Introduction

Investors naturally fleeing cash and bonds in response to inadequate yields, poor prospective returns, and government monetary and fiscal policies. The narrative of "There Is No Alternative" (TINA) is rampant as investors look to equities as the go-to asset class for a significant proportion of their capital. Unfortunately, this appears imprudent and could even potentially prove entirely mistaken.

In this article, we will explore the critical mistake investors are making in thinking "There is No Alternative" when considering their asset allocation and reveal a real emerging alternative to low cash and bond rates. We will explore how this alternative is essential to a good investment and incredibly prospective in terms of meeting prudent absolute return investor objectives and provides a less risky option to being all-in on risk assets.

Why Cash and Bonds are on the Nose?

Many investors and institutions allocate their assets among some combination of the following asset classes: cash, bonds, property, and equities, in line with their perceived risk profile and investment mandates. Cash and bonds are the traditional defensive assets while property and equities are the traditional risk-on or growth assets. The traditional 60:40 portfolio, or a variation thereof, is used as a kind of passive and lazy basis for portfolios for institutional investment management for the last 40 years. It includes 60% equities and property and 40% cash and bonds. It has been effective historically at producing modest risk-adjusted returns as it has benefited across the board from disinflation and lower interest rates, which has been a structural trend since the early 1980s.

However, now that cash rates have gone all the way to 0 (0.1% in Australia) and bonds have a circa 1% yield, history will not be able to repeat itself in coming years. Furthermore, it is realistic that we may even see the reverse happening as inflation and interest rates begin to rise.

Hence, in contrast to seeing the lovely tailwind for all traditional asset portfolios, we may very realistically see a significant and adverse macroeconomic headwind in the coming years. Furthermore, these asset classes are not priced for this to occur as they - and consensus - are dominated by passive investors who are largely trend following in nature, and who buy irrespective of value. It shows by the exponential growth of passive ETFs that predominantly track a market benchmark. If the massive structural trend changes, traditional assets, and portfolios can be expected to lose from the change in a big way.

Most notably, higher inflation is terrible for most non-inflation indexed bonds (and long-duration assets). Higher discount rates would also challenge highly elevated property and equity valuations that are dependent on low discount rates. Some of these growth assets are arguably deeply divorced from fundamentals because of the TINA mantra and a broad consensus belief that central banks can be relied upon to keep interest rates low forever. Interestingly, there are credible forecasts such as Hussman (see chart below), that equities may not provide the high returns investors are generally expecting. Cash and bonds - even with low-interest rates - are priced to provide inadequate returns to meet even modest return expectations. Investors are hence needing alternative investments with greater return prospects and different rather than common, drivers of return and risk.

Predicted and Actual Returns on Conventional 60/30/10 Portfolios

Source: Hussman Funds

Bonds have often been included in a portfolio for their diversification benefits, on the view that they will perform well when equities underperform and hence lower the huge risk from being only inequities. However, this relies heavily upon bonds having a negative correlation with equities. Unfortunately, history tells us even this cannot be relied upon - and given starting yields and key portfolio risks such as inflation and higher yields today - we should not rely upon bonds being diversifying, as they may not be.

There are many times in history when bonds simply do not diversify equity risk, most particularly when inflation rises, and long-term interest rate expectations rise too fast or above critical levels. Given current government policy around the world is to print and spend with abandon until we get inflation or some other calamity, inflation as a risk should clearly not be ruled out. Disinflation should simply no longer be relied upon as the basis to build an entire portfolio, which as an aside basically completely invalidates most passive portfolio approaches. Paradoxically, these portfolios or index-focused investment styles are more popular than ever.

Furthermore, we know from watching central banks for a very long time that their prognostications about future interest rates and inflation have routinely been incorrect. In contrast, they can be somewhat relied upon to follow the market when market conditions push them to do so. They are also influenced by banks and other market participants pushing them around publicly and otherwise when it suits them - indeed we know of at least one activist fund manager that does this to the RBA (and presumably he does so because he thinks it is effective). One of the greatest fallacies we commonly hear is that central banks control our economies and determine growth and inflation and other economic settings. Simply, we don't believe there is any compelling evidence to suggest they control these. Hence, don't assume they do.

Source: FRB, Bloomberg Finance LP, DB Global Research. Note: Data for the graph courtesy of Torsten Slok, Deutsche Bank

Whether you stick with the traditional portfolio or move more into equities, if you are constrained to traditional long-only assets, you will probably end up with a much riskier and lower returning portfolio today than you had before. Bonds may no longer protect and diversify, and equity risk is escalating with the nature of the investors in equities and higher valuations bringing down future return forecasts. There is certainly plenty to be concerned about contrary to consensus (and I haven't even mentioned Taiwan).

