Merryn Somerset Webb talks to Sebastian Lyon, founder and chief executive of Troy Asset Management and investment advisor for the Personal Assets Trust, about markets, debt – and why monetary policy has become “totally unhinged”.
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Merryn: I’m here today with Sebastian Lyon who is the founder and chief executive of Troy Asset Management and also the investment advisor for the Personal Assets Trust, which is in our investment trust portfolio, and which an awful lot of readers hold in their own portfolios. Now, this has been a trust that we’ve been a great fan of for a long time, but one that hasn’t been a great contributor to the portfolio recently. So the first thing I want to ask you, Sebastian: is this is a trust that is designed to preserve capital over the long term?
Merryn: It’s doing that at the moment, but in the process it’s underperforming quite a lot of the rest of the market.
Sebastian: We’ve had a rather dull time going back to the end of 2012. So having had a very good crisis, we had a good 2007, 2008 and then had a good recovery…
Merryn: Shall we start at the beginning, then? What was that good crisis based on? What were you holding that other people weren’t?
Sebastian: We had reduced our exposure to equities going into the crisis. We didn’t necessarily see the crisis coming, but we saw a crisis coming, not necessarily the one that actually presented itself. We had a lot of fixed interest. This is obviously prior to my investment advice of Personal Assets. This is purely in the Trojan fund.
But we had the fixed interest, we had a lot of overseas currency going into the crisis, which obviously with sterling being particularly weak in 2008 was very helpful, and our equities were very defensive. So that all helped, and actually led to us producing a very, very slightly positive return in 2008, which obviously was particularly unusual being a long only fund, not being able to short.
Merryn: It was unusual at the time.
Sebastian: We shifted our equity allocation more positively towards the equity market in late 2008 after Lehman and early 2009. So we captured quite a lot of that upside, and in particular, as we got into the latter part of 2009, we recognised that while there had been a dash for trash – and the banks, which looked as if they were insolvent, came back from the dead, which we didn’t necessarily capture – there were quality stocks that were left behind –things like Nestle, Coca-Cola, Colgate, Palmolive – and these businesses were actually on the lowest ratings they’d been on pretty much in my career. So there were very, very attractive as very high quality equities, cash generative businesses with good long term dividend track records, exactly the kind of stocks that we want in our portfolio longer term.
So we benefited, I think, particularly during the difficult years of 2010, 2011 and 2012, where there wasn’t normalisation of interest rates, where we had the euro crisis. Those sorts of businesses performed very well within the equity market, and actually, to be fair, have carried on performing OK with the exception of 2013. I think just going back to your point about the recent performance, which is really the last couple of years, I mean, our share price has bobbed along sideways.
Merryn: Sorry, can I interrupt briefly just to ask?
Sebastian: Sure, of course.
Merryn: Because we’ve talked about the Trojan fund and now we’re talking about Personal Assets, but effectively they’re run in roughly the same way.
Sebastian: Yes, and returns are very, very similar. Last year, I think, the total return of Personal Assets was 10%, and the Trojan fund was 9%, so they’re very similarly matched.
Merryn: The Trojan fund, just for watchers who don’t know, is the flagship fund of Troy Asset Management.
Sebastian: Of Troy, yes. Yes, it’s the open-ended fund which I’ve been managing since 2001. That’s our long-term track record. One of the things I was going to say was that since our share price, our performance, has been dull effectively since the beginning of 2013, for the last couple of years or so, at least we haven’t had the problem which a lot of investment trust shareholders have of when there is a lull in performance, discounts start widening out.
One of the things, which I know you’re very familiar, with is that we have a discount control mechanism so that if shareholders want to realise their investment, they can do it within 1% or 2% of the NAV. We haven’t gone to a discount which is a small comfort, but nevertheless, a comfort.
Merryn: Have you had to buy back a lot of shares?
Sebastian: No, we haven’t. No, not really. We bought back a few shares probably – I’m trying to think of the exact amount – but really it was a few percent. In the latter part of 2013, when markets were really, really strong and when our performance was particularly marked in terms of what we were doing compared to other people, that was when did a little bit of buyback. We did a few buybacks between October 2013 up until February 2014, and actually since then, we’ve just been issuing shares a little bit again.
So, no, not really, which I think tells you that, as you said at the beginning, our shareholders know what we’re trying to do.
Merryn: Yes, you have a very loyal shareholder base.
Merryn: Yes. Let’s just go back to this underperformance – sorry to have to say that word – over the last couple of years. That has been based on what?
Sebastian: That has been based on a period for about 15 months from the fourth quarter of 2012 to the end of 2013. Actually, last year, the markets were flat and we were up 9% or 10%, so last year was sort of OK, but effectively we were getting back what we’d lost in 2013. The damage was done essentially in those five quarters, and really it was a few factors. Firstly, our defensive higher quality shares, like the ones I mentioned earlier, really didn’t do very much.
