Finance industry flunks and gets an E- grade from Professor Gray

29 September 2011

Finace industry flunks and gets an E - grade from Professor Gray

For today’s MBMG update, I’d like to just hand over to our portfolio advisor, Martin Gray, who was interviewed in last week’s edition of Investment week by Hannah Smith.

"MAM’s Gray: Industry has learnt nothing from Lehman Brothers crisis

Miton Special Situations manager also warns gold is ‘dangerous’ at current levels Martin Gray’s illustrious career running money spans more than three decades, and has seen him at the helm of the top-performing £648m Miton Special Situations portfolio for the last 14 years.Gray’s ‘aggressively defensive’ stance in tough markets has seen the fund achieve a return of 25.1% over the three years to 26 August, ranking it fifth in the Balanced Managed peer group, where it competes with offerings from stalwarts such as Crispin Odey and John Chatfeild-Roberts. Here Gray reviews some of his winning and losing bets during his time in the markets, explains why he is not afraid to sit in cash, and argues the industry has not learnt a single lesson from the Lehman collapse. Next week is the third anniversary of the collapse of Lehman Brothers. What parallels, if any, do you see between that period and the present?
Not necessarily parallels, but what I am concerned about is that the European banking system is in a very nasty place, and the Europeans have buried their heads in the sand and not really tackled what the banks have got in their vaults.They are also desperately undercapitalised. Valuing the balance sheets of banks on a cost basis is pretty dangerous, and I suspect a big part of the banking system is bust. We have got some very wishy-washy politics in Europe and the US now, it is very indecisive. It all seems pretty shambolic, and I am concerned about the European system – they are just kicking the can further and further down the road and are running out of time, because the numbers are getting bigger and bigger.What the banking system needs to bail itself out is strong growth, and we are not going to see that, so it all seems pretty negative to me. So I am steering clear of European assets because I am not sure what is going to happen.

What lessons has the fund management industry learnt from the last financial crisis?
Nothing. It may have learnt a bit about history but it still has the attitude that ‘it will be different next time, don’t worry’. The financial industry in general lives on fear and greed. It is either full on and everything is going great, or else depression.That is how the City works, there is not much middle ground. There never has been.

What is the greatest risk to the global economic recovery?
It is understanding where we are, and the developed world is going to be in a sub-normal growth environment. We will not necessarily see outright recession, but I do think we could see major economies in technical recessions over the next few years, drifting in and out. Some say it may be a deep recession, but I am not so sure about that. We will be struggling to get 1% or 2% growth in the major economies, and that is sub-par growth.

What is your outlook for the UK market? Will the FTSE break back through the 6,000 mark again this year?
Not in my book, no. We had the slump in early August, and the second half of the year has been pretty weak. We might get a bit more volatility now as people realise 6,000 will not be the new normal so they reshuffle their portfolios. It is the same with the S&P 500 and the EuroStoxx – the reality is creeping in that all is not well out there. I do not want to be too gloomy though – there will be places to make money, there will be sources of yield, there will be things oversold, you just have to be patient and build your positions in things where you think you can make money long term.
I just want to make money any way I can, I do not mind where I make it from. I am not besotted with equities as a lot of people seem to be – it is not the only asset class to make money in the long term. One holding you have is the Neuberger Berman Distressed Debt fund, which is an obvious play on the present economic weakness. What other ways can investors take advantage of the present conditions?For long-term investors there is no harm in buying risk assets at lower levels even if in the short term these markets can go a long way further south. It was back in 2009 you could last buy the FTSE 500 around the 5,000 level. Maybe there is an opportunity to buy back at those levels now on a five- to 10-year view. That is true of most assets. I would not be buying gilts on a long-term view today, although it is possible a 10-year gilt yield could dip below 2% at some point. On bad days there is no harm in buying high risk assets, but do not trade them, just lock them away. I would not buy much outside large-cap sustainable yielders.
Do not worry if things fall 20% in the short term – if they are good companies, they will find their way back in future. It is a bit of a Warren Buffett approach I suppose, but it is taking long-term views. Where else can you make money? Yield is a good thing to play, and you have to be a bit careful but you can play currencies. You have to take a view, and that is what we are paid to do.

