Wednesday, August 25, 2010

How would the investment world look like with a stagnating economy?

Here is a ‘what-if’ scenario that seems to become increasingly relevant. With spending by Baby-boomers on hold and increased savings levels, a world of excess cash, reduced corporate leverage and less consumer debt seems to become reality.

Economic growth is often linked to increased residential construction and sales. The U.S. is far from that situation and some predict that foreclosures will probably not peak until 2013 - reasons to forecast muted economic growth.

Corporations like Apple, Microsoft, Brookfield, Exxon-Mobil and many others sit on huge piles of cash and short term treasuries in the U.S. are in such a demand that interest rates are virtually zero. Banks and mortgage lenders appear to be the major beneficiaries because the spread between their lending capital costs (often borrowed or from deposits and short term funds) and the rate on consumer loans and mortgages is horrendous. Also, because not all loans that were written down in the 2008 down turn were bad, many of them are upgraded and added to the banks' corporate profits. Insurance companies are often dependant on good stock market returns (think Berkshire Hathaway or closer to home, Manulife) and will likely be less prosperous.

So where do we find the returns if these muted economics prevail? Many investors would turn to emerging markets such as China’s and those of other BRIC countries. Yes Chinese and Indian economies will likely grow faster than those of the West and their demands for commodities will be steadily increasing as well. But just like with growth companies, the stocks in these markets are highly priced (because of these well known high growth expectations – it is already build into the market) and so profits will be limited not to speak of other investment risk such as poor disclosure as well as different business and accounting standards, etc.

Dividend paying companies provide attractive yields, but are these yields sustainable? Especially when it seems that every other investor is chasing those deals. Strangely enough, “investors” still act very irrational. Risky companies such as Apple depending on one or a few persons, or depending on ‘being in fashion’ still attract the highest prices. In market value, Apple equals Microsoft. However, Microsoft makes twice the profits, buys back shares and has an enormous stash of cash. In fact on an after cash basis, Microsoft’s P/E is around 8 or 9. It has a dividend yield of 2.2% which it can increase without sweat.

People focus on consumer items such as i-phones, but do not look at who dominates the corporate high tech world. New releases of Windows and Microsoft Office are likely to bring in oodles of additional cash. The successful presence of Microsoft in the gaming world (Xbox) and the inroads Microsoft makes in the search engine markets against Google are ignored.

Similar are investments in oil companies many of which are in enviable positions. Companies like Canadian Natural Resources who just started their Horizon Heavy Oil mine and with SAGD projects that produce enormous amounts of oil and... cash. The company is repaying its debt at a very impressive rate while it does acquisitions that it considers ‘play money’ barely worth a press release. Exxon Mobil has been dragged down with the BP debacle but it is well managed, diversified, extremely profitable and pays an excellent dividend (nearly 3%). These companies don’t get the respect they deserve and their prices are cheap. You may need a while for markets to recognize the true value of these companies because they are ‘out-of-fashion’ but there is a lot of downside protection and some cash flow.

Interest rates would likely remain low in a stagnating economy, but yields on short corporate bonds are better than on short term treasuries. It is hard for individual investors to buy bonds and often they have a big fat commission build-in the price offered by the brokerage houses – an area that definitely requires more transparency. But investing in short term corporate bond indexes using ETFs such as offered by I-Shares or Barclays or Vanguard should be considered. You can buy 5 year laddered corporate bond funds as well. Just make sure that the commissions and MERs you pay are low. A 1.5% or higher commission on the purchase and again on the sale via a full-service brokerage does not cut it. Commissions under $10.00 when using discount brokerages, does make these investments attractive. In fact because of the liquidity of these investments augmented by the low commissions they form a good alternative to money market funds.

Another source of income to consider is MICs (Mortgage Investment Corporation) – where you become part of a pool of investment money lend out as mortgages. Not all MICs are created equal so do your research and again ensure transparency. A conservatively managed MIC should yield, even in this low interest rate environment, 8 to 9 percent.

Real Estate markets are offering increasingly better value especially when focussing on cash flow. In moderately priced markets such as Calgary or markets that have high rental rates compared to value as occur in many places in Eastern Canada, low leverage investments offer decent cash-on-cash returns especially when you include the ‘mortgage pay-down’ (see earlier posts). Appreciation of real estate may be muted in a stagnating economy so overall ROI would likely be modest. However, with more stringent CMHC rules to combat speculation and cautious banks, home ownership may become increasingly difficult which bodes well for rental demand.

Cash, capital preservation and cash flow will be even more important than under normal economic growth and the ROI expectations should be scaled back. Focus only on high-quality investments that can be bought for a cheap or reasonable price.

Since a stagnating economy is only one investment scenario, don’t lose sight of other scenarios. A double-dip and a moderate growth scenario look currently likely as well. So also ensure you are set up for some growth. In other words don’t abandon the stock market and don’t eliminate leverage completely - stay diversified and don’t stuff it all in your mattress.

3 comments:

  1. well written post, Godfried !!

    Enlighten us why you

    A) think that MICs can still yield a "safe"
    8-9% !! Don't they do that with
    a) high risk assets, or
    b) 2nd mortgages, or
    c) construction loans ?

    B) what an "ideal" leverage is in this new,
    slow growth world ??


    --------------------
    Yours Sincerely,

    Thomas Beyer, Diamond REIN member and also
    President, Prestigious Properties Group
    T: 403-678-3330 E: tbeyer@prestprop.com

    Don't wait to invest in real estate - Invest in real estate and wait ! ™

    www.prestprop.com

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  2. I can see that you are an expert at your field! I am launching a
    website soon, and your information will be very useful for me..
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  3. Hi Alpha,

    Thanks for your comment. Although I think quite a bit about investing, I am not an 'Expert'. I am just opiniated.

    Having said that, with my personal experience from years of investing, I feel that through this blog I may help others on their way to become succesfull investors as well

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