The Globe and Mail, Report on Business
Published July 8, 2011

By Tom Bradley

Are you confused? I certainly am. It’s not clear whether investors are on a risk-taking binge, or are battening down the hatches for another market decline.

There is plenty of evidence in support of the risk binge. Technology IPOs are coming out at exotic multiples and moving to huge premiums on opening day. Commodity-based funds and exchange-traded funds are now a staple in many portfolios. And there’s been an enormous thirst for high-yield bonds and aggressive fixed-income products.

On the other side of the divide, there are investors who are totally focused on capital preservation. They want and need balanced returns, but aren’t willing to take on the short-term volatility that goes with it. Indeed, some are frozen by the memory of 2008 and are sitting with bulging savings accounts. Most, however, are either soldiering on with their usual asset mix, but are uncomfortable with it, or are pursuing safety through guaranteed and income-oriented products.

As different as they are, both investor types are prominent features of the current landscape. And importantly, both are taking more risk in hopes of achieving their return objectives, whether they know it or not. That’s because low-risk strategies are yielding next to nothing and valuations on higher-potential assets have moved up.

For the bingers, the increased risk comes from paying a larger-than-normal premium for growth. According to the manager of our Global Equity Fund, Edinburgh Partners Ltd., the growth component of the MSCI World index is trading at a 40-per-cent premium to the value part (a price/earnings multiple of 18.4 versus 13.2). To get back to a more sustainable spread, either growth companies have to grow faster than their long-term average, or value companies slower.

Wild About Growth

I should add that some of my favourite thinkers, including Howard Marks (Oaktree Capital Management), Jeremy Grantham (GMO) and Tim Price (PFP Wealth Management), think the risk-takers have gone wild in pursuit of growth.

For the batten-down-the-hatches types, truly low-risk assets won’t deliver adequate long-term returns – government bonds and GICs provide little income – so they now own more corporate bonds than usual, perhaps even some in the high-yield or junk category. They’re also getting more of their income from preferred shares and dividend-paying common stocks. These strategies are fine, but they will come with more volatility. It’s not a matter of “if” junk bonds and banks stocks will go through a rough patch, but “when.”

In this higher-risk/low-return environment, there are no easy answers for either type of investor. In a recent letter, Howard Marks outlined five unappetizing solutions. Investors can (1) go to cash; (2) ignore low absolute returns and pursue the best relative returns; (3) forget about high valuations and buy for the long term; (4) move up the risk curve and reach for returns that used to be available with greater safety; or (5) concentrate on special niches where value still exists.

Our recommendation to clients is a combination of (1), (4) and (5). We’ve been advising that they hold a cash cushion (5 to 10 per cent or more, depending on the objective), go light on bonds where valuations are poor, and focus on high-quality stocks of all sizes and geographies.

Margin of Safety

Why the cash and quality? Because there are not enough cushions elsewhere, especially if we run into serious economic or credit difficulties. Our most effective crisis-fighting tools – interest rates and government spending – are no longer available to us. There’s no room for rates to go lower and the spender of last resort is close to being tapped out. Similarly, the indebted consumer is running close to the line.

The world economy has leaned heavily on China for growth, but there too the cushion is getting thinner. The government can keep spending for years to come, but the stresses of past stimulus are starting to appear – housing excesses, weak banks and rising inflation.

In a situation like this where we’re working without a net, we’d typically expect some concessions in the form of cheaper valuations. But as noted above, even that “margin of safety” isn’t there.

So without adequate cushions in the system, we need to build some of our own. That will take a different form for each type of investor, but should be done, as always, in the context of a long-term strategy.