Insightful commentary from Personal Assets Trust (PNL)



"Investment Advisor's Report

Over the year to 30 April 2011 we held our own in a market environment
we distrust. Asset prices are too high, interest rates are too low and
at some stage both will have to undergo a major realignment. The
trouble is that we have no means of knowing when this will happen.
Although everyone accepts the need for reform in the Eurozone, the US
remains reluctant to accept that it spends over 60% more than its tax
revenue compared to the UK’s ‘responsible’ 32%. This year the US
budget deficit will be $1.4 trillion (10% of GDP) following $1.3
trillion in 2010 and $1.4 trillion in 2009. Standard & Poor’s have
downgraded US sovereign debt from ‘stable’ to ‘negative’ and we fear a
third round of quantitative easing (QE) later this year or early in
2012. In Britain there is a Faustian pact between the Treasury and the
Bank of England whereby the Treasury engages in austerity, withdrawing
its fiscal stimulus, while the Bank maintains its monetary stimulus
via zero interest rates and (when needed) QE, ensuring that the
Treasury turns a blind eye to inflation above the Bank’s target.

Two key issues determine the outlook for real returns - debt
(sovereign debt in particular) and inflation. Debt restructuring must
come, but need not be as sudden and violent as explicit sovereign
default. ‘Financial repression’, a sort of creeping default which
swindles the saver through the maintenance of negative real interest
rates, was used after WWII to whittle away war debt; and similar
policies are being slipped into place today. The Federal Reserve keeps
short-term interest rates at zero while it tries to put a ceiling on
long-term rates by buying government bonds with newly printed money.
Requirements for banks and insurance companies to retain higher levels
of capital and liquidity also fuel demand for government bonds, while
exchange controls may provide a ‘forced home bias’ to such asset
purchases. In extremis there is the potential for the introduction of
capital controls.

Our capital is irreplaceable and we continue to protect it against
inflation via index linked bonds while we work on building a portfolio
of long-term equity holdings in market leaders with real pricing power
such as British American Tobacco, Coca-Cola, Unilever and Nestle. As
frustrated bulls we are excited about the prospect of becoming a stock
picking trust once more; but because the purchase price is critical to
generating long term returns, we have been patient and have not
overpaid for stocks we feel will be available more cheaply later. We
say more about our stock selection process in the accompanying
Quarterly No. 61, but we like companies with strong balance sheets-
preferably with no debt, so they can work for shareholders rather than
for their bankers or bondholders. Nothing focuses the mind better than
the need to pay dividends; and the longer the track record, the more
likely it is ingrained in the culture.Where possible we look at
dividend records over decades, not the last few years. All the
companies just mentioned actually increased their payouts throughout
the crisis and one of the attractions to us of Coca-Cola is its 49
years of uninterrupted growth in its dividend.

We prefer dividends to share buybacks, the timing of which we cannot
control but management often misjudges - many share buyback programmes
came to a halt in 2008, just as markets plummeted. Nestle was one
exception, having returned a third of the company’s market
capitalisation over the past five years in both dividends and share
buybacks. We avoid companies that grow aggressively by acquisition. It
is so often the overpayment for acquisitions, either using equity or
debt, that leads to value destruction. More often than not, investors
celebrate mergers in haste but repent at leisure.

There has been much talk - particularly by those who have never owned
or recommended it - of a possible bubble in gold. With only 0.6% of
global financial assets invested in gold compared to 3% in 1980 and
with the supply of paper money increasing at an exponential rate we
are way off bubble territory. An investor asked me recently, ‘What is
the difference between gold and tulips?’ The relatives of Mr Martin
Sulzbacher, a German Jewish banker, who hid a hoard of gold coins in a
garden in Hackney before being interned in 1940, could answer this
easily. On his release Mr Sulzbacher failed to find the coins but, as
was reported last month, they were recently discovered by a local
resident and returned to Mr Sulzbacher’s son. No paper money could
have preserved wealth better than those coins did over the 70 years
since Mr Sulzbacher buried them. Indeed, paper money would scarcely
have preserved wealth at all.Worth £100,000 when they were found, they
were US $20 gold coins (‘double eagles’) and their total face value
when issued as currency was $1,640."


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