Yield Producing Assets

The crisis that broke last Sept-Nov was a big shock. I was long of property assets with the first round of cash from CMA. I felt wrong-footed by the subsequent turn-down in markets.

My Commentaries since, record my attempt to recover my economic sense of balance. I sought to have a “good crisis”.

As I managed to work out by the final paragraphs of my (tortuous) Feb 2009 Commentary my investment strategy since that date has been to “return to my roots” by investing in defensive but high yielding bonds and other yield producing assets. We focused on perpetual bonds issued by banks (and insurance companies). We judged this sector would recover with government support of the banking system (very low rates interest rates are a licence for the banks to make money). We also purchased some blue chip equities with high dividend yields.

These trades worked well. Our trust securities portfolio is generating cash flow yields at an annual rate above 10%. Capital gains of over 20% since an average entry date of May mean the Portfolio is actually up 27% in four months – an annualised rate of about 90%. We won’t be able to keep up that rate but, absent any major bank defaults (extremely unlikely now with government support) a very satisfactory annual return is achievable. This remains a good opportunity to profit from the panic of 2008.

As a result of this reasonable successful trading (admittedly in very favourable circumstances) I am feeling better than I did last October.

So much for the good news. My next task is to apologise for my bear-ish comments on equity prices in my June Commentary. Although a sell-off in June-July made me feel wise for a time the big rally in late July through September proved me spectacularly wrong.

It is no excuse that I was not alone in this view. 90% of professional investors spent the past six months underweight equities. We were all wrong. Equities have stormed off their lows. As they should have. Looking back, they were cheap and, unlike in 1929, this time the authorities moved decisively to save the banking system and to re-start the global economy. I got the printing of money and selective support for the finance sector right (this was the rationale for purchase of capital bonds issued by the financials). However I missed the positive effect that massive fiscal and monetary expansion would have on the wider economy and therefore stock market.

The lesson for me is to avoid making predictions about stock markets. I am a fixed income guy. Stick with what you know!

I might have been wiser about the action in the equity markets had I read George Soros’ latest book, “The Crash of 2008” earlier in the crisis. Soros reminds us that social organisations like economies are reflexive. One should closely monitor the second order effects of market prices and actions.

A Soros analysis might be: First Lehman blew, then markets and prices broke down. This engendered massive government support to the economy. This, in turn, enabled credit and securities markets to recover.

The traditional securities pricing paradigm is to analyse the risk (especially the state of the economy) and to position oneself accordingly. The Soros paradigm looks at the two way interaction between finance and the real economy. The real economy can drive securities valuations up or down. But actions in the financial space (especially credit expansion) can also act on valuations of real assets.

Keynes correctly identified the urge of investors to run into cash (waiting for deflation) as their major and malign contribution to slumps. He named this behaviour “liquidity preference”. The past six months has been “liquidity preference in reverse”. Investors were (and to some extent still are) caught up in a sentiment where fear and greed, normally balanced, both urged them (us) onto the short side of the market. Into “safe” cash. We are now being expertly “squeezed” out of our liquidity preference by the major central banks, acting in concert. Keynes would be proud.

Where to from here? While taking care to avoid any predictions about equity markets (!) I remain bullish on credit markets. I continue to think this is a once in a lifetime opportunity to purchase great bonds. Hence I am accelerating the launch of recently re-named Craigmore Investments. This is the right time to launch a yield intermediary. I hope to have it up and trading before Christmas.

Until December!

Warm regards, Forbes.

P.S. A quick comment on Global Warming: I received a lot of reader mail, mostly from farmers in NZ who are apparently, to a man, adamant that Global Warming is a myth. Sadly, dear farming colleagues, (and I wish you were right, I would prefer our planet was safe from harm), I think you are being bamboozled. I have yet to read a book or indeed academic research that in any way re-assures me we are not staring down the barrel of an climate disaster. The most supposedly comforting book I have read on the topic is “Climate of Extremes, Global Warming Science they don’t want you to know” by Patrick Michaels and Robert Balling (from the U.S. Cato Institute). These experts have received significant funds from Exxon Mobil and are well known climate change “deniers”. Despite the implied promise in the title that climate change is not happening the authors’ actual argument is 1) climate change is happening, 2) it is man-made, 3) it will in time melt the ice-caps if left unchecked. Their great insight is that the IPCC was wrong to imply the ice-caps might melt within 200 years – raising sea levels seven metres and flooding 1/5 of humanity. They cite some pretty convincing evidence that they will not melt until a date between 200 and 1,000 years from now. Their main point is therefore not a scientific one, but an ethical one. They contend that fossil fuels are too central to our current way of life for it to be a valid decision to tax carbon usage now, and lower present GDP etc. They argue it would be wiser to keep trucking along as we are and simply use the extra time to adjust our life-styles (to a world without ice caps and a lot more sea). I thought a lot about the supposedly comforting nature of this book (it is well reviewed on Amazon by the denier community). I have now decided the book is, ironically, the strongest argument I have yet read for actually doing something about climate change. A couple of well-fed looking Americans don’t have the right to assert we are OK to destroy the environment on this precious planet. Ever. Not in 50 or 100 years. But also not in 500 years.

I would be interested to hear from any readers who agree with Michaels and Patrick i.e. I’d like to hear your logic/moral argument arguing e.g. that IF we were to accept that we are cooking the planet but it might take longer than some thought, THEN this actually gives us the right to go ahead and leave the gas on.

In case you think this is just hot air about hot air Craigmore Farming Co now has a contract to acquire one property for planting of trees for carbon sequestration, and we bidding on another. I will let you know how these progress. As we get comfortable with these investments (which appear to offer high returns on investment) we may decide to devote some of the capital of Craigmore Finance to investing in them.

By the way if you would like to review and maybe make some suggestions about the new Craigmore Fianance organisation do let me know. I will send you a draft business plan. I would be grateful to discuss.