Sebastian Lyon: the benefits of being boring

Merryn talks to Sebastian Lyon, founder and CEO of Troy Asset Management and manager of Personal Assets Trust, on his “boring” approach to asset management. Plus, why ESG investing is not necessarily “ethical” investing; inflation and financial repression; and the point of owning gold.

By MoneyWeek

Published 3 September 2021 In Features

Transcript

Merryn Somerset Webb: Hello and welcome to the MoneyWeek magazine podcast. I am Merryn Somerset Webb, editor-in-chief of the magazine. And with me today, I have yet another special treat. Will the special treats never end? We have with us today Sebastian Lyon, who is the founder and CEO of Troy Asset Management and also the fund manager of Personal Assets Trust, which I know that a lot of you will own. In fact, I think at this point, that the vast majority…

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Merryn: Let's start by talking in general terms about your approach to asset management, because it's not just personal assets, of course. Troy has piles of funds and you’re still the lead manager on your original fund, the Trojan Fund, which many readers may also hold on, possibly, if they have their money with a wealth manager. It'll be Trojan that is held for them [?], rather than personal assets. Who knows? But my guess is…

Sebastian: Charley Ellis, who is an American investor, came up with this idea, which I love, which I think is right. And I think it's right for… Look, there are some people who want different things from investment. But I think there are a lot of people out there who want what I would describe as wealth preservation. Who want to preserve their money in real terms. They want to sleep at night. They do not want the roller-coaster ride which is often given to investors via investing in the equity market.

And when I set up the business and set up the Trojan Fund back in 2001, I was convinced and actually, it was Lord Weinstock convinced me, who gave me the seeding for the fund in the first place. He instilled on me the fact that investors don't necessarily want that up 100, down 50, up 100, down 50. In fact, and funnily enough, what we had last year with the pandemic of a 35% drawdown in the oil share, we were down less than ten during that period.

Which means that, one, our investors are happier and are less stressed. And secondly, the old chestnut of the fact that you actually don't have to take as much risk or have to make as much money back if you don't lose that amount of money. If you're down 50, you know as well as I do, you've got to get 100 to get back to square one. Whereas if you're down ten, you’ve just got to get that 11 back. And it's a lot easier. And we recover much more [overtalking].

Sebastian: Yes, possibly. But I think that there are people out there who don't want that very high level of volatility. And I think that as long as you can invest long term, you can invest in a way that generates equity-type returns. Since the Trojan Fund was launched, we're up, I think, 2% per annum ahead of the market. That's slightly flattered by the fact that we launched the fund as we went into that post-2000, -2001, -2002 full bear market, which we protected capital very well.

And then again, we protected capital well during the financial crisis in 2007, 2008. And again, we protected capital well during the pandemic. But I think that people want that reassurance. And if you can invest in good businesses, the problem is there will be times when you are out of flavour, out of tune with the market, because the market will want reflation trades. It will want to be in very heavily cyclical businesses that are bouncing back from very depressed levels.

What Russell Napier describes as the equity slivers. An example of that would have been Lloyds Bank or Barclays Bank after the financial crisis when they went down 95% and then they doubled or trebled from those very, very depressed levels. And you saw that a little bit in the fourth quarter and the first quarter of this year… Fourth quarter of last year. When we have the reopening trade and big reflation trade.

We looked very boring during that period. We don't mind looking boring. That's fine. Boring’s fine. It's just not going down by 50 to 60%. That's not good. But we recognise there are times when we'll be out of tune with the market, but that ultimately, we get upside in consistent type-returns. I think we're up 10% year to date for PAT. In eight months, that's fine. We'll take that. It's a little bit behind the market.

Sebastian: It’s just under 40 at the moment, yes. And generally speaking, it's ranged. We’ve ranged from 75% in equities, right the way down to 30. We do ask to allocate with conviction. I think we've been lower in equities in recent years, Merryn, because we are concerned about valuations. And we see a lot of risks out there. And those risks were, to some extent, exposed by the pandemic. You saw those very, very big hits to equity markets.

The fact of the matter is the economy slowed down, stopped, our markets tanked and profits tanked as a result of that. And if it hadn't been Covid, there may have been something else out there. But the fact of the matter is, is because the valuations were high, markets were vulnerable. And that vulnerability was exposed. And we did then push our foot very firmly on the accelerator and increased our equity allocation in February and March of last year.

