Hold gold and Treasuries and prepare for inflation, says Troy Asset Management’s Sebastian Lyon.
MoneyWeek launched 15 years ago. Several other interesting businesses launched around the same time, two of which, Troy Asset Management and Capital Economics, I have been watching closely ever since. I don’t know if either of them noticed us at the time. But we noticed them for the simple reason that they both seemed to be thinking businesses which were reaching similar conclusions to ours.
If I ever wanted confirmation in the 2000-2007 period that worrying about the fast-growing credit bubble wasn’t stupid, I only needed to turn to one of Troy’s investment reports. And if I ever felt as if I was the only housing bear in the UK, Capital Economics was always there with the stats to make it better.
In the last two weeks I’ve been over to interview the founders of both of these (now stunningly successful) firms. You’ll be able to see videos of both on the MoneyWeek website, and I’ll tell you about my talk with Capital’s Roger Bootle next week.
Having a good crisis
First, Sebastian Lyon, the founder of Troy. We meet in Edinburgh – he often passes through as Personal Assets Trust, the popular investment trust Troy manages, is based there. We start with the funds’ performance. Personal Assets Trust (LSE: PNL) and the Trojan fund (Troy’s flagship) are run along roughly the same lines, although Lyon didn’t take over management of PAT until 2009.
Trojan had a good crisis (Lyon knew something was coming and so was heavily invested in bonds over equities), and both funds had a good recovery: Lyon piled into high-quality cash-generative businesses such as Nestlé, Coca-Cola and Colgate Palmolive at exceptionally low prices in late 2009.
This boosted performance throughout 2010-2012, but since 2013 the funds have languished. We don’t necessarily mind this: PAT is designed to protect capital all the time, not to shoot the lights out in bull markets – that’s why we hold it in the MoneyWeek investment trust portfolio. But nonetheless I have to ask why.
The damage, says Lyon, was done in the 15 months from the fourth quarter of 2012 to the end of 2013. That was partly down to the fact that the high-quality stocks were “pretty fully valued” already; partly down to Lyon’s refusal to hold “pretty much on principle” the stocks that outperformed hugely after European Central Bank head Mario Draghi’s “whatever it takes” speech (housebuilders, banks etc); and partly down to Lyon’s fondness for gold, which had a nasty correction in 2013, falling from $1,900 an ounce to more like $1,200, from where it has barely budged since.
Hang on to gold
Has he lost his faith in gold? He has not. None has been sold and the metal still makes up 8%-9% of the portfolio. That might seem like a lot, but Lyon (like us) holds it as insurance against future nasties – and “when you’ve got an insurance policy you need it big enough to pay out”. It is also worth noting that holding gold doesn’t come with the opportunity cost it used to. Not that long ago you could hold cash instead of gold and earn interest on it. “You can’t do that any more.” Instead, in some places (Denmark, Switzerland) it actually costs you to hold money in the bank.
Is that sustainable, I ask (this is a question to which I know the answer is no, but still…). It is not, says Lyon. We have entered “an era within finance where monetary policy has become totally unhinged and unanchored”.
There used to be an expectation that interest rates would normalise, but that just isn’t happening. “If anything, over the last six months or so we’ve gone further into unorthodox monetary policy. It isn’t just in Japan and Europe, but countries that had more normal rates – Australia, Canada, Sweden – are cutting rates as their economies are deteriorating.”
Overall, there have been 569 interest-rate cuts from central banks since Lehman Brothers was declared bankrupt. In this world of “greater unorthodoxy… there’s a greater need” for the protection that gold brings.
So how is the portfolio positioned now? It certainly isn’t heavily invested in bonds. There has been talk of a bond bubble for many years, but, says Lyon, we are now “unambiguously in a bond bubble” in the markets in Europe that are offering negative yields. The only way to make money on these is to sell them on to greater fools: it is “pure speculation” and unhealthy for markets.
Lyon has also reduced the equity exposure in the funds. Stockmarkets are not unambiguously expensive, but it is “harder to find cheap good-quality stocks than it was in 2009 and 2010”. The good-quality defensive stocks that Troy likes so much are being bought up by a new group of investors – “cautious savers and fixed-income investors who have been herded into dividend-paying stocks because of a scarcity of income from traditional ‘risk-free’ assets”.
