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Financial Times - Bond proxies: Can you afford not to own them?

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” Warren Buffett once said.
 
I agree with Mr Buffett’s description of a good company. To quote from his 1979 annual chairman’s letter: “The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry etc) and not the achievement of consistent gains in earnings per share.”
 
What Mr Buffett is describing is return on equity capital and despite this guidance more than 35 years ago from one of the world’s most successful investors, his advice continues to be ignored by most.
 
One of the objections levelled at investors who attempt to invest along the lines which Mr Buffett suggested — and I would count myself as one of them — is that the sort of companies with these characteristics may be too expensive. This concern has reached fever pitch recently, with myriad warnings about what will happen to so-called “bond proxies” when US interest rates rise.
 
A “bond proxy” is shorthand to describe equities such as consumer staples and utilities with safe, predictable returns, but have higher yields than much of the bond market (and, crucially, yields which can grow over time).
 
Bond markets have experienced a bull run since the financial crisis and the onset of quantitative easing, which has seen central banks pump billions into buying their own governments bonds, and a disinflationary environment which has led to the sister policy of zero interest rates. Faced with seemingly ever-lower yields, investors have crowded into equities in general and especially those which are considered “bond proxies”.
 
The obvious problem is what happens if — or when — interest rates rise. Bond yields then rise and those equities which have been used as bond proxies will surely fare badly.
 
I would suggest a slightly less simplistic approach.
 
Let’s start with the assumption that interest rates will rise. Eventually that must be true, but when and by how much is less easy to predict. The “when” has some bearing on the matter. There are a number of fine fund managers who have had their performance shredded by attempting to time this and other events.
 
The “how much” also matters. In my view we remain in a disinflationary environment with a mostly weak economic recovery, so the rise when it comes may not be anything like the gradient which we have come to expect from previous recoveries. Short-term interest rates may be at or close to zero and may rise, but they are of less significance in valuing bonds and equities than long-term rates, and US 30-year Treasuries already yield over 3 per cent. This yield may not budge much.
 
If you are worrying about bond proxy equities in this scenario, you might also like to ask yourself where you will put the money that you realise from selling them. Into cash? Good luck with your timing. Into bonds? I think not. Into other equities? Maybe, but the S&P 500 Index’s price/earnings ratio is 19x, so it’s not that they are obviously cheap, and most of the Index is much more heavily cyclical than the bond proxies, making it an interesting choice if you are seeking safety in a rising rate environment. One thing we can be sure of is that the stocks in the index are not of the same quality as the so-called bond proxies.
 
If you are a long-term investor you should own the high-quality bond proxies and close your ears to the siren song of those who say a rate rise will cause you problems
There is another quote from Mr Buffett’s business partner, Charlie Munger, on this subject: “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6 per cent on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6 per cent return — even if you originally buy it at a huge discount. Conversely, if a
business earns 18 per cent on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with one hell of a result.”
 
I agree with them both about this. Let’s take two examples of potential investments which you can make and hold for 40 years — from when you start work in your 20s until you retire.
 
Company A (the bond proxy) generates a return on capital employed (ROCE) of 20 per cent per annum throughout this period. It has ample opportunities to grow and can reinvest all of its earnings each year at the same rate of return. That’s the good news. The bad news is that its shares are not cheap and to buy them you have to pay four times book value. That’s not all — when you come to sell them in 40 years’ time the rating has halved and you can only sell them for two times book value.
 
Company B (the market) earns a 10 per cent ROCE over this period and reinvests all its earnings at that rate of return. Moreover, the investors who take this option have better luck in terms of timing, as they can buy B’s shares at two times book value and when they come to sell them in 40 years, they can sell them for four times book value — their rating has doubled.
 
So if these were the alternatives on offer for your investment career, which would you take?
 
Company A would produce compound returns of 18 per cent per annum and Company B 12 per cent per annum.
 
If you plan to hold a share for the long term, the rate of return on capital it generates and can reinvest at is far more important than the rating you buy or sell at.

That’s why if you are a long-term investor you should own the high-quality bond proxies and close your ears to the siren song of those who say a rate rise will cause you problems. If you are not a long-term investor, I wonder what you are doing in the stock market at all and so will you one day.
 
Click here to view the article on FT.com
 
Terry Smith
 
Financial Times


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