We didn't just sit around and do nothing. We actually invested about 20% of our liquidity in both long-dated US TIPS, but also a very material commitment to equities. And actually, more recently, I would say in the last five or six months, we've been taking the foot off the accelerator as markets have become more and more and more complacent. I wouldn't say valiant, quite, but definitely complacent.

Sebastian: Yes, absolutely. Earnings are going to need to… They are coming through, to some extent, with a number of our companies. But for goodness, they're going to need to come through. And there's a lot in the price at the moment. We live in a zero interest rate world. And how long can these things go on for? I think you and I would have been discussing a long time ago the fact that the valuation of stocks became untethered.

And that when a bond yields being this low and staying this low and cash return’s being this low, equity markets are where people go for returns. And this could carry on for a lot longer. But I'm always looking with personal assets in mind from the point of view of protecting downside first rather than maximising upside. Others, and absolutely fair dues to them, they're there to maximise upside. I don't view that as my job. I’m there to protect first and grow second.

Sebastian: I think the first thing is, is that you don't go zero equities. Because exactly that point, you just don't know when this is going to end. We're 12 years into a bull market. And with the fact that there are no returns on effectively fixed income available or cash available, we don't know when that is going to end. And you can justify higher valuations with that lower discount rate. And that's why higher quality businesses that are growing have been rerated.

I think that the first thing to say is that as somebody focussing on the downside, what you don't want to be in is you don't want to be in those very, very highly valued tech names that are on 30, 40, 50 times sales. The Teslas of this world. They’re relying so much on earnings in the future or aren't anything today to get your grips, get your hands around in terms of valuation. What we want to own is businesses that we can see the valuation that are generating cash, that are generating good returns.

But importantly, I think that are getting heavier, are becoming better businesses. I think one of the big mistakes… And then I've learnt this goodness knows how many times. But the big mistakes that investors make are that it's very, very difficult to value businesses where they're going backwards. And people over-extrapolate the bounce-back, the recovery. But if a business is going backwards, as an equity investor…

And particularly as an equity investor where that company has got leverage, then those cash flows available to the equity investor can shrink very, very quickly. And I think many people make that mistake. And what we've done over the last 20 years is we’ve very much focussed on those quality businesses, some of which are quite boring, like the Diageos of this world that generate good, high single-digit-type returns, but that are not going backwards.

And we're not hoping they're going to recover. We're not hoping they're going to be turned around. And I think particularly in the last decade, that's been more important because of technological disruption. There’ve been a lot more businesses going backwards or really struggling to keep their relevance. And the important thing, I think, from a point of view of equity investment, is to avoid those companies that are being disrupted.

Yes, they might look cheap, but they're cheap for a very, very good reason. The reason is, is that the cash flows are going backwards. And I think it's very hard to get that right. And they will have their moments in the sun. They probably had a very good last quarter of last year and first quarter of this year. But we don't want to play that game. That's a trading game. That's not an investment game. In terms of the equity part of the investment, we want businesses that are getting stronger and growing.

And I think that there are pockets of the equity market where we can look at valuations one, two, three years out, certainly two to three years out, and we don't see bubble-type valuations. We're not looking at… It's not Cisco in 2000 when it was on 100 times earnings. It's not Microsoft in 2000 when it was on 175 times earnings. Or Vodafone was on 75 times earnings in the UK market. There are Alphabet, which we own, which we've owned for the last three or four years.

It's on 23 times earnings year and a half out. It’s not scary, that valuation. We can come on to tech and regulation, etc. But I think that there are some companies… That's gone up 50% this year. Its earnings are up 60. It’s actually been derated this year. It's got cheaper this year, despite going up a lot. There are pockets within the equity market that are growing and are growing well and that are not eye-wateringly expensive.

Of course, there are lots of other areas like clean energy and renewables and SPACs and GameStop and a lot of retail-driven stocks that are highly speculative, which we are nowhere near. There's always obviously the very high, high SaaS tech areas where the multiples are measured in revenue multiples rather than in earnings multiples. Again, that's an acquired taste for those who are happy to take that risk and have that risk appetite.

Sebastian: Possibly, but that's an opportunity, really. The tech regulation is the dog that hasn't barked. If we were on this programme three, four years ago, we'd have been talking about tech regulation. And it's much harder to do than I think that it's obviously got to be globally-led. There has been this tax agreement, which, good news. Companies should pay their taxes, as should individuals. But I don't think that's a particular issue.

