The Case For The Doubters

Those who read the Q and A with Sebastian Lyon of Troy Asset Management last July will be familiar with his conservative, hairshirt style of investing. At recent meetings for investors in his funds, which now include the Personal Assets investment trust, formerly managed by Ian Rushbrook, he updated his views on the market outlook.

These are some of the key points in his presentation:

As a result of the global financial crisis, investors are living in "a phoney world" characterised by zero interest rates and asset prices that are distorted by quantitative easing, among other things;

The consequence is that few investors, even professionals, know what to think. Picking a path through this unprecedented set of conditions is like "being in a dark room looking for a black cat that isn't there";

In Sebastian's view, the secular bear market which began in the year 2000 continues, meaning that the UK stock market is likely to follow a similar parth to that of the Dow Jones index between 1966 and 1982, rising and falling within a trading range (that range, in the case of the FTSE 100 index, being 3500 to 6500);

Most likely that means the equity market will experience one more low before a new secular bull market begins in a few years' time. The trigger for the new setback is likely to be a sustained rise in bond yields;

The current cyclically adjusted equity market p/e ratio, though down from its peak, is still in the top quarter of historical experience and the dividend yield, following ten months of rising markets and many companies announcing dividend cuts, is "nearer poor value than good value";

Given his mandate to preserve the real value of his investors' money, and faced with this unappealing outlook, Sebastian has been buying stocks such as Diageo and Nestle, which have impressive records of growing their dividends (sevenfold in the last 20 years in the case of Nestle);

The companies he is avoiding like the plaque are those such as Cookson and British Airways, whose CEO Willie Walsh has to spend his time firefighting successive crises rather than planning for the future (BA has not paid a dividend since 2001);

Another big holding in both Personal Assets and Troy's flagship fund is gold, something that most investment trusts have never held and many investors hate. Yet gold, which J.P.Morgan described as "money and nothing else", is the ultimate store of value and the only sensible protection against inflation and policy errors in an era of fiscal excess;

Sebastian was keen to point out, finally, that despite the cautious mandate of his funds, he was by no means a "perma-bear", as his successor Ian Rushbrook had never been either. He looks forward to the time (2015?) when the secular bear market has ended, gold is no longer needed in the portfolio and the funds are able to gear up to particpate in the next equity bull market. That time however is not yet here.

Comment: I am a fan of the Troy approach to fund management, not least for its emphasis on low turnover and reraswonable management fees, although I think there is a serious risk that the rebound in the US economy may well surprise this year by being stronger than cautious investors such as Sebastian expect. My own portfolio includes gold and defensive equities for similar reasons to his.

This quotation from Gerald Loeb, author of a classic book on the stock market, with which Sebastian finished his presentation is also very apt: “Profits can be made safely only when the opportunity is available and not just because they happen to be desired or needed...Willingness and ability to hold funds uninvested while awaiting real opportunities is a key to success in the battle for investment survival”. In other words, there is nothing wrong with staying in cash when no clear-cut opportunities for stock market profit appear to exist.

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Q and A: Sebastian Lyon

Sebastian Lyon, the CEO of Troy Asset Management, is one of the coming talents in investment management. The firm he runs was recently given the mandate to run the Personal Assets Trust in Edinburgh, following the untimely death of Ian Rushbrook in October last year. Troy Asset Management started life with the task of running the family money of the late Lord Weinstock and other senior managers at GEC, from whom he inherited his conservative investment style and a focus on capital preservation.

Troy, which is named after Lord Weinstock’s famous racehorse, now runs three low cost unit trusts on an absolute return basis. The funds are aimed at investors whose primary objective is to preserve capital. This is something that the Trojan fund successfully achieved throughout the sharp bear markets of 2000-03 and 2007-09. Sebastian is one of a number of top-flight professional investors who offer me periodic snapshots on their view of the markets, and whose low cost funds I am happy to own and recommend.

Where are we now in the market cycle, in your view?

