This week we would like to revisit that age-old topic, and perhaps one of our recurring favourites, asset allocation. This is a topic made especially pertinent given the unprecedented low-interest rates combined with high valuations across both equities and fixed income.
We’ve mentioned in several previous articles why this seems to be the case, ranging from demographic shifts to central bank policy. So, this brings us back to the topic of how do we actually navigate this environment and construct a portfolio that, at the very least, helps us get a good night's rest. For one thing, let us start with some fundamental tenets, namely:
1 - Maintain purity of investment form
Choose whether a particular asset is meant for capital growth or for income but do not make the mistake of confusing the two in order to avoid value traps. For example, investing in high-dividend yielding companies in an era of low-interest rates is not necessarily the best of ideas. For one thing, there could be a good reason the yield is so high and the market wants to discount it.
2 - True diversification
The traditional diversification forms, based on sectoral and the perceived cyclicals, do not work in the scenario of a rising tide. The key question to ask is whether there are true dislocations in the market. Rather than investing in bonds for diversification or as a hedge against high-growth equities, the more pertinent theme may be to replicate the risk profile and sustain a reasonable yield. For example, this could come in the form of commercial property or bond proxies such as infrastructure or utilities.
3 - To follow up on the point of diversification, there are also different ways to think about this. For one thing, research has consistently shown that geographic diversification yields much greater benefits and risk-adjusted profiles than sectoral diversification. For one, the factor implications are much greater.
Now that we have elaborated upon the three tenets let us move onto actually thinking about how we structure the portfolio. In this exercise we will limit ourselves to three different asset classes namely, equities, precious metals (i.e. gold) and bond proxies. We have left traditional fixed income out of the equation since we have very particular views on that class of assets over a long time horizon, we might be wrong on this but we are open to being proven otherwise.
As we have previously mentioned, we continue to believe that equity markets will remain strong for the foreseeable future. While valuations certainly do look egregious from a valuation standpoint and from a historical perspective, given the low interest rate and expansionary monetary policy they are the one asset class that makes sense. In the absence of a 180 degree turn in policy settings and market sentiment that borders on the expectation of a central bank put there will be continued demand for equities.
The key metrics we see as having a special relevance in this environment are a combination of ROIC (Return on Invested Capital) and ROE (Return on Equity). While traditional portfolio theory would suggest that a fixation on ROE can be misleading, we live in a market context that is vastly different from anything we have seen in the past. For one thing, mathematically speaking in a world where the cost of capital is increasingly zero bound it is ironically those companies with high leverage on the balance sheets that do well. In a low interest rate environment it would make sense to see the returns a business can generate on invested capital and in the absence of policy adjustments seek those that have leverage on the balance sheet to get outsize returns. Ironically the key will be to seek growth with a value bias (i.e. buy good securities at a decent price).
In terms of equities diversification, one of the key themes here will be to take a much longer-term perspective by diversifying geographically rather than according to traditional sectoral biases. This should yield a much longer-term risk-adjusted return. For example, retail or financials might not make sense in the Australian context but could do exceptionally well in the Chinese (where we own Ping An Insurance) or broader Asian context. Similarly, finding equities that could benefit from long term secular trends such as the move towards consumption led growth across Asia would be key to having a well-diversified portfolio. This would not only have the added benefit of sectoral diversification in the sense that different sectors will perform differently across different regions but also factor diversification. For example, research has consistently shown a much lower correlation between country indexes as opposed to industry or sector indexes.
In terms of income, we believe that given valuations as they currently stand, it does not make sense to look to equities as an income-based play but rather to keep purity. On an intuitive basis, this should make sense. If a business can generate an ROE in the double-digit range then there is an opportunity cost to actually distributing it out to shareholders who can only generate suboptimal returns given the RBA cash rate and in some cases, like the EU, negative returns. While this might not make sense from a tax perspective, one has to think of making investment decisions in isolation to other considerations such as tax. Trimming a position and locking in profits to derive an income is just the same as receiving a dividend if tax implications were not to be considered. Furthermore, entering a position based on dividend yield could put investors in the position of falling into a value trap as the classic cases of TLS or AMP have demonstrated (though in all fairness they have been decent buys recently). Thus, when investing in equities, we continue to believe that it should remain the largest portion of an overall portfolio; going as high as 70% (contingent of course on age and the risk profile this might dictate).
