One other conviction that I have compared to the host of “I don’t know”s I gave in my 2011 year end report is that everybody is chasing yield. In a low interest rate environment, capital is shifting towards securities that can spin off safe income – just imagine if you are a pension fund manager and need a targeted return – formerly you could bank on 30-year treasury bonds giving you a ~6% yield in the first five years of the century, but the zero interest rate policy has pushed down yields to currently 3%. If your mandate is to make 8%, formerly if you had a 50/50 bond/equity allocation you would need to make 6% on the bonds and 10% on the equity. With bond yields presently at 3%, the same allocation forces you to make 13% on equity – a much more difficult task for a fund manager. Suddenly placing bets on that speculative pharmaceutical research firm seems to make financial sense.
How do you make up the yield difference on the fixed income side? By investing in treasury bond-like securities and this means climbing up the risk spectrum – provincial/state debt, municipal debt, corporate debentures, and even preferred shares.
Everybody is chasing yield and prices today reflect this. Just be warned that the markets might face a Europe-type situation where the underlying entity no longer can pay out such cash flows – even when European banks are getting interest-free loans, they are still choosing to put their capital into safer 10-year German bonds at 1.9% compared to Italian debt (7.15% currently). Measuring the ability of corporations and sovereign states to actually pay the income is always a vital calculation. As the cliche goes, it is about return of investment, not return on investment.
This could be an explanation why certain large cap stocks are trading at very low P/E ratios – albeit, it makes no difference (taxation differential between dividends and capital gains notwithstanding) whether a corporation makes a 10% after-tax return and retains it, or gives it out in a dividend. Somebody would look at both companies and likely favour the one actually giving out the dividend. The true answer is whether the company can deploy its retained capital as profitably.
The opportunities presenting themselves currently seem to be very narrow and opportunistic and off the radar. It’s not like buying shares of Starbucks under $10/share back during the economic crisis.