Interactive Investor

The secrets of investing when inflation is high

5th May 2023 16:36

by Sam Benstead from interactive investor

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Personal Assets (LSE:PNL) Trust manager Sebastian Lyon sits down with interactive investor's Sam Benstead to discuss how to manage money when inflation is high. This includes why he likes to own US inflation-linked bonds and gold, but has less exposure to UK government bonds.

Lyon also goes into detail about the investment case for some of his largest investments, and gives his thoughts on the outlook for economies and inflation. 

Sam Benstead, deputy collectives editor, interactive investor: Hello and welcome to the latest Insider Interview. Our guest today is Sebastian Lyon, manager of the Personal Assets Trust. Sebastian, thank you for coming in.

Sebastian Lyon, manager of Personal Assets Trust: Sam, it's a pleasure. Good to see you.

Sam Benstead: We're now in this new environment of high inflation and high interest rates. You are a wealth preservation trust. So how are you investing today? And what have been your big recent changes to help investors preserve their capital?

Sebastian Lyon: We've actually been relatively quiet just in the last few months. We were quite nicely positioned for what happened last year. We didn't think there was huge value in the equity market yet. We're being patient. We're waiting for the valuation situation to resolve itself, for those higher rates to lead to lower valuations. I think that requires quite a lot of patience and, generally speaking, our portfolio turnover is low. But I suppose that most recently we made a lot of changes in late 2021 and in early 2022, and in particular we had quite a large percentage exposure to US tech. We had a longstanding holding in Microsoft (NASDAQ:MSFT) and Alphabet (NASDAQ:GOOGL). They were two of our largest holdings. We could see going into 2022 that there was a lot of risk to growth and a lot of risk to valuation. And so that was where we took money out and reduced our equity exposure quite materially. I particularly tried to reduce the stock-specific risk within the portfolio.

We now have about 15 stocks in the portfolio, a number of which we've held for a very long period. But they're much smaller holdings as a percentage of the overall portfolio. So, we've got a lot of holdings, let's say between 2% to 3% rather than having some holdings that are 6% or 7%. So we've just taken down the stock-specific risk. I think that was the really big thing that we did in late 2021, early 2022, and that avoided those those big drawdowns, [and] effectively meant the portfolio was sort of more evenly distributed from a risk point of view. And also we were just very mindful of liquidity as well. We wanted to be in parts of the stock market, but elsewhere there was sort of full liquidity. So our manoeuvrability was very high and that's effectively where we're sitting at the moment. So the immediate past, i.e. the last quarter or two, has been relatively subdued, I suppose, with one exception, which was in the autumn during the LDI situation.

One of the things that occurred following the mini-budget was that yields spiked, particularly in the UK, but also in the US, and you could lock in almost 5%, and in UK gilts, and I think we've [not] seen rates like that since 2007 or 2008. So we pounced on that and used our liquidity, which was in cash, in T-bills, to really lock that in, which we thought was very attractive. I think that was probably the most active we were during those early weeks in October, where we thought those returns were pretty attractive.

Sam Benstead: When you invest in the stock markets, what types of companies do you like to buy?

Sebastian Lyon: When it comes to wealth preservation investing, you want to manage risk and avoid very material risks and risks of very big drawdowns within stocks. And so what are the things that produce those big drawdowns, those big losses in stocks? Well, it's effectively leverage risk. And clearly we're seeing the results of that at the moment. Property companies are highly levered, so property companies did very poorly last year. Business risk [can mean] weak businesses. And by that I mean things like airlines, things that are very unpredictable and where profits are highly volatile and hard to predict. And generally speaking, [these can be] serial disappointers, so they have their days in the sun, but they are usually fairly brief.

So there's business risk, cyclical risk, leverage risk and valuation risk. Obviously we're not going to pay huge multiples even if the growth is there, we're not going to pay those astronomic multiples. We generally avoid profitless companies, those sort of highly speculative companies. Companies we do like are those that have consistent revenues. It's often contracted revenue software companies, for example, but also companies that sell either little luxuries or essentials. And so we've always liked the staples sector, we've always had disproportionate exposure to the staples sector. And I know other investors think that staples are quite boring; Unilever (LSE:ULVR), Nestle (SIX:NESN), Procter & Gamble Co (NYSE:PG). But actually, if you look back at the long-term track record of these businesses, they delivered very good solid growth.