But my feeling is the opportunities in these businesses are really just beginning to be realised in terms of the network effects. And there are a number of businesses within these large companies which the uniqueness of this is that they're growing at a very good, healthy rate. When we started in the early 90s, a company growing at, I don't know, 15 or 20%, that was a high-growth business back then. Glaxo was growing at HighTeam’s [?] growth rate.

And that was one of the best growth companies in the UK market. Alphabet’s growing at 60% revenues and earnings faster. The opportunities for these businesses are legion. And I think that the regulation, yes, perhaps the regulation is leading to that, leading to that lower valuation. But I think that what that highlights for us is that that gives us an opportunity to buy what is a great business that's actually looking after their shareholders, much better than they have done in the past, actually.

Generating much better returns. Obviously, loss-making cloud business becoming profitable. YouTube really moving from a nascent business to a huge revenue generator. It's not just about search, albeit search is a monopoly, a quasi-monopoly. And clearly, that's generating very healthy returns and growth as well. We just think there are lots of opportunities for these businesses. And the ratings remain attractive.

Sebastian: The other thing is, we do own Microsoft. And I think Microsoft is interesting from the regulatory perspective in that they've been through the regulatory headache. They went through it in the early 2000s and come through the other side. And Microsoft, we feel, is a lot less vulnerable to tech regulation than perhaps Alphabet and Facebook are, because they're the next generation, if you like.

Sebastian: And they were, Visa, we bought in late 2000. And then during the crisis, during Covid, we bought a lot more Visa, because we like payments companies. We've owned American Express for a very long time now, almost a decade. But we like the payments companies. And obviously, clearly, Covid has actually been a very big positive for the card companies and the network companies and the benefits to the network effect.

Sebastian: Anyway. But we invested in Experian and we invested in a little holding in Pernod Ricards, which is coming back to China. It’s a very big beneficiary of China growth. But those were the, I suppose, material changes that we made. And also we added a lot to Alphabet back then as well. And then more recently, we've been just edging towards the door. We bought a company back in 2020 and late 2019 called Agilent, which makes spectrometers and measurements based in Silicon Valley, a scientific measurement equipment.

Merryn: Very quickly back to Pernod, one of the things that's come out of China this week… You say it's a big beneficiary of Chinese growth. But one of the big subtrends coming out of China over the last week or two has been this idea that it's time to start reducing inequality and time to bring in prosperity for all. And we're expecting to see, but we're not quite sure what we're expecting to see. But in some way perhaps we're penalising the well-off. Is that a worry or is that so short term that it's not an issue for a stock like this?

Sebastian: But I think that one of the things that we've… We're global investors very much now. When I first met you back in, I think, 2004, we were very much UK investors with a bit of global. Now we're very much global, a little bit more with a bit of UK, certainly from a multi-asset perspective. And I know you spoke to my colleague, Gabrielle Boyle, a few months ago. And she obviously drives our global equity investing side.

But one of the things we've been reluctant to do so far, and we never rule it out to investing directly in China, for the reasons that you state. And there are times when it looks very wrong and you can be very humiliated. And then all of a sudden, over the last two months, the regulatory pressures are there very immediately with equity valuations plummeting as a result of that valuation. Suddenly, you get a wake-up call and are reminded that this isn't a market in the way that the United States market or the UK market or European markets are.

Sebastian: I think that in terms of the alcohol side, I think what we try and do is we try and separate the ethical fund, which is not an ESG fund. It is an ethical fund that excludes particular sectors of the market which people don't like for ethical reasons. That’s not ESG-related as such. I think ESG is one of those things that clearly is getting a lot of attention at the moment. But it's been around for ages. There’s nothing new about ESG, actually.

I can remember in the late 80s, early 90s, you had asbestos. You didn't invest in asbestos for what would now be called ESG reasons, but they're not called that now. What it was about was about the long-term value of that business and whether something existentially threatened it. We don't think that something is existentially threatening the alcohol business. If people don't want to invest in alcohol, then that's absolutely fine with them.

