Yahoo Finance Yesterday’s investing solutions will not work tomorrow, so here's some cash-flow options that might
This past Thanksgiving long weekend provided a great chance to give thanks for the many blessings we’ve been given, such as being able to gather with family and friends in person over a good meal, and the same can be done when looking back at what’s working in your portfolio and what isn’t.
Unfortunately, a lot has probably not been going very well, especially for more conservative investors who didn’t go all in on the seven megacap stocks that are the only positive ones this year. The problem is that a 30-year bull run in bonds has many thinking they are the safest asset in a portfolio, but this completely ignores duration risk because we simply have not had interest rates go up like this in a very long time. This message is even built into risk questionnaires, and know-your-client and investment-policy statements directing investors to own more bonds the more risk averse they are.
Meanwhile, today’s bond market is in chaos, with yields on 10-year U.S. Treasuries almost equal to the trailing 12-month earnings yield on the S&P 500 index, the first time that’s happened going back to 2002.
Howard Marks, the sage investment manager at Oaktree Capital Management LP, recently did an outstanding interview with Bloomberg on this. He started out by stressing that it is important to get a good understanding of the current environment and to identify large structural shifts in the market, or what he calls a sea change.
From 2009 to 2013, the United States Federal Reserve dropped the funds rate to zero to fight the global financial crisis, left it there for a very long time and didn’t get it back up to any normal range. This made life very easy for borrowers and asset owners, resulting in a strong economy and one of the longest market bull runs in history.
It was an easy world, but this has come to an end with the emergence of inflation and rising interest rates, resulting in what Marks thinks is another sea change, meaning the days of easy money are over.
What you should have in your portfolio going forward can be very different than it has been
Howard Marks
Sure, current rates are likely to eventually settle lower, say, between two per cent and four per cent, but they’re not going back to between zero and two per cent unless there is a deep recession that takes inflation levels significantly lower. Therefore, he said, “If it is the change I think it is, then what you should have in your portfolio going forward can be very different than it has been. Yesterday’s solutions will not work tomorrow.”
In our assessment of the current environment, the 60/40 balanced portfolio of yesterday is going to continue to have a difficult time meeting conservative clients’ goals and objectives of tomorrow.
This is already happening, as evidenced by the performance of Morningstar Inc.’s Global Neutral Balanced Index, a composite of Canadian balanced fund managers. It is now showing a paltry annualized 1.5 per cent return over the past three years, bringing the annualized five-year return down to 2.6 per cent, and we think it will be taken even lower in the months to come.
Fortunately, there are some strategies that are adding considerable value over this challenging period for us and our clients. All of them have something in common: cash flow.
We started adding structured notes three years ago and have significantly boosted our position given their predictability and consistency in cash flow. There is also a level of certainty at the expiry of each note depending on the terms and the embedded downside barriers that can range from 20 per cent to 100 per cent for principal protection.
We have also been increasing our private-equity allocation by using managers that can do the same type of cash-flow analysis. For example, we recently met one manager in Toronto who has been buying U.S. machine shops and materially improving output and profitability by implementing new fabrication technology, complemented by introducing self-learning software. It is essentially a play on U.S. onshoring.
Finally, the energy sector that sold off hard last week on worries over U.S. gasoline demand and crack spreads is now offering a chance to own upfront cash flow that is so large that many companies can buy back all their stock and debt in less than five years under current oil prices.
That said, given the volatility in oil, the cash-flow predictability here is the more uncertain of three strategies, but it’s still a nice growth component offering an attractive reward-to-risk ratio.
Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc, operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.
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