What are the alternatives?
Is it the case that, to paraphrase Winston Churchill, that equities are the worst investment around apart from all the alternatives? We don’t think so for two reasons. First, there are still parts of the world where the scenarios for equity investing look fairly attractive and you can reasonably expect to make the 7%-9% or so long term average annual returns that equity markets have historically delivered. Secondly, we think there are still, risk adjusted, some attractive alternatives to equities. This rest of this note explains why we think this as well as discussing some of the recent alternative investments we have made.
Is there a tailwind for equities?
Historically, equities are the highest returning asset over time so why not just allocate as much as we can to them? The answer is that sometimes we do, especially when the tailwind for equities looks favourable. However, the outlook for US equities, by some distance the world’s largest market, looks mixed. Broadly, we think you will have the best medium to long term returns from equities when valuations are cheap, the economy is growing (and accelerating), interest rates are low and the general investing mood is pessimistic. Today investors do indeed on average look pessimistic. As an example, bullish sentiment in the American Association of Individual Investors survey currently stands at 17.8%, the lowest level since April 2005. Perversely this negative sentiment is actually supportive for equities. First, it shows many of today’s dark clouds are probably already priced in to markets and secondly there are plenty of bears to be converted into bulls as and when the news flow changes.
The story on the other measures is less good however (see Table 1 below). For US markets we are now seven years into the economic expansion that began in 2009. Though there is no fundamental reason this cannot continue for a while yet (the recovery has certainly been very muted to date which suggests it could carry on for longer) we are probably nearer the end than the beginning. This reasoning prompts the occasional frights we have seen in equity and credit markets when economic data has disappointed. Labour markets are, however, tight enough now to justify interest rates rises (and the first one happened in December last year). Finally, on most measures US valuations look stretched. It is true that equities still remain attractive relative to the low interest rates available on bonds. But if the bond markets are priced correctly, growth will be low for the decades to come. Low growth also means lower earnings growth. Is this reality properly priced into equity markets?
Table 1: Equity positioning scorecard
Making inflation beating returns
When you consider that the US is by far the world’s largest equity market (more than 50% by market capitalisation) this makes it hard for us to be overweight equities here. We have kept our allocations to Europe and Japan as we think that over time these markets will offer the highest returns for our clients. We remain on the look-out, however, for attractive alternatives.
We have two basic criteria for our alternative investments. First, after adjusting for the risk involved, they should offer an equal or better expected return than equities. Second they should have a different fundamental source of return than equities: i.e. not just be equities in drag. Here are three examples of investments that we have recently made that, we think, meet these criteria:
- UK Wind Farms: our investment is in a portfolio of established UK wind farms that has a yield of around 7%. Half of the income from the investment is effectively government guaranteed and half is linked to the prevailing price of energy. One of the attractions of the investment is that we have been through a period where energy prices have declined sharply and the investment and cashflow yield has proven reasonably robust. As an example, when oil fell below $30 a barrel briefly early this year and equities fell sharply, the market price for the portfolio fell by only 40% of the fall in broader equities. Given that 7% is close to the long run return from equities, being able to achieve this sort of return with around half the risk of equities is obviously attractive. Also, the income stream has the advantage of offering some inflation protection and so a good diversifying asset for the portfolio.
- European Commercial Real Estate Loans: Here the idea is that a portfolio of loans on commercial property might be more attractive than investing in the underlying properties themselves. The reason is that post the 2008 crisis banks pulled back from real estate lending and still now limit the amount and type of real estate loans they have on their books. This creates an opportunity for non-bank lenders to fill in the gaps. We invest in a portfolio that yields around 6.5% and which has a typical average loan to value of around 60% to 80%.
- European High Yield: This is lending to sub-investment grade European companies. While obviously the diversification argument is less here (what is good for European equities tends to be good for the European high yield market and vice versa) we like the fact that the European economic recovery is at an earlier stage than in the US. Also, the ECB is now buying investment grade corporate credit as part of its Quantitative easing programme. This helps provide general liquidity support for European credit markets and so should support the market value of our investment.
If we are right, each of these investments should be able to achieve something close to an equity return for substantially less risk. The returns on them also come from sources that are fundamentally different from the profit levels and price earnings ratios available in global equity markets. For these reasons we will continue to search out alternative, reliable compounder investments and add them to our portfolios when we find them.