Analysis: Good news from corporations would be overshadowed by bad policy

The following is excerpted from the Q1 commentary letter by the Van Huzen Asset Management investment committee. To read the fill letter, click here.

Innovation and productivity are drivers of sound investments. There are companies who force change and there are companies who only change when forced. In terms of risk and reward, high quality companies continue to look attractive. If the current market rise is sustained, high quality companies will participate in the rally, and if we hit a financial speed bump, money will flow from speculative stocks into high quality stocks. Either way, we like the reward-to-risk ratio of the world’s dominating brands versus companies with too much debt and too little cash. Flexibility is the key to working through a volatile time in history and companies with strong brands and strong cash flows have the most options.

Due to the absolute size of the world’s debt loads and the growing risks of monetary and policy errors, we continue to model large downside risks must factor in a domino-style waterfall that could occur if any single country defaults. We see many good investment opportunities trading at decent prices. But let me be clear: there are sovereign risks and enormous imbalances that would affect an entire economic system. These risks are entirely outside the control of corporate executives and their boards. It’s all about liquidity. A policy error by a country’s political leaders or a monetary error by central bankers would far outweigh any good news coming out of corporations.

The Federal Reserve has stated their intention to keep interest rates near zero until at least 2014. Given this outlook, we are limiting our purchases of short-duration bonds, opting to focus more on intermediate-term bonds. This is because short-term bonds yielding just 1-2% present significant reinvestment risk when they mature. Suppose you have the choice to invest in a 3-year bond yielding 2%, or a 7-year bond yielding 5%. While the 7-year bond might feel risky, the 3-year bond poses a significant reinvestment risk. If you buy the 3-year bond yielding 2%, hoping to reinvest the proceeds in a higher-yielding bond when it matures, you would need 4-year yields at 7.2% in 2015 to make this decision profitable. Yields have not reached that level in 14 years, and we think it’s a bad bet to assume they’ll soar that high in the near-term.

Our target maturity of bond portfolios has been 3-4 years, but due to better risk/reward ratios in the intermediate-term, we are lengthening our average duration to 4-5 years by buying quality bonds maturing between 2017 and 2020. Corporate bonds with stable and improving credit metrics still offer good returns with low risk. Select municipal bonds, particularly school district GO issues, are also attractive.

Primary Themes:
– Remain liquid and flexible
– Replace any variable-rate debt with fixed rates
– Review budgets, estate and trust documents, financial plans
– Focus on income generation in your portfolio (stocks, bonds, real estate)

Equities:Equal to target allocations, emphasis on
– Dominant global brands
– Energy (oil, natural gas)
– Health Care (pharmaceutical, HMO, disposable devices)
– Technology (innovators and brands)
– Utilities (water)
– Food (brands, distribution, growers, seeds)

Bonds: Equal weight, lengthen duration 1-2 years to receive higher income
– Emphasis on corporate investment-grade quality
– Corporate bonds with improving credit metrics
– 2017 to 2020 target range for new buys
– International government bonds
– Select municipal bonds with reliable revenue streams

Real Estate: focus on valuing as an income asset
– Rental properties with positive cash flows

In closing
America’s middle class helped make this country great. Small businesses are the country’s employment engine: generating 65% of the net new jobs in the past 17 years; employing half of the private sector workers in the country, and hiring 43% of the country’s engineers, scientists and computer programmers. The US economy is 70% consumption and our middle class is the majority of that consumption. Without a healthy middle class, a country is susceptible to social unrest, lower tax revenues and higher deficits. The recent crisis and the subsequent liquidity actions to solve it have created structural imbalances and moral hazards. So-called “too big to fail” entities still pose big risks for everyone.

Somehow in this recovery, the middle class will need to regain its health and participate. So far, large corporations (especially banks) and a narrow segment of the population is benefitting from the recovery, we will need it to broaden.

Related Topics: Asset Allocation