Imagine a mythical pet store. It has cats and dogs and parrots. But this one has snakes and spiders and tigers too. Some animals in this store will make the perfect companion, enriching your life and bringing joy. Some will bite your hand off.
In this kind of store, we would want choice. The choice to buy the Border collie, the Burmilla cat or, if you were my niece, a pug!
Imagine though, that you had no choice and that you were blindfolded. You would just wander into the store and buy the first thing you touch or worse still imagine you are made to buy one of everything regardless of its tooth size!
That’s how some investors behave. Blindly buying a piece of everything just because it happens to be in the store.
There are too many snakes and spiders and tigers in financial markets to take that risk, in my view.
For me, the biggest stand out in markets in June was the continual fall in long term interest rates. By month end some $13 trillion of fixed income investments around the World carried negative interest rates. This includes $1 trillion of corporate debt. That’s money borrowed by companies where, in essence, you are paying them for the privilege of them borrowing from you! This kind of tiger doesn't eat your hand, but over the years will surely consume your wealth.
Passive investors, who own a piece of everything in the market, make no choices about what they will buy. They line up with billions of dollars to fund governments and companies at rates of return guaranteed to lose money over the life of an investment. This does not seem even a little bit rational.
No choice investing imposes a heavy burden. Not only does it mean you have to buy these securities but that you have to hold them, come what may, while they remain part of the market index.
As an active manager we have choice. While we don't own a lot of fixed income investments with negative yields our Head of Fixed Income, David McLeish, chose to own some with the view that rates would fall, leading to capital gains. He was right. But he can now change his mind and lock that profit in. A passive investor holding the same fixed income investment is forced to hold to maturity and will watch any gains disappear. I guess someone has to feed the tiger!
Fixed income is not the only part of the market where dangers lurk, and choice is a prerequisite for success. I have mentioned this statistic in previous monthlies, but over the last year some 80% of new companies listed in the United States weren't generating bottom line profits. In some cases they were even posting huge losses. This trend has continued in 2019 with loss makers like Uber and Lyft, Pinterest and Slack listing. Some of these are large companies that will form part of recognised share market indices and will be bought as part of passive investment strategies.
While losing today doesn't mean a company can't go on to be a wonderful success the odds aren't great. Research, admittedly a little dated now, from US investment house GMO showed that loss making firms, in the United States, underperformed the average company by 8%pa over the period from 1979 to 2011. Choice, not blind faith, in making investments in risky, loss making companies, is essential.
One last danger that we should all be aware of is the flip side to low interest rates. Like moths clustering around a light many companies have been drawn in by the allure of low interest rates. This has meant debt levels at companies rising, and rising markedly.
Whatever way you cut it the numbers are scary. Focussing primarily on the United States, largely because this is where we get the best data, total corporate debt as a percentage of GDP is close to all-time highs, and this is in a good economy. Debt normally peaks in recessions. Net leverage (net debt to EBITDA) for the Russell 3000 index is close to all-time highs and issuance of BBB rated debt as a percentage of all investment grade debt issued, is also at all-time highs (BBB is the lowest quality rung of investment grade debt). The message from debt markets is clear!
As we all know, like having a huge mortgage, too much debt can be dangerous. It's all OK if interest rates stay stable, we keep our jobs or the kids don't need expensive orthodontic work! If things change too much debt means going from OK, to being out of business very quickly. This makes us incredibly picky investing in companies with too much debt. Passive investors aren't. Beware.
Financial markets have become more divergent. Divergence has opened up the gaps between the haves and the have nots, the indebted and the financially responsible, between assets expected to deliver positive returns and those locking in long term losses. Choice has become even more important than ever. We remain steadfastly committed to applying that choice, in a thoughtful way, to enhance your long term financial well-being and to avoid the snakes, spiders and tigers lurking in today's markets.