We have been in a secular bear market for equities since 2000. This is a long process of valuations being derated. That has been my view since the Trojan Fund was launched in 2001.  The bear market is likely to last 10 to 14 years.  Having had two down phases (2000-2003, the tech bust and 2007-2009, the credit bust), we are now well into the second half of that bear market, in my view. Having been very cautious, we can begin to be a little more optimistic on equity markets. There is a clear correlation between starting valuations and 10-year equity market performance.

The UK stock market, for example, has derated from a PE of 24x in 2000 to a PE of around 10 today.  Bear markets usually bottom on single figure PEs, so arguably there is one further derating to go before we can celebrate an enduring new bull market.  Now that the S&P and the FTSE have bounced off the 2002/3 lows in 2009, markets may have bottomed in nominal terms, but not when inflation is taken into account.

In a bear market equity income is the key to equity returns as it is clear that PE multiple expansion is not likely.  We have therefore concentrated on stocks that pay a high and sustainable income.  This served us in good stead during the credit crisis when financials, cyclicals and highly leveraged businesses have all been forced to cut their dividends. Investors in these sectors suffered permanent capital loss and the added insult, in many cases, of huge dilution as balance sheets have had to be repaired.

What have you been buying recently and why?

Nestlé: Over the past five years dividend growth has been 14%. The valuation (11 x earnings) is the lowest I have seen it in my career, so what you get is a top quality consumer staple at a very attractive entry point. The firm is globally diversified, operates in 130 countries, and has a highly conservative balance sheet (interest cover of 16x). The company is a proven innovator and has better top line growth than its peers over the past 10 years. Yet it is valued at no premium to them.  Should inflation return, fast moving consumer goods companies will be in a good position to pass on rising input prices.

BATs. Over the past five years dividend growth has been 16%.  The tobacco company offers material international diversification for a UK investor since its sterling earnings are minimal.  We believe the UK economy with struggle to grow for a number of years and quality defensive international exposure is underrated by investors. Such predictable cash generators are often ignored or seen as dull by the consensus.

Berkshire Hathaway. We have avoided financials stocks such as banks and life companies because of the opacity of their structure and exposure to bad debts/illiquid unmarketable securities. Berkshire Hathaway has not performed well this year. Strong balance sheets are not in favour for now. Pricing power in insurance and reinsurance remains very strong however. Berkshire’s other direct corporate investments are valued conservatively at book value.  It seems we are paying little if any premium for Mr Buffett’s investment abilities. We know investors go through periods of according different degrees of goodwill to Berkshire. At present we have a good margin of safety, with some healthy upside on a two to three year view.

Gold: In a world of currency compromise gold will retain its real value and protect real wealth for private investors. Still viewed with skepticism by mainstream investors, gold has risen in value every year this decade.  Although we have a small exposure to gold miners, we prefer holding bullion as miners are notorious in failing to create long term value for investors. The volatility of mining stocks is also much higher.  Gold is independent from the world financial system and supply is limited, not something that can be said about sterling and the dollar!  I view our gold holdings as being in lieu of holding cash.

What are you avoiding and why?

We do not own cyclical recovery stocks and financials for the reasons given above.  Banks will require more capital and the overhang created by the UK ‘nationalised’ banks (Royal Bank of Scotland, Lloyds Banking Group etc) has still to be unwound.  A number of UK domestic sectors, such as pub stocks and airlines, have been recapitalized, but I believe they have not yet raised enough money. Debt levels are far too high.

I am wary of corporate bonds. There is a consensus rush into corporate paper which makes me nervous. We need to be in real assets - equities, index linked and gold.  Bond spreads may look mouth- watering, but liquidity is very poor in the UK corporate bond market.  My concern is that lessons have not been learned from the dash for yield that occurred in 2004-07.  The truth is that were it not for quantitative easing (QE), government bond yields would be higher and corporate bond spreads consequently lower.

Any further thoughts on the markets?

Investors are more short term minded than they ever were. They are not, in my view thinking forward to the unintended consequences of fiscal and monetary policy. I think and hope that following the severe losses incurred in 2008, the obsession with relative performance in investment may now be seen for what it is – an absurd and imprudent way to manage private wealth. What is suitable for pension funds is not suitable for irreplaceable capital, whether that capital has been earned or inherited. There may still be one final lesson to be learned before we can say goodbye to this problem.

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