IS CASH TRASH?

IS CASH TRASH?

We have an investment environment where investors can get 2-3% for cash and about 2.5% to 4% for term deposits depending upon the term and the particular institution. Now those rates of return are certainly not handsome particularly considering that inflation as measured by the CPI is running at around 3%. If you pay any tax on your interest you are going backwards at least in the shorter term. Even that master blaster of avarice Shylock would baulk at those rates. And given how the world’s central banks have been suppressing interest rates in the greatest monetary experiment in world economic history it may well be that things are not going to change significantly any time soon. Although one never knows of course and when things do change (whether this be in the next 3 months or the next 3 years) it will, as it always does, come out of the blue and take most investors (and some of their financial advisers) by surprise.

We also have a current sharemarket where there are definite longer term risks (see the Goldilocks blog at www.lifestylefstas.com.au) though it doesn’t feel like it with shares gradually ascending. And markets may well continue to rise for some time yet. I struggle to remember the last time there was a meaningful correction. Have negative markets been repealed?

One major consequence of the continued low interest rates has been the continued demand from yield chasing baby boomers for shares that have a reasonable dividend yield. This is on the basis that grossed (for franking credits where relevant) income is higher for most property funds, infrastructure stocks and many listed shares than it is for cash and term deposits. This has pushed up prices to levels where many of these stocks are now selling for prices well in excess of what is a reasonable longer term value as measured by the return on equity valuation methodology (the Warren Buffett methodology to drop a famous name). It is all likely to end in tears again one day but for the time being the sun is shining and the band is hot.

So if one has cash (or shares that are potentially significantly overvalued which could be sold and converted into cash) what does one do in the current investment environment? Does one chase a higher income now (and maybe risk the permanent loss of capital when the music stops) or does one stay in cash and accept the current low returns?

Perhaps the most critical aspect to investments is trying to get the risk return equation right. All investments have some element of risk. Risk is not something to be avoided (that’s impossible) but it should be assessed. The longer term potential return should also be assessed and investments should only be considered where there is a reasonable expectation of getting a sufficient return to justify the risk being taken. So for example the return on cash or a government guaranteed term deposit may appear low but this return is reasonable considering the very low level of risk with this type of investment. And there is a thought. Back in the days of 2009, 2010 and 2011 whether an investment was government guaranteed was a frequent question. Investors really must be comfortable with things again because the question no longer seems to get asked. With shares we need to have the realistic potential of getting a longer term return (from a combination of dividends and capital gains) that is significantly higher than what is available from cash and term deposits. If there is not that expectation then you are taking a risk that is not acceptable and leave yourself open to the risk of poor returns or even capital losses.

To illustrate what is meant by this let us look at the analogy of driving a car through an intersection controlled by traffic lights. Going through on a green light does not guarantee that you will not have an accident. Equally running a red light does not mean that you will necessarily have an accident. However if you consistently run red lights rather than green lights then sooner or later you are likely to have an accident (or multiple accidents).

With shares investing in companies that have the potential for a rate of return that will justify the risk for that particular company is regarded as green lights investing and investing in shares where, if everything goes as expected, you are unlikely to get a sufficient return that justifies the risk or unlikely to get a longer term that is significantly higher than that available from cash and term deposits, is red light investing.

Lets look at an example of red lights investing. APA Group (originally Australian Pipeline Trust) mainly operates natural gas infrastructure and is regarded as a stable well run business. At the right price it would most definitely be an attractive investment. The lack of volatility in the business means that the profit and income distribution forecasts upon which a valuation for APA is based have a relatively high chance of being achieved and that the probability of profit and income distributions being significantly below forecast is low. This stability also means that there is also a relatively low chance that future profits and income distributions will be significantly higher than forecast. The current price is about $7.80 and rising. In 2014 it paid unfranked income distributions totalling $0.36 per unit providing an APA investor with an income of 4.6% which is higher than the income that would be received from cash or term deposits at this time. Forecast concensus income distributions for the 2015, 2016 and 2017 years are $0.37, $0.39 and $0.41 respectively which results in income yields increasing to 4.7%, 5.0% and 5.25% respectively. All good so far. Based upon current concensus forecasts and using the return on equity valuation methodology the current estimated underlying value for APA is $3.48 now rising to $3.75 in 2016. If interest rates remain low it may well be that the price will never go anywhere these valuations. What, however, may happen if term deposit interest rates were to rise to 7%?

