Barbarians at the Gates?


By John Nicola
& Rob Edel

 
“May you live in interesting times” is supposedly the English translation of an old Chinese curse. Given how much debt the Chinese hold in failed U.S. financial institutions, they may want to come up with a stronger version.

Let’s consider the past few weeks and especially the last couple of days:

  • The U.S. government puts mortgage giants Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) into conservatorship – a euphemism for nationalizing them – and is, in effect, guaranteeing their debt of $5.4-trillion (much of it held by China and Japan).
  • Bear Sterns, a Wall Street investment bank, avoids bankruptcy as it is swallowed up by Morgan Stanley provided that the U.S. government offers liquidity and loan guarantees to make the acquisition work.
  • Lehman Brothers (who have been in business since 1858 and survived the depression) files for bankruptcy on Monday and Barclays Bank of England is acquiring one of their U.S. divisions for $1.75-billion.
  • AIG has a major liquidity crisis. The Treasury comes to the rescue with the Fed to the tune of $85-billion of loan guarantees. In return, they get a lot of very nice assets and 80% of the stock of the company. 3 years ago AIG had a market value of $190-billion dollars. Now the equity in private hands may be $5-billion.
  • Canadian life companies and banks are exposed to some of this bad debt in the form of loans, credit default swaps and equity positions. However, to be fair, the losses look quite manageable and likely less than other previous financial scares such as the Asian crisis of 1998 and the Latin American loan losses before that. (Is there anyone out there old enough to remember Dome Petroleum?)
  • The U.S. housing bust continues unabated. New home construction is down another 6% in August and the Cash-Shiller Index shows an average decline in house prices of 17% with perhaps another 10-15% to go.
  • Canadian house prices are officially down 5.2% for the last twelve months after peaking some time last year.
  • The world’s largest wealth management firm (Merrill Lynch) is taken over by Bank of America because, while its core business is very profitable, its leveraged debt requires a huge injection of new capital.
  • Both the S&P 500 and the S&P TSX are down 20% from their peaks earlier this year (the official bear market sign).

Worst of all:

  •  The 2008/2009 Canucks still do not have any good scoring.

So is this apparent financial implosion something to make light of? No. But as with most crises, we need to keep perspective and review our strategy (which, if correct, will allow us to survive well and, in time, prosper from some solid choices we have and will make).

While many commentators are saying this is the worst financial crisis since 1929 and another Great Depression looms, there are some facts to consider before drawing those kinds of conclusions:

  • In the 8 years leading up to 1929, the S&P 500 rose by 700%. In the 8 years leading up to today, the S&P 500 is almost exactly the same (i.e., no growth at all).
  • The unemployment rate in the U.S. hit 25% in 1933. There was no unemployment insurance, social security, Medicare or deposit insurance at banks. Unemployment in the U.S. is 6% and no one believes it would ever get near 25%.
  • The world is incredibly interdependent now, and nations cooperate far more than they were willing to do in the 1930’s (which was one reason for the outbreak of WWII).
  • Currently, firms such as Merrill, Lehman and Bear Sterns are hugely leveraged. They have, on average, about $30 of assets and liabilities for every dollar of shareholder equity. If those assets or liabilities change in price by 5%, their equity vanishes. This is no different than buying a rental home with 3% down and hoping that somehow your rent covers your debt servicing costs and the house will appreciate. Could work on paper, but not in an environment where asset prices are shrinking.
  • The Fed and other national banks made credit far too easy to attain after 9/11 and the Dot-Com bubble burst. This credit inflated asset prices and now it has come home to roost. As the world delivers itself, there will be more asset price declines which, in some cases, may be very attractive levels for those capable of buying.
  • When equity and real estate prices drop, both good and bad assets are affected. In the case of good assets, they often offer cash flow as good or better (in the form of rents and dividends) than they did before. This can be seen in some real estate trusts, drug companies, energy companies and financials that are still solid. Opportunities always exist.

So what have we been doing and what do we think you should do as we move forward?

First, the world is not going to end. We have always stressed the importance of buying assets that generate cash flow and that cash flow should be as much as 50% to 70% of your long-term return. That means rents, dividends and interest income are more important to total return than investments that can only generate capital gains over time. Nothing has changed; we feel that 2008 has proven how well this approach works in very tough markets.

  • On a year-to-date basis, most of our clients have returns between -2% and +4%.
  • Our Strategic Income Fund (SIF) has distributed an income of 7.1% on a trailing basis over the last 12 months. Since January, the total return has been -2.3%, which is far better than the either the S&P 500 index total return (-16.3%) or the S&P TSX total returns (-10%).
  • The SIF has 30% of its assets in cash and preferred shares, and so is very well positioned to acquire assets when prices and opportunities make sense (but always with the idea of acquiring good and growing cash flows at reasonable prices).
  • Overall, our clients have about 35% of their assets in equity markets. It is quite possible over the next year or so we will recommend that percentage increase.

Besides cash flow, we have also stressed diversification and patience. Our clients’ portfolios are well diversified; this is something we do for you. Patience and calm, on the other hand, are things you need to bring to the table. Right now they are invaluable, because cooler heads will do well in these times.