But from time to time, investors do get bored of them. There might be something more exciting over there, a recovery in the mining sector or in the banking sector that gets investors more excited. And so they ignore the, perhaps, less thrilling parts of the market. And that's when we find those situations really interesting. If you look back at turnover within our stocks, it is pretty low. We've held a company like Unilever since 2004, we've held Diageo (LSE:DGE) since 2006, and we've held Microsoft (NASDAQ:MSFT) since 2010. We don't tend to trade huge amounts in and out of stocks. We might move the holding sizes up depending on the valuation. But what really gets us excited is when companies like that are out of favour and, for whatever reason, people aren't particularly excited about them. One of the most recent instances where we did add to a company in 2021 was Unilever, because it had a couple of really difficult quarters after Covid, and the share price had been very weak, and it was very unloved.

It's one of those companies where it's never going to be very highly rated, but it's never going to be a very lowly rated either. And it's generated good 8% dividend growth, solid earnings growth over the long term. And so if we can buy that company, when frankly everybody is looking in the opposite direction, that's great. Those are exactly the kind of opportunities that have little downside, healthy upside and, from a wealth preservation point of view, absolutely tick our box.

Sam Benstead: And what about the UK market? It was one of the best-performing markets globally last year. It did protect investors when most things were falling, but a lot of that was mining and oil companies. And banks. So what's your view on the market and have you dipped your toes in that sort of cheaper parts of the market perhaps?

Sebastian Lyon: I think coming back to that cyclicality risk, if we are going into a downturn, then the thing you need to be very careful on is cyclicality. And it was quite interesting last year that it was those technical parts of the market that were quite strong. That hasn't been the case so much this year, and so the UK market, interestingly, did do well in sterling. If you were an American investor looking in dollars, the UK market pretty much only did a little bit better than the US. But I think we are not going to dive into the very highly cyclical parts of the market like mining, like banks, those areas, because as we move towards the likelihood of a recession, that's where you see the greatest earnings cyclicality.

I do think, however, that the US market's been fantastic over the last decade and if I look at how our portfolios evolved, 20 years ago it was much more UK with a bit of US. The last decade it's been much more US with a bit of UK and a little bit in Europe. I suspect that over the next five years, things are going to even up a little bit. And I would expect that as we increase our active exposure, I would anticipate it's going to be more evenly balanced towards the UK and Europe. And certainly we are looking at opportunities both in Europe and the UK. A lot of the opportunities five, six, 10 years ago, we were looking at in the US, but I think it's more evenly balanced today.

Sam Benstead: You have nearly 10% of the fund in gold. How do you invest in gold and why are you buying gold?

Sebastian Lyon: We've got an allocated account in gold, like a bank account at JP Morgan, so we don't invest through an ETF. That's one of the pluses of being an investment trust is that we can kind of hold gold in that way. So we're one step closer to it than owning it via an ETF and that keeps costs very low. We think that gold has a role in a negative real interest rate world. We've been in a negative relationship for quite a long time since the financial crisis.

That negative release rate obviously spiked up last year because inflation was high and interest rates were a lot lower than inflation. If you live in a world of sound money where interest rates are above, or well above, the rates of inflation, you don't really need to own gold because you're not in an era of currency debasement. But since the financial crisis, and particularly due to QE, you've seen money growth growing hugely over the last decade and a half, and gold generally has a role to play within the portfolio from the point of view of offering protection. We saw that particularly in 2020 during the pandemic, gold was very strong then. We saw it during the invasion of Ukraine, tragically. But in a very difficult period, gold did well and so offset losses elsewhere within the portfolio and in the first quarter of this year.

