Delivering returns in a low-return world

By Andrew Headley

It is more than seven years since the US Federal Reserve reduced the benchmark interest rate to zero. Since then the central banks of all major developed market nations have followed suit and short term rates have remained firmly rooted to zero or near zero. The implications of this are many and varied.

Careful considerations
Having had rates so low for so long, one widely accepted consequence is that future returns from the major asset classes will be low when one considers the following:

  • Savings
    With zero interest rates, and in some countries negative long-term rates, it is impossible to generate a satisfactory (inflation-beating) return through traditional saving.
  • Fixed interest
    As with savings, extremely low (or negative) yields on fixed interest instruments preclude making a real return on these assets, except perhaps through trading the instruments should yields move lower. As an example, in the course of the last quarter Sanofi issued a three and a half year bond with a negative yield. So rather than receiving an income if held to maturity, lenders are effectively paying Sanofi for the privilege of lending the company money. This is clearly not normal and indicates the degree to which free markets have been distorted by policy makers around the world.
  • Equities
    Low yields elsewhere have encouraged investment in equities pushing up the prices and valuations to historically high levels. Despite relatively lacklustre revenue, earnings and cash-flow growth, valuations today sit at the highest level since the tech bubble as illustrated by the US cyclically adjusted PE. Effectively, low policy rates have brought forward the return on equities (which are extremely long duration assets) strongly implying that future returns will be much lower than those experienced in the recent past. This of course was the intent of central bankers with the expectation (hope) that the gains would be spent, thereby driving the consumer economies of the western world.

Given the low yields available (and high valuations in equities) future returns are likely to be uninspiring, at least for any extended period until valuations and yields can return to more normal levels. If this assertion is correct then savers (anyone considering retirement) will need to put greater amounts aside to generate the final ‘pot’ which will be able to provide the annual income required. As rates have been held so low for so long, savers are increasingly coming to recognise this and consequently are saving more (leading to a savings glut). This is diametrically opposed to the outcome that the central banks are seeking, who want us all to spend more.

Contemplating risks
Looking more specifically at equities, the median annualised total return expected (in local currency) across all the companies that Veritas analyse is c.4% for the next four to five years. While this is a positive return, it does not compensate investors well for the risks that they bear investing in equities. While this is only an estimate based on our analysis and valuations, it is as likely to be overly optimistic as it is to be overly pessimistic. In fact it may be biased to over-optimism as we do not forecast a recession in our estimates, but given we have not suffered a recession since 2008 there must be a risk of one within the next five years. 

So if savings, fixed interest and equities are all priced to deliver low returns for the foreseeable future, how should one invest? Our answer to this is to remind investors that while the equity market as a whole may deliver very low returns for the next five years, the variability of returns on individual equities provides opportunity. This may also be the case in fixed interest (corporate debt) but likely to a much lesser extent. Some companies share prices will fall drastically over the next five years but some will rise handsomely. An astute investor, looking to invest on a long-term basis in a select few companies that have the right attributes of quality and valuation should be able to deliver returns well above an encumbered market index over the next five years. Stock picking may be returning to its glory years.

Quality valuations
It is our view that there are a few ‘methods’ of equity investing that have proven to work over the long term. These would include deep value, momentum and quality at an attractive valuation. Obviously it is important that whatever method is selected is fully understood and suits the psychology of the investor. This is particularly important for deep value which can sustain long periods of poor performance. The method used by Veritas involves buying high quality companies when they are attractively valued. Sometimes this is straightforward, for example when equities fell steeply in 2008 / 2009 and both low quality and high quality companies suddenly became cheap, but at other times is more difficult. With high valuations today, now is one of the times that identifying value in quality companies is more difficult. But it is not impossible.

There remain a number of ways to still find bargains in today’s market: For example buying companies that have long-term, strong and durable franchises, but for one reason or another are suffering a temporary problem that has led to shorter-term investors abandoning their positions and selling out. This, in turn, creates a valuation opportunity for those with foresight and a long-term time horizon. Our purchase of Rolls Royce earlier this year is a good example. This holding was bought following a sustained period of underperformance driven by a mix of accounting issues and weak profitability caused by the introduction of a new aerospace engine which has taken substantial market share. Normally this would be positive, but in the early stages of an engine’s life its sale is loss-making for the manufacturer, thereby exacerbating the company’s profit issues. However, the engines are profitable over their lifetimes as the profit from repair and maintenance is extremely high. Accordingly, we know that engines sold at a small loss today will be very profitable in the future, but this does not show up in today’s profit and loss account. Many investors are not prepared to wait for this eventuality, which (together with accounting issues) led to the share price falling from over 1200p to under 600p creating the opportunity for the long-term investor.

While Rolls Royce is a good example, there are not many of these. In many instances when a share price falls, it is fully justified. To find the ones that are suitable investments requires many hours of thorough analysis of a company’s market, competitive position, management, products and competitors. This takes time, but fortunately we do not need hundreds of such ideas each year: a long-term fund that is relatively concentrated (say 30 positions) with an average holding period of five years requires only six positions (on average) to be bought (and sold) each year. We believe that the market will continue to give us such opportunities so that even in an over valued market with low return expectations we will still be able to find sufficient investments that will deliver on our target annual return of CPI+6% or better over our investment horizon.