Where to park it?
Analysis: Last week saw high-yield bond yields drop below an average of 7% for the first time in six years, according to BofA Merrill Lynch data. On the face of it this is good news: low recent default rates should persuade lenders to dish out more loans to small businesses, while low costs of capital for businesses will encourage hiring and expansion.
The wider problem is that most of the high-yield market’s performance stems from investors needing to find somewhere to park their money while real interest rates are negative. The decision process is therefore not based on sound business fundamentals, but rather on speculative need.
In a blog I wrote in December 2008, I referenced the Dean of Harvard Business School, who said that he would only invest in the US stock market when less than 10% of his graduating class went into investment banking. Over the past few years he will have been avoiding the stock market. In 2008, 45% went into financial services, in 2009 it was 41%, and last year it was 34%. The trend would suggest that things are going in the right direction, and there will be a point where ‘industrial America’ holds greater attraction than ‘financial services America’ for the brightest business minds.
The era of “making money out of money” as Bill Gross calls it isn’t completely over, but as he points out, the scope to do so is diminishing, despite the best efforts of politicians and central bankers the world over to sustain the old system.
“Fifty years ago, the highest paid and most prestigious professions were that of a doctor or a 707 airline pilot who flew the “golden” route from Los Angeles to Honolulu. Today the yellow brick road begins on Wall Street or the City. Aside from supernova innovators such as Steve Jobs or Mark Zuckerberg, the money is made from securitising things instead of booting and rebuilding America.” Gross points out.
Goldman Sachs paid each of its 26,000 employees an average of $370,000 in 2010, nearly ten times the take-home pay of other American workers. Almost a quarter of the 400 wealthiest people on Forbes annual richest list make their money “from money”, whereas only 8% could make that claim in its first issue in 1982, and probably close to 0% when my father graduated from business school in the early 1970s.
Some of the most egregious examples in the Forbes rich list are those of hedge fund and private equity fund managers who routinely extract 2% running per annum (regardless of performance) and 20% carried “performance based” interest. I simply don’t understand the intrigue and excitement associated with these structures for investors, especially when you consider that 80% of active fund managers underperform the market as a whole. Returns on these investments have been boosted by a global asset price boom, which has been fuelled by ever increasing interest rates of a 30 year period.
Rates can’t go any lower, so there has to be a coming tipping point where the real money is to be had from making things that people need. Perhaps the time is now.
In the US the S&P 500 list of companies is currently sitting on a cash pile of $1,081bn, as scaled-back inventories, cost cutting and a nascent economic recovery have buffered reserves significantly. Globally the corporate cash pile is believed to be in excess of $4,000bn. That’s a lot of dough. No wonder the pace at which companies are undertaking share buy-backs is rising. M&A investment bankers are tearing their hair out as they try to push their corporate clients into the next big acquisition, yet the uptake isn’t high as valuations of many businesses still remain questionable.
Gross continues the story: “This metaphorical devil’s bargain has its equivalent in the credit markets these days. Central bankers have lowered the cost of money for 30 years now, legitimately following global disinflationary forces downward, but also validating increased leverage via lower real interest rates. Today’s rock-bottom yields, however, have less to do with disinflation and more to do with providing fuel for an asset-based economy that promotes unsustainable wealth creation and a false confidence in perpetual capital gains. Real 10-year interest rates fell from over 5% in the early 1980s to just under 1% in recent months and have arguably been responsible for 3,000–4,000 Dow points and 2–3% annual appreciation in bonds over those three decades.”
Consequently, where I want to “park it” is in sound operational business that are competitive in selling real products that people need either in domestic or export markets. There are plenty of these businesses around, and it sounds simple enough to judge what these companies look like when you find them. It’s not however, as global competition is making yesterday’s business plan redundant tomorrow in many cases.
Take Cisco systems for example. Cisco has been an unbelievable success story of the new information technology era. On Thursday it announced earnings which beat Wall Street’s revenue and earnings per share estimates for its second quarter with $10.4bn and 37 cents respectively.
The market reaction? 14% knocked off the share price.
Why? Investors seemingly are worried about profit margins. During the quarter gross profit margins fell more than 3%, which would be terrible if your starting point was 10%. In Cisco’s case, however, the 3% erosion takes them to the heroically brilliant level of a mere 62% gross profit margin. The company’s mature switching business, which contributes about 30% of its revenues, is under pricing pressure both from rivals such as HP. Rivals ability to catch-up, or Cisco’s inability to stay ahead has lead to sales of switches falling for three consecutive quarters, while revenues from routers, another “mature” segment of their market, fell 9% versus the previous quarter.
Perhaps an eroded level of competitiveness justifies the 14% drop in Cisco’s shareprice, but in recent times Cisco has generated enough cash to have $40bn sitting on its balance sheet. It has room to manoeuvre!
Consider an innovate company like Cisco as an investment versus bond investments – from high yield debt to government backed bonds. Cisco with its profit margins is relatively inflation proof – as prices rise, it can push up its own prices. Bonds are not. In the UK core inflation is running at 3.7% per annum. A yield of less than 7% on high yield debt is a ‘real’ return of around 3%. That’s a pretty god-awful return given the considerably high risk involved.
At the other end of the supposed risk spectrum are government bonds. As Bill Gross again points out: “Today’s negative real yield on 5-year (Treasury Inflation-Protected Securities) is perhaps reflective of a market that has lost its fundamental anchor. A century long history of average 5-year real yields would point out that bond investors in AAA 5-year sovereign debt have demanded and received a real interest rate return of 1.5% instead of today’s -0.1%. We are being shortchanged, by 160 basis points from the get-go, a “haircut” that is but one of four ways that governments attempt to escape from an over-leveraged national balance sheet.”
Businesses that make real cash from selling real things is where I want to “park it” – anything else is a fools paradise; whether high-yield credit, or secure government bonds. Perhaps as the share prices of these cash generating business move in the opposite direction to those of our financial institutions the Dean of the Harvard Business school will realise his goal of seeing an “industrial minded” MBA class rather than a “finance minded” one.