You said recently you thought the price of gold was ‘justified’ when it hit $1,500 – now it has gone above $1,800, has your view changed?
My view is changing. We made our money in gold in the last decade as opposed to this one. Like a lot of things, I have taken profits much too early. I am concerned, but I would not put people off holding gold as an alternate currency rather than a commodity.I think the price is completely disconnected from reality and at some point will have to come back to meet gold equity prices. I have 2% in Special Situations although in the past I have had nearer to 10%, but it is mostly in gold equities. Do I feel like taking that up to 5%? Not at the moment. It has to come down, but whether that is at $1,950 or $2,950 I do not know. We saw it happen with silver, when it lost 35% in two days.I would hate to think that could happen to gold, but the way the ETF market is being driven at the moment, it could happen. It is unlikely, but gold does feel very dangerous at these levels. One of the strategies you use is to hold quite high cash weightings during difficult markets. What would you say to critics who say fund managers are paid to invest in the market and not to sit in cash?
There are two answers to this. As a macro-driven asset allocator, when I want to buy a large-cap European equity fund I do not want that manager taking a view on cash, I want a manager who is fully invested, and probably aggressively so. In the multi-asset sector people should be buying me not to be fully invested, but to have a long-term global balanced approach, and I will manage the risk and returns over a long period of time. I will try to match upside when markets are going up and try to defend when they are going down, and whatever it takes to do that I will do. In the 14 years I have been running Special Situations I have held a high cash position on more than one occasion. Back in 2002 we had at least 30% cash, and a lot of low risk assets such as gilts. So I am not afraid to try and cut back the volatility in portfolios when I think it is appropriate.

The eurozone and US debt crises have caused unprecedented events in bond markets, with US and UK government bond yields sinking to record lows. What is your view on this and how have you been playing it?
We bought quite heavily into sovereigns generally – gilts, global bonds funds, especially aimed at the US – in summer 2009, when the first round of QE came in and yields rose. We topped up again reasonably aggressively at the beginning of 2010 when we had that famous statement from Bill Gross that buying gilts was like lying on a bed of nitroglycerine.We added to our weighting then, and we bought again in February this year – back then you could have got a 16-year gilt with a 4.4% yield, and the fact it is now a 3.4% yield is quite good as far as I am concerned. During the second half of last year we also bought into Asian sovereign debt and investment grade. We have done very well with the UK purely on a contraction of yields, having fortunately bought at the right time during the spikes. In Asia, there has been a currency kicker as well in terms of how we have held Asian debt. It has been great for the fund and is one of the reasons Special Sits is up over the last three months. I would not be buying gilts at these yields but neither would I be an aggressive seller, although we have taken some profits. But why wouldn’t you when you have made that sort of money?

What would you need to see to change your stance on the asset class?
Well it is an evolving thing. In the first 10 days of August I did start buying some risk assets as I thought it was appropriate to dip a toe into the water. I bought some UK large cap, sustainable yield, focusing on non-financials, non-resources, the Neil Woodford, Bill Mott type stuff.I also upped risk a bit by swapping Asian currencies for some Asian equities. I am still cautious on where we might go from here, but you cannot sit around waiting for markets to hit the low point on your forecast, because you might miss it by 1%, 5% or 10% and never get in.

What calls have you got wrong?
There are lots! A recent example was the effects of quantitative easing. When those liquidity packages happened in the spring and summer of 2009, I did not like the idea of printing money and how that would pan out, so I took profits on what risk we had built up in March and April, and I sat back and thought ‘this is disastrous, the financial system will not be able to cope with QE on a big scale’. Of course I was completely wrong because what happened was risk asset prices went through the roof and we got left behind. Also, in summer 2002, I felt everyone had become too bearish about what was going on around the world and there was value being overlooked. I bought risk assets heavily going into 2003 and was then left for dead until the spring, when I looked very clever. We had a pretty rough downside through that year and we were fourth quartile. There are plenty of wrong calls, but they are as important as the good things, as you learn from them.Aside from currencies, you have been negative on emerging markets for some time, with just 0.3% of Special Sits in EMs at the moment. Why is this?
I have nothing against the emerging world long term. In fact, long term, we have made huge money out of being early into emerging markets, for example, aggressively buying Latin America in 1988 and Asia in the bubble territory of 1992-1993. I had 10% in Eastern Europe in 2002-2004 before we took profits and made huge gains, and I had 8%-9% in China in 2006-2007 before we took profits in 2008. There is short-term money in these economies, not necessarily long-term money, but as the West slows down and has to grind through a tough decade, emerging markets will fall back with them as they are still based on supply economics not demand economics. Until they focus more on their domestic economies, which they are loath to do, they are going to be hit harder. We have seen that to an extent this year – whatever the Western equity markets have done, most of the emerging markets have done worse.

Finally, wasn’t buying Latin America quite an edgy bet to make back in 1988?
Not really. I was fascinated by the region so I did some reading. It was too early because it all fell apart again after the debt market collapsed in 1994, and emerging markets disappeared off people’s radars for the next 10 years because they took an absolute beating. They were undervalued and there were not many easy ways of getting into those markets because they were very immature.If you look to the early 1990s, there were a lot of launches of esoteric funds, moreso than you have seen in recent years. There was something like seven or eight Latin American investment trusts launched between 1989 and 1993, there were even individual Brazil and Chilean funds and things like that.So there was a lot of exposure to the region because it was the overlooked region. Fortunately we were in early so we got caught up in all that hype and did not suffer too much downside by taking profits. That was a long time ago, but it is about being early into things and seeking out value long term. I like to take long-term views and buy things when they are out of fashion, based on my economic views and people underestimating what has been achieved and what can be achieved." Spot on, maestro, spot on!

Paul Gambles