Lethal cocktails rarely end well

When our three daughters were younger, being their best friends was not our first priority.

Our role was to be their parents. Setting boundaries. Teaching right from wrong. Friendship would come later.

We were definitely not the coolest parents. The one and only (underage) teenage party we hosted came with several conditions.

No alcohol. No weed. No diving off the wall into the pool. No couples sneaking off into the park next door.

I must confess, the role of sombre supervisor is no fun.

Watching a bunch of bored teenagers sitting around twiddling their thumbs and counting down the hours, hardly qualified as a party.

Other parents ran party houses. Alcohol. Drugs. Wild antics. Access to bedrooms.

Not that we knew this at the time. Stories were shared many years after the fact.

As a young fellow I know which party would have been my preferred choice.

However, we were no longer 16 year olds.

Life had taught us a few lessons. We were the responsible adults. Other parents had entrusted us with the welfare of their children. It was a responsibility we took very seriously.

When you mix a cocktail of youthful bravado, alcohol, drugs and sex, there’s a few scenarios that come to mind.

One possible outcome is it’s the best party…ever. The one the kids can’t wait to talk about at school. Obviously, this is what everyone expects. Otherwise why attend?

But another is it could go horribly wrong.

Drug overdose. Alcohol poisoning. Sexual assault. Gate crashers. Or, death by accidental drowning (which did happen at a school party a few years earlier).

These grim outcomes are the stuff of nightmares and regrets.

Why did we? Why didn’t they? Where were the parents? We didn’t think?

All the questions in the world AFTER the event, won’t change the outcome. The damage is done. Physically. Mentally. Characteristically.

Thankfully, our days of hosting teenage parties are well behind us.

Memories of being a ‘wet blanket’ came flooding back recently when someone remarked, ‘it must be tiring being so negative all the time? Lighten up. See the bright side. Enjoy the party’.

The response was prompted by my less than positive view on global markets.

Taking on the role of the responsible adult can be lonely. Who wants to be the spoilsport?

Seeing risks when others only see rewards is really boring. And yes, at times, it can be tiring.

People want to be shown a good time. Uplifted. Not discouraged and depressed.

I get that. I really do.

There are times, when even I want to be given a break from me.

Surely there’s something positive about current market conditions? Believe me, I continually search for it.

When you’re 60 you have a slightly different view of the world.

You’re young enough to see life could continue for another two, three or possibly four more decades.

But you’re not young enough to begin rebuilding a capital base.

You weigh up the alternatives.

The potential of higher returns versus the potential for heavy losses.

Does the offer of an extra few percent warrant the possible loss of half or more of your money?

Or to use the party analogy.

Does allowing under-age teenagers the unrestricted freedom to really enjoy themselves outweigh the duty of care you owe to their parents?

My answer to both scenarios is…NO.

Others may choose differently. That’s fine. We all have to live with the consequences of our actions.

The consequence for me has been a capital base that’s made glacial progress. The purchasing value of our portfolio is not — currently— being maintained.

I stress, currently, because that dollar in the bank could — if a significant downturn eventuates — buy two, three or four shares for the price of one today. We’ll see.

Experience has taught me — that on balance — it’s better to err on the side of caution.

The Great Depression and the GFC, the two most severe economic downturns in modern history, were a result of too much debt in the system.

Current debt levels dwarf both those periods. The pile is massive. And unlike 1929 and 2008, it is now a global problem.

Developing (especially, China) and emerging markets have all added to their pre-GFC debt piles.

On the other side of this debt, there are those who’ve lent the money.

And with ultra-low rates, lenders are being forced to lower their standards and increase their risks.

Here’s an extract from the October 2019 IMF Global Financial Stability Report (emphasis is mine):

‘Lower-for-longer yields may prompt institutional investors to seek riskier and more illiquid investments to earn their targeted return. This increased risk-taking may lead to a further build-up of vulnerabilities among investment funds, pension funds, and life insurers, with grim implications for financial stability.Furthermore, institutional investors’ strategies to search for yield may introduce additional risks. Low yields promote an increase in portfolio similarities among investment funds, which may amplify market sell-offs in the event of adverse shocks.’

In order to deliver the rate of return required to keep investors satisfied, institutions are all chasing the same higher returning, lower quality offerings.

The following charts from the IMF report highlight the domino effect of negative rates.

Almost 30% of global bonds (red line referenced to RHS) are now paying NEGATIVE yields.

How can an investment manager make a positive return in this market?

The answer?

Lower your standards and increase your risk.

Look at the increase in the red bar — Not Rated securities — over the past four years. That’s not good.

