22 October 2009
Dear Fellow Investor
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.
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.
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).
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.
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.
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