“I haven’t owned a housebuilder or a retail bank for 13 or 14 years. There are some parts of the market which I just won’t go to”
Merryn: They’re very expensive by now.
Sebastian: Yes, exactly. They were pretty fully valued by then. But also there was a feeling at that time particularly when Mario Draghi stood up and said, “I’ll do everything it takes to save the euro”, I think there was a feeling of huge relief, normalization you know; the crisis was over, not just the financial crisis but the European crisis, and particularly cyclical stocks, housebuilders, banks, etc, did very, very well during that period. These are companies which we don’t hold pretty much on principle; we don’t hold those, we don’t play the cycle from that perspective. We like to buy and hold.
Merryn: OK, so on principle, no cyclical stocks.
Sebastian: Yes, not really, not very capital intensive. I haven’t owned a housebuilder or a retail bank for 13, 14 years, so, no. There are some parts of the market which I just won’t go to. I can assure you that not owning a retail bank in 2008 was a very good thing, so there are parts of the market that we don’t own.
On a relative basis, some of our stocks were very dull. But the most important thing and the biggest contributor, and the one that you’ll be most familiar with, Merryn, is of course gold which we’ve owned since 2005, which has been very helpful as a diversifier. Gold obviously had a very big correction in 2013 falling from, I think, $1,900 to pretty much $1,200 where it pretty much is today. That lost us quite a bit of capital in the short term.
Merryn: How much of the portfolio was in gold then?
Sebastian: At the peak, perhaps, the portfolio was about 14% in gold. Today it’s about 10% or 11%, so we haven’t actually sold any. But clearly it was a pretty uncomfortable experience and that was really one of the things that did the damage, along with gold miners. We’ve always had a relatively modest exposure in gold miners. Our bias has been much more towards bullion, fortunately, and much less towards the miners.
Merryn: And that’s still the case now?
Sebastian: That’s still the case now, very much so. In fact, actually we’ve got less mining exposure now. We’ve only got about 1% mining exposure.
“When it happens, the next crisis will be different. It will be less about credit so much as about money itself”
Merryn: Why is that? Why bullion rather than miners?
Sebastian: The reason why we don’t like the miners – and we’ve always been rather nervous of the miners, we’ve always had a sort of nervous relationship with them – is coming back to the kinds of companies we invest in. The kinds of companies we invest in are essentially companies that pay us to own them. You know, cash generative businesses that pay dividends that buyback their stock, where the valuation is relatively straightforward to calculate where one can look at free cash flow yields.
If you look at a company, for example such as Newmont Mining which we held for a long time with success and latterly less so, which ultimately we sold, the returns on capital over the last five years have been about 2%, and it’s been investing really, really hard. Over 100% of its pre-tax profit has been invested in that business in order to get a return of – more than cash – but very, very little.
Merryn: Almost nothing.
Sebastian: So that’s the reason we’ve always had much more of a bias towards bullion. We like bullion for the reasons which you’ve explained in the past.
Merryn: You and I generally agree on gold, but what are the main reasons why you keep holding this pretty hefty position?
Sebastian: Yes, it is a hefty position. I think when you’ve got an insurance policy, you need it to pay out. There is no point in having 1% of your portfolio in an insurance policy. If things are going to get very difficult, as they did during the crisis, and I think as and when it happens the next crisis will be different. It will be less about credit so much as more about money itself, which we can come onto. But I think that you want to have a meaningful commitment, rather than have none at all. I think that from the point of view of why we still own gold, the first thing is, one of the things that is put up against gold is, “It’s an opportunity cost. You can keep your money in the bank. You can earn interest.” Well, actually, you can’t do that anymore.
Merryn: You can’t.
Sebastian: In fact, it costs you money to keep Swiss francs in the bank, or keep Danish krone in the bank, so that argument has dissipated. I think that clearly what has happened since 2008 is we’ve gone in for an era of – we’ve called it a phoney financial world – but effectively an era within finance where effectively the monetary policy has become totally unhinged and unanchored. Those risks, if anything for me, have been increasing rather than decreasing.
While there was always the expectation of normalisation of interest rates, here we are six years after the crisis, after interest rates were slashed to zero in the UK and in the US and elsewhere, we haven’t had normalisation of interest rates. If anything, interestingly over the last six months or so, we’ve gone further into unorthodox monetary policy, so not just in Japan and in Europe, but you’ve seen countries which had more normal interest rates, Australia for example, Canada, Sweden, actually cutting rates as their economies have deteriorated. So actually we’re heading into a world of greater unorthodoxy, and I think there’s greater need for that protection.