Expect a Paradigm Shift

We can see rampant signs of speculation on equities, and the period we're living through is very reminiscent of late 1999. For instance, there is massive call volume bidding up the prices of the worst quality and most shorted stocks in the market (see diagram below), as well as less shorting in markets than we've seen for a very long time. We could potentially see continuing rises on equities driven by price-insensitive buyers such as index investors and speculators, before a massive market collapse similar to 1987 or early 2000 when the trend reverses. This is what happens in bubbles - they become removed from fundamentals, escalate, last longer than anyone expects, and then - often with unpredictable timing - they collapse.

Bidding up the Prices of the Worst Quality and Most Shorted Stocks in the Market

Source: OCC, Compustat, Haver, Deutsche Bank Asst Allocation

Note: Most shorted defined as top 10% on short interest % of market cap. Sector absolute, equal weighted, monthly rebalance.

We have not had high and increasing inflation for decades. It should be clear that while "this time may not be different", it is very different from the time period which most investors, advisers and institutions have worked through. Importantly, some advisers and institutions are inflexible and hopelessly ill-equipped to manage well anything other than a rising market.

The real question is not what short-term return will be achieved while the bubble inflates, but whether your assets are being risk-managed and what your compounded return is over time when markets turn south. Given many investors are doing exactly what they did in early 2020 when we last witnessed great market complacency, it may be instructive to see what happened to your portfolios in early 2020; how badly was your approach hurt from a market crisis, and how quickly did your approach recover from these falls (if at all?).

Prima facie, while it may be very exciting, far from increasing equities and risk assets into escalating prices and speculative mania, it could very reasonably be argued that it is more reasonable for a prudent investor to be reducing risk when risk-loving is rampant or at least not increasing their exposure. This is even more important for conservative investors or for those who can't tolerate huge losses. It is very difficult to tell when the music will stop, so playing musical chairs with dangerous markets will not suit more conservative investors who are averse to large drawdowns.

We do not argue against owning equities selectively; indeed, we can still identify numerous pockets of attractive opportunities for active and well-researched investors. However, unquestionably a real need for great active management, a risk management focus and differentiated portfolio management.

Disclaimer: This is a high level conceptual exercise and all figures are approximations using the CY2020 accounts.

In early 2010, Berkshire Hathaway finalised the acquisition of BNSF (Burlington Northern Santa Fe), the largest US based railroad for the consideration of $26 billion for the stock it did not already own. This equated to a total deal value of $34 billion.

The consideration of $26 billion was paid with ~$16 billion in cash and the balance in Berkshire stock; with around $8 billion in debt drawn to partial fund the cash consideration. Broadly, this structure was in line with Berkshire's target leverage of around 30% against assets.

Berkshire's operandi modus is to let competent management teams run their businesses but enforcing strict capital discipline with a strong focus on cash generation to the parent company. Optimal capital allocation decisions result in a large advantage over time, which Berkshire personifies in many ways. 

Without digging too deeply into the operational performance since acquisition, it is clear that Berkshire purchased BNSF at a cyclical low with extraordinary timing; just as the post-GFC recovery was gaining momentum. The growth in top-line revenue has been anemic, with a rise of only around 25% over the 10 year period since acquisition. However, cost control, capital allocation and market conditions have been sound and allowed Berkshire to harvest outsized returns from the investment.

Since acquisition, Berkshire has invested $41 billion in capital expenditure offset by depreciation of $20 billion. This implies that BNSF may have been either 1) under-investing in capital items prior to Berkshire's acquisition or; 2) Berkshire have invested heavily in capital items due to a strategic rationale. 

The latest Berkshire shareholder letter provides some clues: "Railroading is an outdoor sport, featuring mile-long trains obliged to reliably operate in both extreme cold and heat, as they all the while encounter every form of terrain from deserts to mountains. Massive flooding periodically occurs. BNSF owns 23,000 miles of track, spread throughout 28 states, and must spend whatever it takes to maximize safety and service throughout its vast system."

Whilst depreciation is a relatively stable portion of fixed assets; year-to-year capital expenditures can fluctuate more broadly depending on capital allocation decisions and any externalities that may impact the operations. In addition, given the relatively long-life nature of heavy fixed railway assets and the inexorable push of inflation over time; this effectively means that a dollar spent today, could mean over a dollar saved tomorrow in aggregate holistic costs.
Accordingly, we anticipate that BNSF will require a relatively lower capital requirement going forward, probably a figure closer to BNSF's depreciation and amortization expenses.

Incidently, this aggressive capital investment program has come about despite almost $42 billion in dividends paid to Berkshire over this time period. No doubt that a reasonable portion of this has come from levering up the balance sheet against new fixed assets against which Berkshire has greater certainty around their effective life. None-withstanding, this is a fantastic result against Berkshire's cost base of ~$30 billion. 

The largest component of value attributable to BNSF is the terminal value. The company's claimed equity value on its books is around $65 billion which looks to be under-valued on a standalone basis. For instance, BNSF's competitor, Union Pacific Corporation (UNP), is valued at around $154 billion at a capitalised dividend yield of approx 1.8%. 

I cannot say whether UNP has invested the minimum requisite capital expenditure necessary to keep its operations running smoothly, but I can say that BNSF's heavy capital investments provides it a good degree of certainty around its future capital requirements; so it's appropriate to use UNP's dividend yield as a basis for our standalone terminal value. 

