Yields are almost as low as before. Do you have to take on debt to invest in shares, real estate and other things that can generate a return greater than the cost of repaying the loan? A well-known investor shows how well trading can generate large profits, but has a major drawback.
The UK Wellcome Trust is scheduled for 2020 as it is likely to be the most pandemic charity. He was co-founder of the Coalition for Epidemic Preparedness Renewal in 2017. It is run by an epidemiologist who warned in January that Covid-19 is much worse than everyone thought.
The UK’s largest medical charity fund, with £29 billion, or $39 billion, protected 20% of its shares from derivatives when the market was complacent to consider them risky, outperforming global equities by a wide margin.
It’s not just a question of the right way to enter 2020, although Wellcome, which has a multi-year portfolio of growth stocks, including Alibaba, Tencent and JD.com from China, has also performed very well. It is rather Wellcome’s decision to borrow in 2018 at the then lowest interest rate on 100-year corporate bonds to invest in (mainly) equities.
On the other hand, the stock selection was brilliant. In the year ending September, Wellcome’s equity portfolio returned 11% after inflation in pounds sterling, including dividends, or 16% in dollars, which is the annual yield since 1985 and well above the yield of 12% of global equities in dollars.
Despite all the success Wellcome has had in investing in equities, it would have been better to buy back one’s own debt. An investor with the choice between copying Wellcome’s trading portfolio and buying an A-rated perpetual bond should have bought the bond: This year it achieved a return of more than 30%.
The good thing is we had to recognise this missed opportunity by including an accounting charge of £260 million to indicate that it will now cost more to buy back the debt. In fact, it has cost them a missed opportunity to issue their bonds now at an even lower interest rate than in the past.
Investors who are considering using cheap money to increase their indebtedness should ask themselves whether this will happen again.
Anyone in a position to issue high-quality bonds should consider this, said Nick Moakes, Director of Investment at Wellcome.
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The main argument is that in the long term equities will yield a higher return than the cost of debt. With a yield of 1.4% on Wellcome bonds maturing in 2118, this seems more than plausible – but if this yield falls again, bond sellers will be annoyed that they haven’t waited for even better terms.
The prices of long-term bonds are very sensitive to changes in yields. If the return on the Wellcome bond had gone from 1.4% to 0.4%, the bond would have won 70% – a big missed opportunity. It’s hard to believe that anyone would even want to give the troika a 0.4% loan for a century. But this is the yield on the 100-year Austrian bonds issued in June.
In a sense, a missed opportunity is precisely that which does not affect the underlying logic of trading. The only question is whether the share will continue to exceed the initial value of the bond, which is 2.5% for a Wellcome 100-year coupon. By the time the bond matures, the losses should be recouped in the market as the redemption value is fixed.
Jeremy Farrar of the Wellcome Trust is ahead of the market this year.
Unfortunately, the stock situation is weaker than it was. Well, welcome to the big equator: Over the past year it has performed about the same as the average of the past 35 years. Again, three things have to be combined: Value growth, economic growth and an increase in the share of the economy that accrues to shareholders, measured by profit margins. Unfortunately, the next 3.5 decades will be even more difficult.
It’s hard to imagine that this could happen again, Moakes said.
Valuations are approaching the peaks of air bubbles, making further growth more difficult. Economic growth has slowed since the 1980s and is likely to be hampered by the hangover, business losses and the loss of skilled labour as a result of the pandemic. At the same time, profits are close to the record level, making it difficult to further increase profits.
This year’s worst economy was offset for shareholders by a combination of valuations supported by central bank action and profit margins supported by government spending. Both can take a while, but not forever.
Mr Moakes restructured his portfolio to remove those parts that depend on simply matching the performance of developed equity markets because he believes that they will not be able to deliver 4 percentage points more than the inflation Wellcome needs to maintain its research funding.
If you are considering borrowing to invest and have access to cheap money, a nominal return of 4 to 5% – 2 to 3 percentage points above the inflation target – is still well above the cost of quality debt. But returns are to be expected, very variable and often negative over the years, while interest rates are fixed. This is a safe bet, only for those who think in the long term, i.e. decades, not just years, and who will not be ruined if something goes wrong.
Inventories are increasing as companies lay off millions of employees. WSJ explains why the stock market seems to be disconnected from the economic reality in the United States. Photographic illustration by Carlos Waters / WSJ (originally published on 13 October 2020).
Email James McIntosh at [email protected]
Corrections and additions
Data for the first two charts published in this article by Tuesday 15. December. In an earlier version of this article it was wrongly stated that it ended today. (Established for 16 December)
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