Merryn: When you say that you expect the next crisis to be not about credit but about money, what does that mean?
Sebastian: Essentially, what we’ve had on an ongoing basis since 2008 has been serial debasement. We’ve called it a relay race to debase. There’s always someone who’s got the baton. At the moment, it’s obviously the Europeans and the Japanese. But earlier in the cycle it was much more about the Americans going QEs one, two and three, and the UK obviously much more in the earlier part of the cycle between 2009 and 2012 when effectively the UK banking system was being put on more of an even keel. So the baton has moved on, but it’s still ongoing.
I think that there is a concern particularly if you look at what’s happening in Switzerland where people are actually paying money to have money on deposit in the bank, which is something which is pretty extraordinary. I mean, it has happened once in 1979, but very, very briefly, in Switzerland, but you’ve now got it in Denmark as well. Maybe that will begin to happen in other countries. We will see. So this is unprecedented – it’s a word that has been used far, far too often within this world that we live in…
Merryn: But it is.
“Stock markets are now unambiguously expensive – not as expensive as bond markets are, but it is harder to find cheap, quality good stocks now than it was in 2009 and 2010”
Sebastian: …but it is unprecedented, and where will it end? I can’t see the likelihood of normalisation of interest rates anytime soon. So we’re on this series of debasement and debasement. I think when you can have gold, which historically has been money where it can’t be printed, where supply is actually very tight, then I think to have some sort of protection for insurance within the portfolio is extremely important.
One of the things that concerns me just at the moment is clearly with those interest rate cuts and with what’s happening in Europe is that whereas people had been talking about a bond bubble for many, many years, we are now, I think, unambiguously in a bond bubble in certain markets in Europe, where you’ve got negative yields. You are in a situation where people who are buying five-year bunds or whatever on negative yields are buying it on the basis of a greater fool theory – that they’re going to be able to sell it on.
Merryn: Yes, because there isn’t any other way to make money.
Sebastian: Yes, absolutely. It’s pure speculation. All of these signs, they’re not really signs of health within the system.
Merryn: No, not at all. So recently you’ve cut the equity exposure in the portfolios.
Sebastian: We’ve been reducing the equity exposure, yes, because coming back to your comment about “those stocks are expensive”, we are concerned. Stock markets are now unambiguously expensive, not as expensive as perhaps historically bond markets have been, but it is harder to find cheap quality good stocks than it was in 2009 and 2010. So we have been increasing liquidity.
Merryn: OK, and where does that go?
Sebastian: That goes into T-bills primarily.
Merryn: It goes into T-bills.
“People are handcuffed volunteers in the equity market. If you want a yield, you have to pay up historically high valuations to generate income”
Sebastian: Yes, yes. Obviously temporarily with the idea that we anticipate that we will be able to invest at better levels sometime in the future. It worked very well for us in the mid-2000s, but obviously we’ve had to wait a little bit longer this time.
Merryn: Yes. Do you have any sense of how much longer you might have to wait this time?
Sebastian: My instinct is it is building up ahead of steam. People are effectively handcuffed volunteers within the equity market. If you want a yield, clearly cash is not the answer, clearly bonds are not the answer, so people are finding themselves having to buy and pay up historically high valuations in order to generate income.
What concerns me within, for example, the UK market is payout ratios. Company managements have recognised this; they’ve been rewarded for it. Payout ratios have gone up a lot from about 35% to about 65% in the last few years, so there is only so far that that can go on. So you’re not going to see huge dividend growth from here, and there is risk that those dividends will not ultimately be sustainable.
We’ve seen obviously big dividend cuts during the crisis from the banks, but we subsequently have seen dividend cuts from BP and from Tesco and from Centrica last year as well. We’re starting to see some cuts from larger companies, which I think is a concern. The difference between valuations and earnings growth has not been very robust. So effectively there has been this huge P/E multiple expansion valuation, investors have been prepared to pay a higher and higher percentage of profits.
Now, we know that that can go on. It happened in the late 1990s particularly after the Alan Greenspan’s irrational exuberance speech. From the end of 1996 to the end of 1999, we saw markets just have a huge P/E multiple expansion in a period where profits actually weren’t very strong, so we know it can carry on.
Merryn: So this could be a really long wait.
Sebastian: It could be two or three years, it could. Yes, absolutely. But I think that we’re not going to start playing bubbles, and ultimately you know what the end result is, which is huge capital damage.
Merryn: Yes. In the last Personal Assets Quarterly, Robin wrote that Personal Assets is either like a stopped clock that’s right twice a day, or an amazing lily that blooms twice a decade.
Sebastian: Yes. We’ve bloomed fairly well in 2001, 2002 and we’ve bloomed very nicely in 2007, 2008, 2009.
Merryn: Yes, so we might have another four or five years to wait.