But I don't think that's necessarily an ESG issue, other than the fact that we want to make sure that the company is behaving. Very importantly, it's a good citizen and is behaving well from that perspective. And we will engage with companies to make sure they are being responsible and being… If the company’s selling alcohol, obviously, then we will engage with them from that point of view and we'll engage them on packaging or the carbon targets or whatever it might be.

But I think you want to be a little bit careful to confuse the ESG with the ethical. And the ESG side, from our perspective, is more about, are these businesses going to be affected by the ethical side? Is it going to be affected by the environmental side? Is it going to be affected by the social side? Particularly, social is very important because an awful lot of these companies are capital-light businesses.

They're low-intensive businesses. They've got intangible assets. Actually, they’re built on brand and reputation. Reputation is absolutely essential. And management's getting this. They're really getting this. I think that governance can destroy businesses very, very quickly. And you haven't realised that the governance is weak until the blow-up happens, whether it be Maxwell or Polly Peck or Enron or WorldCom or even GC [?] for that matter.

Weak governance is something which you need to be on top of. And that's where real value can be destroyed by poor governance. The ESG side is all-encompassing, really, from our perspective. And what we want to do is make sure that the value is going to be there in five, ten, 15 years’ time because investing in equities is all about the future. It's all about that future value. We want to see that future value growing rather than weakened.

And the problem that I have with something like the oil stocks, which they've done very well over the last year or so with the oil price rallying, but over the long term, have been very weak businesses. And I actually made quite a big call back in 2009 and 2010 when I inherited the portfolio of PAT and we sold our BP and our Shell. And it was quite a big move because back then, everyone had BP and Shell in their portfolios.

They were the largest holdings in the UK market. And people said it’s a very big step for you not to own BP and Shell. And I just recognised that the pressures that are there in terms of the fact that these businesses were going to generate probably low returns in the future and they also had to evolve their businesses. The businesses, they weren’t in steady state. They've got to invest very aggressively to diversify the businesses away.

Merryn: But it's interesting, isn't it? Because the way you're talking about ESG, you're talking about is that it's all-encompassing, anyway. It's absolutely not new. And it's not about anything to do with morals or with ethics. It's about managing long-term risk. You didn't sell the oil companies because you're instinctively anti-fossil fuels. You sold the oil companies because you felt they wouldn't provide the portfolio with an appropriate long-term return. It’s completely different.

Sebastian: Look, and we haven't always been right on this. But I think that we'd lived in this very strange world of this untethered, I’d call it this phony financial world, going back to the financial crisis. I was reading a note last night about the really bizarre situation that we're in about monetary policy. The Bank of Japan owns 48% of JGBs. The Bank of England owns now 40% of gilts. And the Fed owns 32% of treasuries.

Forget interest rates. Interest rates are irrelevant. That's where monetary policy has been instigated over the last decade or two decades in the case of the JGBs. But certainly over the last decade or so. And that's really what matters. And people are exercised about interest rates. Interest rates are not going up, not for a long time. And there's a lot of noise, a lot of noise about tapering, a lot of noise about when interest rates are going to normalise.

Sebastian: Financial repression, as Russell Napier wonderfully calls it, is stealing money from old people slowly. And the best way that I can demonstrate it is we had a client update recently with someone who kindly invested in the Trojan Fund back in 2007. And the fund was up about 100% over that period and they're happy clients. But what I thought was particularly interesting when we were reporting is that actually, we also report against market which was up a bit less.

But interestingly, cash returns from 2007 in Sterling was 6%. Not 6% per annum. 6%. That's all you've earned over the last, whatever it is, 13, 14 years. The RPI is up 39% over that period. That is a 24, 25% debasement, devaluation of, as Harold Wilson would have called it, the pound in your pocket, over the last 14 years. We’ve had inflation. Merryn, you’re banging on about inflation, but we're having it. We've had it.

We are having it. There's nothing new about inflation. The real question, and I know you're going to ask me, is how much more are we going to have? And that's the easy question and the very difficult answer. I don't think we're going back to a 1970s, totally, very, very high levels of inflation we saw back then. But I think there is a risk that inflation is more sticky this cycle than the last cycle. We're seeing it at the moment

I think there's a huge amount of noise in the data because of the supply interruptions from Covid and demand interruptions from Covid. I think the numbers at the moment are very, very noisy and I think you've got to be very, very careful about drawing long-term conclusions from short-term data. I think the really interesting thing will be next year and actually probably 2023, as the economy normalises post-Covid.

