“…they (investors) should try to be fearful when others are greedy and greedy when others are fearful.” – Warren Buffet
(Buffet just invested $10-Billion in GE Capital and Goldman Sachs with a 10% preferred return and a significant win if shares rise in the next five years.)
I thought when we sent out our last e-mail newsletter a few weeks ago (Barbarians at the Gates) that we had covered a litany of woes from financial institutions (primarily in the U.S. at that time). As it turns out, it appears to be just another chapter in the story of the impact of expunging bad debt.
Just recently I was speaking with one of my partners who told me about a call he had received from a concerned client. After reviewing the client’s position and giving them comfort that they were weathering this storm well, my partner asked our client what else we could do to communicate better when times are as turbulent and worrisome as they are now.
He replied, “Just make sure you tell me exactly as it is. I can handle the unvarnished truth as long as I know what it is and what our plan is for managing it.”
Well that seems like sage advice to me, so let me first summarize what we will cover in this memo.
- The unvarnished truth as we see it. In many ways, this is the biggest financial crisis any of us have ever experienced as adults. And it is not over yet.
- The risks and opportunities as we see them. If you are trying to buy good cash flow at better prices, then this is the market for you.
- Depression Investing. We’ll walk you through how a cash flow oriented portfolio would have performed if one started investing in 1929 and relied on their portfolio to provide an income through a 10-year depression and a world war. The results will surprise many of you.
So let’s get started:
The Unvarnished Truth:
The bad news is that we do not have enough space in this memorandum to give a comprehensive list of everything that is going awry financially. Here are some salient points:
- On Wednesday, Central banks in Canada, the United States, Britain, the European Union, Sweden and Switzerland cut key lending rates by half a percentage point. Notwithstanding this unusual coordinated effort, stocks dropped about 2% in most of those countries.
- The U.S. government finally approved a plan to acquire illiquid debt obligations (mostly mortgages) from banks at a discount. This discount, however, is likely to be higher than current market prices and will provide liquidity to the banking system. There is some similarity between this new program (TARP, which stands for Troubled [perhaps they should have used Toxic] Asset Relief Program) and the Resolution Trust Corporation which acquired bad debt of savings and loans in the U.S. during the 80’s.
- In the last 30 days, most major markets have dropped over 20%, and from their peaks in the last 12 months, the S&P 500 and S&P TSX are down about 35%. This year alone, Canadian equity funds are down on average 25% and even balanced funds (which usually are 40% or more in bonds) are down between 10% and 17%.
- You will be receiving your quarterly statements in the next few days. Most client accounts are down by an estimated average of 3% YTD as at September 30. While no one likes to see their capital go down, over the same period, this is a much smaller drop than the MSCI (-21%) or a balanced portfolio (-16%). In addition, the cash flow generated on our portfolios has not dropped and remains strong and reliable.
- Ireland, Germany and Iceland have all agreed to insure 100% of all bank deposits regardless of account size to prevent funds from leaving their banks. England, France and the U.S. have announced large increases in bank deposit insurance ($250,000 in the case of the U.S.) Many countries have created special lending structures for banks in return for preferred equity (England just announced a CAD$70-billion facility to provide equity to the Royal Bank of Scotland and Lloyds, two of their largest banks.
- Our situation in Canada does not seem as bleak as some other countries. Our banks and major Life Companies have solid balance sheets and relatively smaller amounts of non-performing debt (especially a much smaller exposure to sub prime mortgages). The federal government has not yet found it necessary to increase deposit insurance (although that could change if all other countries opt to provide unlimited coverage) and Canada has the lowest Federal debt-to-GDP of any G7 country, so our fiscal house is in better shape as well.
- Normally, when banks lend to each other they charge a small premium of about 0.25% to 0.50% over what government T Bills pay. This rate is called LIBOR (London Interbank Offered Rate). Yesterday, LIBOR rose to more than 5.3%; these recent credit spreads are unprecedented. Banks are afraid to lend to each other (which partially explains governments increasing bank deposit guarantees and adding new equity).
