"Investment Advisor's Report
Over the year to 30 April 2011 we held our own in a market environment we distrust. Asset prices are too high, interest rates are too low and at some stage both will have to undergo a major realignment. The trouble is that we have no means of knowing when this will happen. Although everyone accepts the need for reform in the Eurozone, the US remains reluctant to accept that it spends over 60% more than its tax revenue compared to the UK?s ?responsible? 32%. This year the US budget deficit will be $1.4 trillion (10% of GDP) following $1.3 trillion in 2010 and $1.4 trillion in 2009. Standard & Poor?s have downgraded US sovereign debt from ?stable? to ?negative? and we fea r a third round of quantitative easing (QE) later this year or early in
2012. In Britain there is a Faustian pact between the Treasury and the Bank of England whereby the Treasury engages in austerity, withdrawing its fiscal stimulus, while the Bank maintains its monetary stimulus via zero interest rates and (when needed) QE, ensuring that the Treasury turns a blind eye to inflation above the Bank?s target.Two key issues determine the outlook for real returns - debt (sovereign debt in particular) and inflation. Debt restructuring must come, but need not be as sudden and violent as explicit sovereign default. ?Financial repression?, a sort of creeping default which swindles the saver through the maintenance of negative real interest rates, was used after WWII to whittle away war debt; and similar policies are being slipped into place today. The Federal Reserve keeps short-term interest rates at zero while it tries to put a ceiling on long-term rates by buying government bonds with newly printed money. Requirements for banks and insurance companies to retain higher levels of capital and liquidity also fuel demand for government bonds, while exchange controls may provide a ?forced home bias? to such asset purchases. In extremis there is the potential for the introduction of capital controls.
Our capital is irreplaceable and we continue to protect it against inflation via index linked bonds while we work on building a portfolio of long-term equity holdings in market leaders with real pricing power such as British American Tobacco, Coca-Cola, Unilever and Nestle. As frustrated bulls we are excited about the prospect of becoming a stock picking trust once more; but because the purchase price is critical to generating long term returns, we have been patient and have not overpaid for stocks we feel will be available more cheaply later. We say more about our stock selection process in the accompanying Quarterly No. 61, but we like companies with strong balance sheets- preferably with no debt, so they can work for shareholders rather than for their bankers or bondholders. Nothing focuses the mind better than the need to pay dividends; and the longer the track record, the more likely it is ingrained in the culture.Where possible we look at dividend records over decades, not the last few years. All the companies just mentioned actually increased their payouts throughout the crisis and one of the attractions to us of Coca-Cola is its 49 years of uninterrupted growth in its dividend.
We prefer dividends to share buybacks, the timing of which we cannot control but management often misjudges - many share buyback programmes came to a halt in 2008, just as markets plummeted. Nestle was one exception, having returned a third of the company?s market capitalisation over the past five years in both dividends and share buybacks. We avoid companies that grow aggressively by acquisition. It is so often the overpayment for acquisitions, either using equity or debt, that leads to value destruction. More often than not, investors celebrate mergers in haste but repent at leisure.
There has been much talk - particularly by those who have never owned or recommended it - of a possible bubble in gold. With only 0.6% of global financial assets invested in gold compared to 3% in 1980 and with the supply of paper money increasing at an exponential rate we are way off bubble territory. An investor asked me recently, ?What is the difference between gold and tulips?? The relatives of Mr Martin Sulzbacher, a German Jewish banker, who hid a hoard of gold coins in a garden in Hackney before being interned in 1940, could answer this easily. On his release Mr Sulzbacher failed to find the coins but, as was reported last month, they were recently discovered by a local resident and returned to Mr Sulzbacher?s son. No paper money could have preserved wealth better than those coins did over the 70 years since Mr Sulzbacher buried them. Indeed, paper money would scarcely have preserved wealth at all.Worth £100,000 when they were found, they were US $20 gold coins (?double eagles?) and their total face value when issued as currency was $1,640."