I think gold is trading even in dollars only about $50 away from its all-time highs. There aren't many things that are trading close to their all-time high in dollars. The reason why we hold it is effectively as a good diversifier. A number of peers use protection strategies, [they] use derivatives, but there is a cost, there is a guaranteed cost of using derivatives. And what we found over the years is that gold [does] a very good job in terms of providing that protection. We saw it in the first quarter of this year [and] we've seen it before. I just think that we're in a world where there's greater geopolitical risk and, frankly, greater sovereign risk. One of the things with the LDI crisis and the mini-budget was an incident of sovereign risk effectively being revealed. Suddenly markets lost confidence in the UK. Yes, it was very brief, but it was a, if you like, microcosm of that sudden loss of confidence in terms of the decisions that were made in that budget. And obviously they had to be reined back on. But I think it's those sorts of instances that are going to continue to make gold quite interesting. I think it's very topical, but it is notable that it is one of the few assets at the moment that is close to making new highs.

Sam Benstead: Let's talk about the bond markets. You have a lot invested in US government bonds that are linked to inflation. You also own short-dated gilts. Why did you find these parts of the market attractive?

Sebastian Lyon: At the moment you're offered 1.5% from a US TIP, which is more than with UK index links. So we have held UK index links in the past, but we don't at the moment and we may well hold them in the future, but they are less good value than the US. And after last year we were rather glad we did not own any UK index-linked bonds, which had a very difficult year, but TIPS were not as bad because they were protected by their better value. I think that if we're right and inflation remains a little bit stickier, maybe it's 4% or 5% over the next five or 10 years rather than the 1% and 2% that we've had in the past, and you can get a real yield of 1.5%, well, that's a 6% or 7%, 5% to 7% return in nominal terms. That may well not look too bad, I suspect, compared to other assets.

If you're thinking, well, where are we going to make money for our investors over the next five years, equities are still pretty fully valued despite what happened last year. I think that index links and US TIPS in particular look pretty attractive both as a diversifier, but also in terms of generating that high single-digit return in nominal terms, obviously not in real terms. What was interesting and frankly rather strange last year was that they didn't perform that well. If you were to tell me, Sam, that inflation was going to be the highest it was in 40 years, quite rightly you'd probably have gone out and bought some index-linked bonds and thought that was probably quite a sensible thing to do, a rational thing to do. And they had a terrible time. But in a way that makes me more confident because they didn't go up in value a lot last year. In fact, they fell in value modestly and yields rose.

So, sitting here today, I think there's more upside there if we're right about inflation, and even if we're not right about inflation and perhaps yields go lower, then there's a sort of barbell within the index-linked bonds whereby if nominal yields fall, then you'll still get the upside of those nominal yields falling. So you have sort of got a foot in both camps. You have sort of got a foot in the bond market and you have sort of got a foot in the inflation market. And at the moment we think the risk/reward is pretty good in terms of short-dated. We have got a lot of liquidity because we're very defensive at the moment. As I mentioned, one of the really big changes we made to the portfolio last year was diving into the UK short-dated gilt market. We don't want to take a huge amount of duration risk because I think that over the medium term bonds were in a bull market for 40 years [and] yields troughed in July/August of 2020, [and] we saw 10-year Treasury yields at 0.5%. I'm not sure we're going to see those sort of yields again for a very long time. Maybe not in my career, maybe longer than that. But I suspect we are now on a trajectory where, throughout the various cycles of the future, yields are probably likely to be going higher rather than going lower.

And therefore I suspect there will be moves in the bond market, which are probably tactical, but not necessarily strategic. So I think that's why you want your duration long term. The bond markets aren't particularly attractive, so you're not being paid to take duration risk at the moment anyway. So keep it short, one/two years, that gives us huge flexibility and liquidity [for] when we think equities are right to return to in a big way, which I suspect probably will be the case sometime in the next six to 18 months. Then we'll have the wherewithal to increase our active allocation very quickly with the liquidity that we've got.

Sam Benstead: Finally, the question we ask all our guests, do you personally invest in your portfolio?

Sebastian Lyon: Yes, Personal Assets Trust is my biggest shareholding, and I think it's in the accounts for public record. I eat what I cook.

Sam Benstead: Sebastian, thank you for coming to the studio.

Sebastian Lyon: Good to see you.

Sam Benstead: And that's all we've got time for today. You can check out more Insider interviews on our YouTube channel, where you can like, comment, and subscribe. See you next time.


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