Precious metals is perhaps one of the most divisive topics in the world of investing. For one thing, as the greatest investor in our history, Buffett suggests the metal itself has no intrinsic value apart from that which is derived from its perceived “preciousness”. However, while this remains the case, history is not on Buffett’s side. Gold and, to a lesser extent, silver has been the currency of choice for most of human history. From the Romans who paid off the Franks to the Franks who paid off the Vikings in order to stop their raids up till the very recent times of the Johnson administration effectively dismantling the Bretton Woods system. Percentage-wise our call is that it should ideally take up no more than 20% of a portfolio and even then purely for hedging purposes.
On the other hand, even here we have a preference for owning gold companies like Westgold or Bellevue Hill who have clear runways for growth and should benefit from any tailwinds in terms of upward momentum in the price of gold. Another alternative is the ownership of bullion directly or gold-based royalty companies such as the Franco Nevada Corporation (FNV.TSE) or Newmont Mining (NGT.TSE) which sidestep many of the risks of actually holding mining assets by buying up royalty streams.
One of the key things to remember is that this is a hedge and should not be looked upon as a growth play. Gold has a long trajectory to go but we do not see a breakout anytime soon in the absence of downward pressure on the USD (to which it has an inverse correlation) and bond yields (especially T-Bills, again, inverse correlation). What we would need to see is a clear break out of this relationship for gold to truly come into the money. What has been interesting in recent times, as we have previously elaborated, is the increasing propensity of central banks around the world to buy up bullion and add to gold reserves from the PBOC in China to Russia. We will see a much longer-term trend but for it to have its day in the sun, the USD must take a turn for the worse, which will not be the case in the medium term, and inflation would have to pick up substantially (both of which are much more long-term plays). Nevertheless, from an overall portfolio structure perspective, having an allocation to precious metals should smooth out the volatility in returns.
We would like to start with a clear definition of what we mean by bond proxies. For us, it is an asset that replicates the risk profile of a bond without actually having any exposure to bonds. When we say this, it could be sectors as diverse as infrastructure or utilities. In fact, this is where things look interesting not only in the short to medium term but over a much longer time horizon. Again, central bank policy and fiscal policy will be key here. In fact even today, there is a trillion USD gap in the required spending on infrastructure to the actual spend (refer to the graph below). Infrastructure and utilities, given their capital intensive nature, are highly leveraged beasts and, in the absence of higher interest rates, they are able to not only deliver good yields but also benefit substantially from the current and future growth in spending without the volatility of other asset classes.
At TAMIM we see infrastructure as a good long-term growth story. Not to mention the fact that our global equities portfolios hold significant positions in companies that benefit from this particular aspect (ranging from China Lesso to China Water Affairs). The key here will be to identify companies with a disciplined capital management system in place as well as those that have regulatory capture via lock-in revenue growth (absolute or indexed to inflation). Examples could be state utilities corporations in the United States or companies like TransAlta Renewables in Canada whose diverse product mix, from coal to geothermal, makes it a rather interesting play. Others include Veolia in France or Encavis in Germany.
Alternatively, property presents an interesting component here as well depending on where you look. For us, the key thing when we look to assets is duration risk (i.e. longevity of tenancies) and the escalation in rents. In essence, one could actively use private assets to replicate the risk profile of an investment-grade bond and ascertain a yield that is suitable for their portfolio.
Such assets, when taken together with the equities (to deliver growth) and precious metals (to hedge out volatility), make for a truly diversified portfolio.
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.