This lot are a problem. Not only have they driven prices up, but they aren’t in it for the long term. They are “handcuffed volunteers” in the market, says Lyon. Think of them as “bridge players nervously trying their hand at poker”. As and when “cash and bonds offer reasonable returns again, these fairweather marginal buyers” will be out as fast as they can, despite the fact that the cash flows from these businesses are not only bond-like, “but should grow in real terms” over time.
We’re not playing bubbles
Where is the cash raised going? Into Treasury Bills (very short-term, highly-liquid government bonds) with a view to investing “at better levels sometime in the future”. How soon, I wonder, is that “sometime”? “My instinct is that we are building up a head of steam,” says Lyon. Look, for example, at the payout ratios in the UK market (the percentage of profits paid out as dividends). They’ve gone up from about 35% to 65% in the last few years.
There is “only so far” that can go, so you’re not going to see huge dividend growth from here – there is also a risk that the current level of dividends “will not ultimately be sustainable”: note that, banks aside, we have seen cuts from BP, Centrica and Tesco since the crisis.
Add that to the fact that we haven’t seen much earnings growth recently, and that the push into equities has, as a result, meant huge price/earnings multiple expansion (ie, stocks have got a lot more expensive) and there is reason to worry.
None of this means a crash is imminent – from the end of late 1996 to the end of 1999, we saw “huge p/e multiple expansion in a period when profits actually weren’t very strong… we know it can carry on.” So the wait for a time when we can buy cheap stocks again could be a long one? “Yes, absolutely, but we’re not going to start playing bubbles,” says Lyon.
That said, he isn’t going to cut his equity allocation “particularly aggressively from here” either: he has shifted as far as he can to “relatively better value and better yields” and that’s enough. Hold good consumer staples firms and, “while there will be bumps in the road in terms of share-price volatility, the cash flows should grow”.
Companies with strong brands, high market share, and above-average profit margins “will be able to raise prices” and over time “grow into their rich ratings” over the medium term. Now it’s just a matter of waiting.
The inevitable return of inflation
Finally I ask about inflation. PAT has long held index-linked bonds: is he still expecting today’s disinflation to turn into proper inflation? He is. Global debt has increased hugely in the last five years. That’s a “leaden weight” holding back investment and growth. It has to go.
And the “natural route out” is inflation. In the past, those countries able to printtheir own money have always inflated their way out of debt. In the end, this time won’t be any different – it might take a long time, but it is the only way. But how, I ask, will we get inflation? We’ve printed an awful lot of money so far and created nothing but a few asset bubbles. What’s going to change?
Governments will recognise that QE hasn’t worked. Then they “will have to take more direct action”, perhaps piling printed money into infrastructure, for example. That would take the cash not into the markets, but straight into the pockets of consumers and companies, something that really would cause people, quite rightly, to worry about inflation. “That will be very difficult for markets…equities will struggle but index-linked securities will do very well.”
We leave it there. But you get the point. PAT remains exactly what we want it to be – a trust that aims to preserve our wealth for the long term, regardless of the monetary and fiscal shenanigans going on in the markets around it.
It might not have the greatest of short-term records, but I suspect that won’t be the case when we look back in another five years. I also suspect that when we next review our investment trust portfolio (all the funds in which I hold myself) PAT will be staying in.
Who is Sebastian Lyon?
After graduating from Southampton University in 1989 with a degree in politics and international relations, Sebastian Lyon joined Singer & Friedlander Investment Management. In 1995, he moved to Stanhope Investment Management, which managed the pension fund of engineering conglomerate GEC, and became joint manager of their £2bn equity portfolio.
Lyon left Stanhope in 2000 to set up his own firm, Troy Asset Management, which started life as the family office for Lord Weinstock, the former chairman of GEC (a family office is a company that manages investments for a single family).
In 2001, the firm launched the Trojan fund for external investors. Since its inception, Trojan has returned over 180%, compared with around 108% for the FTSE 100, while the size of the fund has grown more than tenfold in the past seven years, from £182m in 2008 to £2.5bn today.
Apart from the Personal Asset Trust, which has around £600m in assets, Troy also manages four other funds, including the £2.1bn Trojan Income Fund. The firm is known for its conservative approach, which focuses as much on capital protection as growth.