And then where are we? Where are we with… And wages are the key. Wages are the dog that hasn't bought in terms of inflation. That is the thing that will get inflation up. And so far, wages have been relatively benign over the last two and a half decades, for all the reasons that we know in terms of supply of labour coming from east to west. And I don't know the answer to that question and you don’t and actually, no one does.

But that's the thing that you need to monitor. But I think there is certainly a risk compared to the last decade where monetary policy was very much targeted at resolving the banking issues from post-crisis and getting bank balance sheets in a healthy situation. Now, as we know, monetary policy is spreading and it's more about shifting towards fiscal policy and supporting government actions, whether it be in climate, whether it be on the social side in terms of unemployment.

It's not just about the RPI. That's not just about targeting the RPI. Central bankers, if you like, their remit is spreading and the tentacles are spreading. And that will lead to potentially a risk of inflation. It's not a slam dunk because there are an awful lot of deflationary pressures that are still out there, tech being probably one of the largest ones. I think we do need, as investors, protection from that 24% hit that we’ve had in the past.

And it could be higher over the next decade. And we own index link. We don't own conventional bonds. Conventional bonds, I think, are really for the birds. You're very much picking up pennies in front of the steamroller in terms of if you're buying conventional bonds to make money. They might be a trade, but they're not a long-term investment. We own index links, which at least have our foot in the inflation side and have our foot in the conventional bond side.

They are less correlated with other asset classes. But also, we own gold, as you know. And gold, I think, looks particularly interesting at the moment. Actually, it's been very subdued over the last year. But I think that with equity markets coming [?] very, very strong, I think it's been left behind. And I think that there are always these times, there are these phases where it's dull. But particularly at the moment, I think it's quite interesting.

Sebastian: No. It's done a really, really good job within the portfolio. And it's done that at times when often, the equity market has been weak. Rather than spending huge amounts of money on portfolio protection and derivatives, gold, for a diversifier, has done a really good job for us in terms of diversifying risk and generating returns, when perhaps other parts of the portfolio aren't performing very well. But the thing I would emphasise to MoneyWeek readers is it's not about making money from gold.

It's about, you've got to have that mentality of the fact that you're buying this to protect what you've got rather than as a money-making opportunity. And I think once you've done that, once you understand that, then it will look after you. Sadly, we're not going to a world where, Margaret Thatcher would describe as sound money, where interest rates are going to be above the rate of inflation. Which was the case for the early part of our careers.

Sebastian: That’s not the case. Markets will never fall again. Look, QE will come and go there'll be a lesser or a more extent of it, but it will be there. I think that's the point. It will be a policy that will still be being used for a long time to come. I think I remember the deputy governor of the Bank of England back in 2009 talking about the QE being a temporary emergency phase and it'll be reversed in a year or two’s time.

Sebastian: Bullion or miners? My feeling for this mandate, I prefer bullion because this mandate is about taking low risk and about sleeping at night and about lower volatility. And miners, I've been there, it's very hairy. Also actually, capital allocation within miners has been pretty atrocious over the years. They tend to invest at the top of the cycle and lots of M&A. And then the cycle turns down and the earnings collapse and it's pretty ugly.

What I like though is we hold a company which we've held now since 2017 called Franco-Nevada which is this streaming and royalty business, almost like a fund manager, really. And it provides capital to miners and as a result, gets a stream, gets an upside from those mining operations. And the gold price goes up, they get incrementally more revenue. Slightly, it's more geared to the gold price, but it's not as geared as a miner.

Sebastian: I think as somebody put it, if you want to stay rich, you own gold. And if you want to get rich, you buy crypto. And I would put it, if you want to try to get rich, you buy crypto. Look, crypto’s rocket fuel. Total rocket fuel. The volatility of crypto, of Bitcoin, I think it was 180% annualised volatility over the last decade. That means it can go down by 80% and go up by 150% or something like that in a year. Gold is, I think, 15% annualised volatility.

You can sign up for our brilliant Money Morning daily e-letter, mostly written by John. It's excellent. I think you'll enjoy it. Otherwise, if you enjoyed the podcast, and I can't see why you wouldn't have, please write a review at your podcast provider of choice and do me a favour and make it a good one. Because it’s only with good reviews that I can get brilliant guests such as Sebastian to come on.

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