Sebastian: Well, I hope not. That’s twice a decade. Yes, not four or five years, but it was 2008. Yes, you could have another two years of having to be patient, but I think that we are patient. We’ve proven in the past that we’ve defended capital when it’s needed to be defended.
I think that the other point is that we’re not going to decrease our equity allocation particularly aggressively from here because we recognise all the points that you’ve made. We have selectively shifted the equities a little bit. We’ve taken some profits in those very high quality defensives which we referred to earlier, and shifted them, just reduced risk effectively where we saw a greater downside. And occasionally where there were stocks where perhaps they hadn’t performed particularly well, particularly due to the strong dollar, particularly where there was currency translation and the share price had been very dull. Then we’ve been allocating a little bit more capital into that area where we’ve seen relatively better value, at least, and better yields. But I wouldn’t see us decreasing our equity allocation aggressively from here.
Merryn: Also in the portfolio there’s quite a big holding of index-linked gilts.
“We’ve got to find our way out of this debt – it’s incredibly deflationary, and has huge risk implications for the global economy”
Merryn: So long term you’re definitely expecting inflation?
Sebastian: Absolutely. I think that global debt has actually increased quite materially since the crisis. Everybody back in 2010 was talking about deleveraging, and what we’ve seen is quite the opposite of that. There was a McKinsey report out in February talking about deleveraging, no deleveraging yet, and I think the figures were that global debt has increased from something like $142trn to $199trn over that five year period. So we’ve got to find our way out of this debt, because clearly it’s incredibly deflationary and has huge risk implications for the global economy. It’s like a leaden weight keeping growth back, keeping spending back as well, and keeping investment back.
How are we going to get there? How are we going to actually delever? Our view has always been that the natural route out would be higher levels of inflation. Countries that can’t print their own money obviously struggle with that, as we’ve seen with Greece. But in the past, countries that can print their own money have always ultimately inflated their way out. Now, clearly that has taken a long time and continues to take a long time. The sheer weight of that debt has meant that the deflationary forces have been incredibly strong.
Our expectations have change and evolved over the last few years whereby we think that, firstly, bond markets are, as I mentioned earlier, very, very high risk. There was a time when you would have part of your portfolio, a defensive portfolio, in bonds. They were supposedly the risk free parts of your portfolio. Now we view them as very high risk. Index links are more of a hybrid whereby if fixed interest markets perform well then they will perform respectively, which they have done since 2009, not as well as fixed interest but nevertheless, they’ve been OK.
If ultimately interest rates start to rise, and they start to rise because of inflation, albeit we think that that will happen with a lag, then people will pay a premium for that inflationary protection. But having said that, our duration at the moment, so the life of the bonds, is actually relatively short because we actually don’t want to take too much risk from that front. So our duration is around six years which is, on balance, shorter than it has been for a very long time.
“Governments will have to take more direct action. I’m not taking about helicopter money per se, but governments directing money into the economy, into infrastructure”
Merryn: OK, but in an environment like this, how does deflation turn into inflation? We’ve had a lot of money printed, so far it hasn’t created inflation. What’s the transmission mechanism here?
Sebastian: Yes, absolutely. I think that what is going to happen, or what I expect to happen, is that there will be a recognition by governments that actually money printing hasn’t really worked, that QE hasn’t worked in terms of generating inflation.
It worked briefly here in 2011, we got to an RPI level of I think it was 5.6% thanks to the devaluation of sterling in 2008-2009. But obviously, that disappeared as we stopped printing money back then. So my expectation is that there will be a recognition that it hasn’t really worked, and that governments will have to take more direct action. I’m not taking about helicopter money per se, but I’m talking about perhaps governments directing money into the economy, into infrastructure.
Merryn: Directing what money?
Sebastian: Well, quite. Directing printed money, because the problem has been that the printed money hasn’t been spent. The printed money has gone into the financial system and effectively it has gone into assets and it has created asset bubbles. So it hasn’t gone to where ultimately the money was intended to ultimately get to, to consumers and companies etc, to spend money. So I think there will be more direct spending.
Merryn: Print money, actively spend it.
Sebastian: Yes, and more direct spending. Actually, that will be very difficult for markets, because all of a sudden whereas you’ve had a period where printing money has been very benign for markets, suddenly people will start worrying about those bond valuations, they’ll start worrying about higher levels of inflation. I think the next crisis will be more of a deflationary shock, but then after that, we will see rising prices as a way out ultimately of those very high levels of debt which we still continue to experience. That is further down the track. That is probably in four or five years’ time.
Sebastian: Then, your index linked will do very well within that environment, and you certainly don’t want fixed interest. Equities will struggle, I think, within that environment as well to some extent.
Merryn: Thank you very much, Sebastian.