessarily risky
pursuit. Investors earned much the same from
holding government bonds without the ups of
the Tech Boom in the late 1990s; the collapse
in the early 2000s; the money led boom of the
period from 2003 to 2008 and the subsequent
GFC crash in that year.
However, we need to put this period into
perspective. Those who were around in
the mid-1980s will recall that period as one
of runaway inflation. State Governments
in Australia were issuing long term debt
at interest rates in excess of 17% pa (for
maturities at 10 years or longer). The real
interest rate on Government bonds exceeded
5% (before inflation). That is, investors then
could lock into Government guaranteed loans
for 20 years plus with a known return above
inflation not too different from the risky long
term return from investing in equities.
If there was any time when we could have
safely said “This time it is different”, then surely
it was in the late 1980s and early 1990s.
For soon into the 1990s, inflation fell, but the
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lucky investors who had lent to governments
at 17% pa, still earned their 17% income
payments year in, year out. This was a period
of massive returns to bond holders resulting in
a re-distribution of wealth from tax payers to
investors.
The point of this history lesson is that
perhaps the most important determinant of
future returns, not just of bonds but all long
term investments, is the level of real interest
rates at the start of that investment.
The bad news for investors today is that real
interest rates have almost never been so low
(see chart above). Going back six months
(around February this year), the real interest
rate on US Government debt was indeed
negative. Investors were actually paying the
government to hold their money, so concerned
were investors with all other investment
opportunities.
Extreme low rates of interest are not
sustainable within a healthy economy. As the
economy recovers, real interest rates should
rise with the economy. And rising real interest
rates have an adverse impact on investments
in a number of ways. Higher interest bills
are a real cost of doing business, and come
directly from the profits of doing business.
Shareholders suffer in this environment.
And there is an adverse valuation impact as
well. As interest rates rise, the current value
of distant cashflows are diminished. Rising
interest rates result in downward pressure
on share prices (price-earnings ratio), and the
valuations of properties and infrastructure
assets. The impact on these different asset
classes depends on a wide range of different
factors, but it is virtually impossible to see
rising interest rates as being a positive
contributor to returns.
JANA’s own assumptions for the next 7 – 10
years for returns from a typical balanced fund
It goes almost without saying that any strategy
needs to be sufficiently flexible to adapt to
changing conditions, as we can be certain of
one thing, and that is that the environment
will change. However, with that said, there are
a number of different strategies that we think
that investors should be considering as their
preparation for this coming Ultra Marathon.
Strategy 1: Be realistic
Trustees, members and regulators need to be
aware that real interest rates today are almost
3% lower than they were a decade ago. This is a
3% pa handicap on future long term returns.
Strategy 2: Be flexible
Other investors may be less realistic than
you. This could well lead to periods of panic
and present great long term investment
opportunities. Investors should not be scared
to have a large holding of cash when no other
investment seems reasonably priced.
Strategy 3: Avoid long duration
assets
Rising real interest rates will hurt valuations.
Long duration assets if valued on current low
real interest rates are high risk.
Strategy 4: Hunt for alpha
We expect that the proportion of future
returns to come from active management
rather than simply the return from markets
to increase in this period. The case for passive
management is inferior today compared to a
decade ago.
Strategy 5: Consider credit as a
substitute for equities
Tight money conditions and tighter regulation
may result in sustained and more secure
returns from lending to companies than buying
their equity. Higher interest rates are a direct
cost to equity.
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Investing in the desert
Strategy 6: Look for individual
opportunities
Regardless of the broad macro economic
and financial environment, investors that can
find sound investments with a reasonable
real return should be prepared to lock those
investments in.
Strategy 7: Protect against Inflation
Rising interest rates and high debt levels
are a savage combination for borrowers like
governments. Inflation bursts are typically
unexpected and protection should be in place
when inflation is least expected.
Strategy 8: Be wary of past winners
Easy money and low interest rates appear to
have been the driving force in many surging
markets, such as commodities, emerging
markets and indirectly, Australia. The opposite
conditions are likely to have the opposite
impact.
Unlike the runners in the Simpson Desert, we
have no choice but to participate in our Ultra
Marathon of investing. As the terrain changes
then so should our investment strategy. We
can see a long period of desert before us, and
while we don’t anticipate a complete change in
strategy, we are adjusting our thinking for the
conditions. Investors need to too.
Important information
This publication has been prepared by JANA Investment Advisers Pty Ltd (ABN 97 006 717 568) (AFSL 230693) (JANA) and MLC Implemented Consulting (MLC IC). MLC
IC is a division of GWM Adviser Services Limited (ACN 002 071 749) (AFSL 230692). JANA and MLC IC are members of the National Australia Bank Limited (ACN 004
044 937) (AFSL 230686) (NAB) group of companies. This publication is intended to provide general information for wholesale clients (as defined in the Corporations
Act 2001) only. It may contain general advice without taking into account any particular persons objectives, financial situation or needs. Investors should, before
acting on this information, consider the appropriateness of this information having regard to their own circumstances. Any opinions expressed constitute JANA and
MLC IC’s judgement at the time of this publication and are subject to change. While due care has been taken in preparation of this publication, no warranty is given to
the accuracy or completeness of the information. Except where under statute liability cannot be excluded, no liability (whether arising in negligence or otherwise) is
accepted by JANA, MLC IC or any other member of the NAB group of companies for any error or omission or for any loss caused to any person acting on the information
contained in this publication. This publication does not constitute an offer or invitation to purchase any investment product. Any offer of an investment product will be
made in a disclosure document and applicants will need to complete the application form attached to that document.
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