In case you’re not familiar with the Credit Rating system, this is from Investopedia (emphasis is mine):

‘The bottom tier of investment grade credit ratingsdelivered by Standard and Poor's include:

‘BBB+

‘BBB

‘BB-

‘Companies with these ratings are widely considered to be "speculative grade"and are even more vulnerable to changing economic conditions than the prior [A rated] group.

‘Nevertheless, these companies largely demonstrate the ability to meet their debt payment obligations.’

Bottom tier. Speculative grade. And, that’s just the B’s.

What about the ‘Below B’ and ‘Not Rated’ bonds?

That stuff is junk and it’s being stuffed into portfolios.

The chase for return is reducing credit quality AND increasing exposure to illiquid investments…in the form of ‘Highly leveraged Alternative Investments’.

Any asset with that label should be ringing bells loud enough to be heard across the Pacific.

But, in the search for return, the funds are loading up on this toxic stuff.

While the money-go-round continues, then all is well.

Investors (lenders) receive their promised returns and those looking to withdraw in an orderly fashion are paid out.

But what happens when performance starts to falter and more investors head for the exit?

The plight of investors trapped in illiquid investments has been a topic of discussion in The Gowdie Letter.

In the July 2019 monthly issue, we altered readers to the dilemma UK investors were facing in the Woodford Equity Fund.

…The Financial Times on 2 July 2019…

‘Investors in Neil Woodford’s £3.5bn [AUD$6.3 billion]Equity Income fund will have to wait at least another month to access their money, as Britain’s best-known stockpickerannounced that the fund’s suspension would continue indefinitely.

‘The suspension of Woodford Equity Income four weeks ago sparked the biggest controversy in UK fund management for a decade, with hundreds of thousands of retail investors unable to reclaim their capital from a fund that has since been forced into a fire sale of its assets.’

That was three months ago.

The news has gone from bad to worse.

Here’s the latest headline from the 16 October 2019 edition of The Daily Mail:

The Equity Income Fund won’t be re-opened. It’s going to be wound up.

And, now a second fund faces the same fate.

Here’s an extract from the article (emphasis is mine) …

‘Another fund run by disgraced financier Neil Woodford was suspended today as investors — many of whom used their life savings— rushed to pull outup to £258million in cash. 

‘Link Fund Solutions, which administers the Woodford Income Focus Fund, said the move was made to protect those with cash invested as its value plungedfrom £500million since April. 

‘Hundreds of thousands of investors are already facing huge losses after the investment empire run by disgraced fund manager Woodford crumbled to dust last night as it emerged his flagship £3billion Woodford Equity Income fund will be wound down.

‘And now shares in a second smaller fund — the Woodford Income Focus Fund — have also been suspended from dealing amid a rush to pull out investor money.’

The ‘Income Focus Fund’ (the one that offered a higher return than cash) has had an abrupt change of nature.

Income is no longer the focus.

Investors are now focused on getting their capital (life savings) back.

How much (or how little) they might ultimately be paid out is an unknown.

What was the former investment guru’s big mistake?

According to The Financial Times on 16 October 2019 (emphasis is mine)…

‘…he [Woodford] was later known for a reckless investment style,piling into illiquid and unquoted stocks, which led to the destruction of his clients' savings.”

Woodford’s ‘reckless’ investment style is precisely what the IMF latest warning refers to…

‘Lower-for-longer yields may prompt institutional investors to seek riskier and more illiquid investmentsto earn their targeted return.’

Woodford is not an isolated case. It’s just an early casualty in this lower return, lower quality, higher risk environment. 

Worrying about whether this toxic combination is going to end badly could be a complete waste of energy.

But are you willing to bet your life savings on that being the case? I’m not.

Everyone who invests expects the ‘higher returns party’ to be a good one. Otherwise why do it?

However, the current conditions are a lethal mix.

Excessive debt. Poor credit quality. Historically high PE multiples.

In my mind, this assortment is not all that different to…youth. Alcohol. Drugs. High-powered cars.

In each case, these lethal cocktails have track records in ending (very) badly.

And after your worst fears have been realised, there are all the questions.

Why did we? Why didn’t they? Where were the parents/authorities? We didn’t think?

These are the questions the investors in the Woodford funds are now asking. Too late. Damage is done.

Yes, I’m a party pooper. But that’s ok. I’m patient.

Delayed gratitude has its rewards.

Our adult daughters are our best friends.

And, in due course, I’m firmly convinced our disciplined approach to the responsible management of our capital will also be as rewarding.