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Cash is king

2708_cash is king

Cash is king

As you already know, Magellan Financial Group are approached regularly by smaller equity managers seeking an investment. To date, Magellan have only invested in one manager – Montgomery – and Magellan remain the only external investor in our company.

One reason for the relationship is that we share a number of common bonds. And a very long-term perspective and the preservation of our investors’ wealth are right at the top of the list.

In my video last week (Crushed by Cash), I discussed our thesis that the market could grind higher, thus fuelling an asset bubble; while interest rates in the US and Australia remain low. I also note that the rational pricing of risk is not working because low rates are corrupting everyone’s view of risk.

Even though low rates, yield-chasing baby boomers and large amounts of cash should spur further stock market gains, investors are right to dance – while the band is playing – close to the door. There’ll be no cabs to take you home safely if you wait until the music stops! The slow-moving train wreck we can see will cause untold pain for many investors.

As I mentioned in the video, we are actively seeking great opportunities but we note that our process is continuing to suggest and produce high levels of cash. In The Montgomery Fund, 24 per cent of the portfolio is held in cash, and in The Montgomery [Private] Fund, 35 per cent of the portfolio is invested in the safety of cash.

To be clear, we don’t like cash – our preference is outstanding businesses generating high returns on incremental equity. Cash is generating a negative real return and it produces an anchor-like effect on our returns if the market does indeed continue to grind higher.

Nevertheless, we believe that it’s worth considering whether the gains made from this point on are ultimately wiped out when the music stops. And this was the question that my friend Hamish Douglass asked over at Magellan in last week’s Global Equities Update.

Here’s an excerpt:

“In the last week, we have increased the cash weighting in our Global Equity Strategy to approximately 10%. The last time we materially increased our cash weighting in the Strategy was at the commencement of the European sovereign debt crisis in early 2010. We are lifting our cash weighting to increase the defensiveness of our portfolio in response to the massive compression in risk premia across multiple asset classes over the last 18 months. We believe there is an elevated probability that this risk compression will unwind over the next 12 months or so as the US Federal Reserve ends Quantitative Easing (QE) and investors focus on a normalisation of US interest rates. An unwind of the compression of risk premia combined with rising long-term interest rates could lead to a material correction in credit and equity markets.

While we are not predicting that there will be a market crash, we consider it prudent to be cautious as it is unknown how investors will react when US interest rates start to normalise. There are scenarios where US long-term bond yields do not rise, risk premia do not revert to more normal levels, and markets remain benign or even strong. In such scenarios, our decision to increase our cash weighting will be a drag on short-term performance. In our view it is better to be prudent and cautious, given the current set of facts, than be complacent.”

You can read the full report here


Roger is the Founder and Chief Investment Officer of Montgomery Investment Management. Roger brings more than two decades of investment and financial market experience, knowledge and relationships to bear in his role as Chief Investment Officer. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. Roger,

    Stupid question, but can you please explain (in simple terms) exactly what Hamish is alluding to when he talks about interest rates and the associated double and triple whammys ?

    He seems to be talking about the detrimental effect that possible rising US interest rates would have on their equity markets (flight to yield and safety ?) and possibly a parallel between that and German bunds (as in, being higher rated than PIIGS issued debt and corporate hybrids).

    In other words, there is a “bubble” in that people are seeking yield and doing so over and above other factors (e.g. overpaying for it or paying for bad businesses that give a high (and unsustainable whether high or low) yield and thus not preserving their capital because the underlying business doesn’t grow because (a) it is bad and (b) all or most of the profit is being returned as a dividend.

    When interest rates go up, there is predicted to be a correction in both credit and equity markets because of the market’s appetite for a “safe, yet high yield” (being US Treasuries or German bunds vs equities, PIIGS bonds or corporate hybrids; the latter set being much higher risk).

    Or am I being too simplistic in my understanding ?

    • The doublke whammy is the dual impact on Australian long bond yields when rates rose in the US in 1994. You add the US yield increase to AUuie yields and then there was also a spread increase. The result was that between Feb 94 and December 94 aussie rates on 10 year bonds rose from 6.5% to 10% – a 21% capital loss for bond investors. Th triple whammy describes the potential impact on some EUropean bonds (e.g.. Italy); 1) US yield increase, 2) German Bund/US Bond spread increase, and 3) italian BTP/German bund spread increase.

  2. A little off the beaten track, but iron ore now at a 2 year low along with most mining services companies,Roger you told us this would happen 2 years ago, thanks for being a brilliant observationalist and strategist and allowing your followers and there are many, to be made aware of the ramifications and giving them early notice to adjust their portfolios.

    • We won’t get every call right and I expect we will end up making every mistake there is to make, along the way, but it is nice to receive some recognition for the odd prescient call. Thanks Garry.

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