Dear Reader and Fellow Investors,
Having worked in a private banking environment over the last few years, I have often got frustrated with the greater emphasis on asset allocation rather than security selection.
However, since 2007, when I have been in such a working environment, the overweight cash position with risk asset investments that shifted in early 2009 to the 30/30/30 asset allocation with cash, bonds and equities respectively, we have significantly outperformed any major equity index. We hope to continue this positive start we have enjoyed with our clients over the last three years. Though we cannot guarantee this, we do guarantee that your author will be enjoying/suffering the same ride as you, mirroring all investments that are recommended to clients.
It seems that when macroeconomic conditions are in extreme conditions, asset allocation becomes justifiably important. This is similar to our arguments presented in a previous blog where we suggest asset allocation should become more important as risk assets reach valuations closer to the extremes of being over or under valued relative to “intrinsic value”.
The extreme macroeconomic environment we indicate refers primarily to the strong reduction in private credit growth experienced in developed countries since 2008. Its affect has been subtly dampened by huge government intervention. With recent political talk shifting from who can print the most money to who can cut their budget the fastest – this lack of public credit into the economic system will reveal the cracks of significant under investment, weak credit growth and reduced consumer spending from the private sector. Indeed, such a rapid shift in political sentiment will bring to the fore the systems natural tendency to deflate with the current incentives and conditions in place, which it has been yearning to do for several years now, but governments have done such an admiral job in trying to hold it back.
As a result, we are maintaining the principal concept of the asset allocation presented in this blog over the last few months, thereby holding our anxiety to buy more risk assets. Over the last few days we have increased the cash component further at the cost of reducing our senior high quality paper and sub investment grade bond exposure. We fear future credit risk brings more possibility of capital lose than gain moving forward considering the far too tight spreads present in the market at the moment. A portion of such sales have been invested into equities. As a consequence our asset allocation has shifted slightly to:-
Cash 35%
Bonds 22%
Equities 33%
Alternatives 10%
Yours sincerely,
Alessandro Sajwani
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Hi Alessandro,
ReplyDeleteIt is difficult to commit to either the inflation or deflation camp at the moment. Many believe governments have a tendency to inflate, hence we should consider this scenario as more possible. I just don´t know. Having spent time in Spain, I understand what you mean by the "natural tendency to deflate", prics are really falling. I guess not even a weakening euro can help, as Spain, as an example, would still have to compete with other countries that use the same currency! I guess in a deflation environment being heavy in cash and bonds is good. How do you think equities would react in such a scenario?
charles,
ReplyDeletewhen you have deflation, equities fall, as they did in the 1930s. this is because companies make less profit as prices are falling! cash and bonds have a "fixed income", hence can provide a better relative return. equities provide a varible return, depending on how much profit the underlying companies make.
I agree that it is hard to decide whether inflation or deflation can be a problem. we just have to react to the stats. Uncertainty is huge at the moment, increased by political interference.
Dear Charles,
ReplyDeleteMany thanks for your comment.
I agree with Alpha Fishing that history suggests that equities tend to under perform in a deflationary environment. When I say under perform, I mean relative to their own historic peformance as well as relative to other asset classes during a deflationary period (i.e. cash and bonds).
However, this does not mean one should have zero allocation to equities during a deflationary period.
If one develops a good criteria of value, be it asset backed or estimating the earning power of a company, fantastic opportunities can arise in such a scenario. However, deflation means that a flow of future cash flows will be worth less, as well as hard assets. Hence, one should increase their usual margin of safety in such an environment, to be able to ensure an "asset backed" investment is still such a strategy in the future, even if a prolonged period of deflation were to occur.
With regards to buying companies due to their "earning power", we feel their exist certain companies that due to their market structure and the attributes of the companies product, which have considerable pricing power.
In a deflationary environment, if their pricing was too fall less then their costs due to their pricing power, this would actually still lead to margin expansion, and hence more profits per unit of revenue. The question is, how much would their revenue fall and would it be a permenant reduction?
We are keen buyers of companies that show the above mentioned properties, though many have still not reached the prices we would like to pay to own them.
Let me know if I have been unclear or have any more questions.
Kind regards,
Alex
Dear Charles,
ReplyDeleteMay I add that companies with pricing power are also very useful in an inflationary environment.
To put that statement in a general context, equities, as a real asset, generally do well in a "soft" inflationary environment. Once inflation rates hit above 7%, equities performance starts to weaken. No doubt this can be attributed to costs incresing faster than their own products princing, leading to margin compression and therefore less profit per unit of revenue.
Kind regards,
Alex
There are not many companies like that. But i agree with the approach. as a long term investment approach it makes perfect sense. in the area i am involved in, i get judged in a shorter time period, on a quarter by quarter basis, hence this strategy would only be a small portion of the investment. personally, for my own pension, this is the approach i would take.
ReplyDelete