In this situation investors may now want an 8% income yield from APA. After all why would investors take a lower yield than that available from term deposits considering that APA stapled securities are a riskier investment than a term deposit. Because likely increases in income and valuation over time are only likely to be modest investors may now only be prepared to pay $4.50 to $5.10 (ie the prices at which they will receive 8% from APA if forecast income distributions are achieved. So if interest rates were to rise it is unlikely that there will be a sufficient increase in the underlying value of the business (given that APA is quite a stable business that is unlikely to produce income distributions significantly higher than forecast) to hold the share price at current levels and there would be a real risk of a significant fall in the price of APA. If the current price of APA was around $3.50 to $4.00 ie close to the underlying value of the business the downside risk from a rise in interest rates would be much more modest.

Now the above is not a pre-ordained outcome. However given how far above underlying value the current APA price is the probabilities of longer term significant capital growth from the current price to compensate for this downside risk are not high. If the potential for longer term capital growth (as opposed to shorter term price fluctuations) is nil or modest at best an investor in APA is potentially risking a loss in capital of 35% ($7.80 down to $5.30) in order to gain an extra 1-2% per annum return as compared with cash or a term deposit. Now man that does not look attractive and is definitely what I regard as a red lights situation. Which means with APA you may or may not get away with it but if you consistently invest in this type of situation you are sooner or later going to get caught big time.

There are many, if not necessarily as extreme, similar risk reward propositions in today’s market. And it’s many of the popular yield stocks (particularly the infrastructure and property funds) that in many cases have a quite poor risk return relationship. Not all shares of course represent a poor risk return proposition. There are quite a few companies which appear potentially overvalued but the overvaluation appears relatively modest. Examples include the banks and Telstra. There are also (although not too many at the moment) companies which do appear to have the realistic potential to produce a return sufficient to justify the risk.

So if you have cash what should you do? If you can find shares that do represent a reasonable risk return proposition you should buy. In the Black Sabbath and Shares blog (go to www.lifestylefstas.com.au) there is a list of stock selection criteria which focuses on long term buying of sound businesses at rational prices. The risk of a market downturn is not a good reason not to buy. And if you cant find enough shares at the moment to buy you should consider holding your funds in cash until such time as opportunities arise which they inevitably do. Yes you may only get 2-3% at the moment. And holding cash in a rising market (when everyone else appears to be buying with their ears pinned back and getting rewarded in the shorter term) is not easy and requires discipline and an understanding of why you are doing it. You will, however, eventually be rewarded for this by significantly reducing the possibility of permanent capital losses and having the cash available for when there are attractive buying opportunities.

With your portfolio (either held directly or through a managed fund where some managers have to or do remain fully invested regardless of whether that appears sensible or not) are you running too many red lights? Do you even know which stocks you own represent red lights and which represent green lights? Some investors may be blissfully unaware of the real risks to their capital that they are currently taking. Lifestyle Financial takes a highly disciplined approach to share investing. I don’t know when the next bear market will be but I do always form a view as to whether a particular stock represents a green light or a red light (or somewhere in between) situation. Unless you are confident that your portfolio is mainly filled with green lights please consider contacting me for a review of your portfolio. Particularly if you want to ensure that you are not exposed to any risks of which you may be unaware. Contact details are available at www.lifestylefstas.com.au.

So cash is not trash. The only other alternative is to invest now and know when to get out before the market turns down again one day. If you want to play that game I suggest that you dance very close to the door. As if that is consistently possible. In the meantime the band plays and the music continues. If or when one day the band you are with starts playing different tunes I will see you on the financial dark side of the moon.

Regards

Curtis