For CY2020, a $5.8 billion dividend was paid by BNSF to Berkshire; we expect this to grow over time largely dependent on the sustaining capital requirements. Capitalising this dividend at a yield of 1.8%, provides us with a terminal value of $322 billion. If we are even more conservative and decide to use a 3% capitalisation figure, this provides us with a terminal value of around $193 billion. Both figures are vastly higher than BNSF's claimed book value of $65 billion.

Berkshire's overall return on BNSF has been over 28% per annum in our upper case and almost 23% in our lower case. It's actual return on equity is significantly higher; circa 32% and 27% in upper and lower cases.

These are extraordinary returns considering the size of the investment and truly demonstrate why the Berkshire team are considered the world's pre-eminent living investors.

In private debt funds - unlike in boutique equity funds - there is a big payoff for investors from having a bigger loan book. Scale makes private debt providers more relevant to borrowers and investors, says Metrics Managing Partner Andrew Lockhart.

Conventional wisdom says that by staying small, boutique managers can deliver superior returns. They are nimble and can move in and out of stocks without the burden of having to invest, even when conditions are not favourable.

But what is true of equity managers does not hold for private debt providers. Increased scale makes a private debt manager more relevant to both the borrowers and the investors and provides more consistent returns. In this article we look at the reasons why, using the Metrics Credit Partners experience to illustrate the benefits.

Metrics was established ten years ago, a pioneer in non-bank lending in Australia, by a team of three partners who worked at NAB and who had extensive experience in lending and portfolio risk management. Since then, Metrics has grown to a team of ~100 people with AUM of ~$10 billion. Metrics has not grown just for the sake of getting bigger, but because there are clear benefits for investors.

Having scale makes Metrics more relevant to borrowers because access to non-bank debt finance can help them grow. With increased funding, Metrics can lend larger volumes to clients to help realise their plans. A smaller lender may not always have the capacity to match the needs of some borrowers and they don't have the certainty of capital that a larger lender provides.

Metrics is not a bank. It is a minnow compared to the balance sheets of any of the Big Four. But  it does not have their cost structure or rigid business practices, either. As one of the largest non-bank providers of debt finance to Australian businesses Metrics has the capability to match the needs of borrowers in a way that banks cannot. There are regulatory restrictions which impose a higher level of capital to be retained on balance sheets for banks that lend to business compared with lending for consumer purposes where the loan is secured against a residential property. This reduces the returns that a bank can generate from lending to companies which reduces their appetite to do so. But Metrics is focused on business and real estate lending. It has a highly skilled and a professional team with a deep understanding of each borrower, which means they can assess risk and price it accordingly.

Through the recent wave of lockdowns that began in June 2021 Metrics again demonstrated its commitment to business borrowers. In the September quarter alone, Metrics financed in excess of $1.2 billion. By December, as the economy re-emerges from lockdowns, Metrics expects to finalise another $2 billion. It's unlikely any of our non-bank fund competitors can provide this volume of finance to Australian companies.

All through this period Metrics has further added depth and breadth of expertise, increasing its team ~100 people. By resourcing teams in origination and risk assessment it has a larger more diverse team to consider more lending opportunities. That in turn delivers more attractive returns and capital preservation for investors.

Contrast that with small private debt providers who claim to have the same benefits of a boutique equity investor. Their small scale means they can only do a handful of loans for a small number of clients before they reach capacity. That limits the potential of their borrowers. It also limits the managers ability to create diversified portfolios for their investors, increasing concentration and single large counterparty credit risk.

The big global credit players setting up shop in Australia have a similar scale problem. On the face of it they have huge resources and big, well-known brand names to offer the local market. But the reality is that their local teams are small and lack the capacity to originate many good lending opportunities. When they do find one, the credit decisions are usually taken offshore, away from the relationships and understanding of local nuances that a larger, local private debt manager like Metrics provides.

Being more relevant to borrowers has several important benefits for investors. Scale provides access to better deal flow, giving Metrics a better understanding of the market and the ability to focus on the best quality lending opportunities coming through. Having the ability to lend in larger size also means more negotiating power when determining the terms and conditions on the financing. It allows Metrics to tap sources of income - such as origination fees - that those smaller players cannot, generating better returns for investors.

Scale also provides important risk management capabilities for investors, by allowing diversification across a wide range of industries and sectors. A larger portfolio of loans, where each exposure represents less than 1% of the total, provides cover against any one loan having an outsized impact on the returns to investors. This is also important in preserving investor capital, reducing concentration risk from any one borrower.

Scale is only useful when it delivers better outcomes for borrowers and investors. Metrics' continued growth and performance reinforces this. This year alone, both listed funds have undertaken significant capital raisings to expand their capacity and continue to trade at a premium to their NAV. New additions to the Metrics suite of funds have and will continue to come to market to ensure those benefits of scale are realised for borrowers and investors alike.