- As of October 8, 2008, oil prices have dropped by $65 per barrel in four months to $82. As a result of the fears of a global economic slowdown, overall commodity prices are down about 40% since July and the Canadian dollar has just dropped to less than USD$0.90. Right now the U.S. dollar is perceived as a haven of safety. The Euro has dropped from USD$1.62 to USD$1.35 and one of the biggest losers has been the Australian dollar, which was near par with the U.S. dollar a year ago and is now back to USD$0.65.
- While commercial real estate has held up well so far, housing prices are falling everywhere (not just the U.S.) Of particular note has been the drop in the prices of REITs. Most of them are trading well below their net asset value and their yields have not been this high in more than five years (more on this later).
The Risks and Opportunities:
So what can we garner from this information and extraordinary environment?
- For many years, asset prices rose far faster than the rate of growth of the economy (first stocks, then housing as well as commodities). A lot of debt was used to acquire those assets and it was priced far too cheaply for the risks involved. Some of that debt will not be repaid as we deleverage.
- Having said that, much of that debt will be repaid and it is now trading at prices that offer investors some very good yields when compared to the risks. Lending is not going to stop, but lenders will get better returns relative to risk on the loans they do make in the future.
- This type of environment is likely to be deflationary. Government interest rates will drop (as we are seeing as this memorandum is being written) but that may not mean much to most borrowers, as banks and other lenders require bigger spreads between the cost of their money and the rates they charge borrowers.
- We are in a recession that has hit Main Street, not just Wall or Bay Street. Consumer spending will drop as unemployment rises. We should be prepared for this to last for most of 2009.
- Regardless of economic issues, many good companies have great balance sheets (in fact, corporate debt is far lower as a percentage of capital for non-financial firms than during other recessions). Many companies also have strong cash flow, which is one of the major items we care about.
- As noted above, REITs are now trading at big discounts to asset values. Yields for Canadian REITs vary as at October 8, 2008 from just under 8% for the largest REIT (Riocan) to almost 10% for Artis and 13%+ for Chartwell. Yield by itself is not the whole story, as cash flow must be sustainable and ideally growing, but value certainly exists in this sector right now.
- Some companies, such as Canadian Oil Sands, are likely going to cut distributions soon (Canadian Oil Sands’ current yield is almost 17%, because its stock price has dropped by almost 50% in the last 3 months), but they still represent good value to us. Other energy options include Suncor and Encana (down 65% and 48% respectively from their highs).
We have not seen equity markets this low since the 2000-2002 bear market. If we go back further, most equity markets are where they were in the mid-to-late 90’s. We are in a very turbulent period and prices could easily drop from here.
So what does one do when things are so uncertain? One option is to liquidate to cash, accept a 2-3% guaranteed return and wait it out. But that begs a few questions you need to ask yourselves:
- How will you know when it is time to get back in?
- If your cash flow from your portfolio is 4% to 6% and very tax efficient, wouldn’t you lose a lot of investment income being in cash?
- If things are bad now and prices of many good companies have dropped so much, shouldn’t you be buying selected cash flow generating assets? Buffet seems to be doing so.
The option we have always recommended (and have always done for our own accounts) is to have a well-diversified portfolio that generates a significant cash flow which, on average, should make up at least 50% of the long-term returns earned from the portfolio.
So this brings me to the last item.
In this environment, a cash flow oriented, balanced approach to investing has weathered the storm very well. How might it have done during the worst economic times the world has experienced – the 1930’s?
We have collected data on equity, real estate and fixed income returns from a variety of sources and constructed a hypothetical portfolio that begins on January 1, 1929. We then invested that portfolio for our mythical client to see how it would have performed on both price and income. The assumptions are as follows:
- Starting balance is $100,000, which our client (Jonathan Kent) has just received as an inheritance. In 2008 dollars, this would be the equivalent of $1,250,000.
- The funds are invested equally between the S&P 500, a small apartment building ($33,300 would have been enough then to have acquired a 15-20 suite apartment building), and fixed income government and corporate AA Bonds.
- The yields for each asset class are 3.8% for the S&P 500, 6% for the real estate (but we also assume a 10% vacancy rate), and 4.2% for the fixed income portfolio. First year income from this portfolio is $4,360.
- For comparison purposes the average income in 1929 was $1,970 per year, the average bungalow cost about $3,000 and average rents were $15/month.
- We have adjusted all figures so that we take into account both inflation and deflation. In other words, each year we calculated what Jonathan’s income and capital worth would be in 1929 dollars.
Below we have written this as a financial diary and selected certain key years where Jonathan writes a summary about how his portfolio and the economy are doing.
January 1, 1929:
This is exciting! We just put together our investments. Reluctantly, I agreed to put only 1/3rd of our assets into stocks, but that is where all the money is being made! Martha says it will be alright and I have to admit that monthly cheque of just over $350 is great. We don’t need it all, so we spend about $250 and reinvest the rest. Our advisor says “keep it balanced” – seems a little tame to me.
January 1, 1931:
It has been 13 months since the stock market crash of 1929. For a few months there things looked like they would bounce back, but by the end of 1930 my stocks are down more than 10% from where I started and about 25% from the peak. Luckily I am still collecting my rents and bond interest, and so far the dividends are being paid on my stocks as well. Prices have dropped more than 6% in the last year, so when I adjust for that, my income last year was higher at $4,700 and the overall portfolio has not dropped at all. I am a little worried about the bad news I hear everywhere, but eventually things will get back to normal.
January 1, 1933:
Things are really bad. Unemployment is now 25% and prices have dropped 25% as well. I have had to cut my rents by that much just to make sure I can keep some good tenants. I don’t want to think about my stocks. My advisor tells me that even when I adjust for inflation my stocks are down by almost 70% and the dividends have been cut by 40%. I want to sell, but he has convinced me to stay the course and in fact do something he calls “rebalancing”. I call it stupid, but I go along anyway. Overall the portfolio is at $92,000 (down 8% from where we started). Martha says we should stick to the plan, since last year we received $4,800 in income because the bonds did well. That’s good. We need it. Martha found an abandoned baby in the back yard. We adopted him. We’re going to name him Clark.
January 1, 1940:
We are at war. Somehow we survived the 30’s just to get into this mess. At least the portfolio held up well. Right now we are still a little down at $95,000, but the income held up well at $4,400 last year. Still more than we need. However, Clark sure eats a lot for a little guy.
January 1, 1956:
Well, the war is long over. Clark graduated from college and Lester B. Pearson, our PM, deserves the Nobel peace prize for what he did in the Suez war. On the financial front we have finally got back to where we started. We would have got there sooner, but there was a lot of inflation after the war and prices have gone up 100% since 1933. The bonds that saved us during the worst of the depression are not doing well now, but with the stocks and the real estate we still have $4,600 of income and just over $100,000 in savings in 1929 dollars.
In 1956 dollars, our account is now worth $165,000 and generates just over $600 per month in income. We are in good shape. Over the last 27 years, our overall accounts did, at one time, drop by 25%, but our worst income year in real terms was just after the war in 1947. And even then we still received $3,700 (a 14% drop from 1929). More than we needed. I guess this cash flow balanced approach for investments really works. I had a math professor friend of mine calculate for me what Martha and I earned over the last quarter of a century. He tells me we averaged 4.7% per year after inflation. Given a depression and world war, that seems pretty good to me.
Postscript, January 1, 2008:
I just found dad’s diary. We stuck to his principles for all of these years, since he and mom died. That original $100,000 is now worth $2.7-million and generates cash flow of $85,000 per year. Of course he would say to me if he was here, “Clark my boy – a buck just isn’t what it used to be.” So in his terms the account is now worth $220,000 with income of $7,000 in 1929 dollars. My parents left a great legacy for Lois and me, and I don’t just mean the money.
For all of the reasons above we believe strongly in cash flow investing. And over the coming months and years, we expect to see many new opportunities to acquire good assets that will further contribute to the income portion of your portfolio. Even in the worst economic conditions, a portfolio that emphasizes balance and income works and makes sense.
We are in a tough environment (although nothing like the 1930’s), but being diversified allows us to rebalance and acquire assets we feel are cheap and which generate solid cash flow, allowing us to continuously dollar cost average in volatile markets. These approaches worked in the 1930’s and they will work now.
For a more detailed synopsis, an extended version will be made available on our website in the coming days.