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Abundant capital, scarce growth will limit investment returns

Tuesday, April 2, 2013

SCOTT BARLOW

sbarlow@globeandmail.com

Investing truisms can be maddeningly vague and are usually nothing more than platitudes trotted out to explain why everyone just lost a bunch of money. But there is one bit of advice that, in today's environment, has profound practical implications: Returns are best where capital is scarce.

This observation comes from Richard Bernstein, former chief strategist at Merrill Lynch and founder of Bernstein and Associates. At first glance it merely tells investors something they've already heard - to avoid the popular stocks that everyone wants to buys and instead seek out-of-favour, more attractively valued investments.

But Mr. Bernstein's advice is also a reminder to keep an eye on initial public offerings and secondary stock and debt issues. A flurry of IPOs in a sector is a sign that capital is abundant. As new offerings keep on coming, the quality of the deals inevitably declines. Investors who participated in 2010's festival of junior gold miner financings have learned this lesson the hard way.

Patient investors are more likely to be rewarded in sectors where banking deals have failed or where the prospects appear so weak that no deals are being attempted. This indicates that an industry is being starved of capital. Projects have to become steadily more attractive, in terms of valuations or quality, to attract investors.

The relationship between investment returns and available capital is particularly important in today's environment. Since 2008, global central banks have increased the money supply by unprecedented amount. The U.S. Federal Reserve and the Bank of England have tripled the size of their balance sheets while the European Central Bank has doubled. Those vast increases in balance sheet assets provide a rough measure of how much central bankers have pumped in to their respective economies. Yet global growth remains sluggish.

As a result, oceans of capital are desperately pursuing scarce growth opportunities. In Europe, the fierce competition to find havens left German, Austrian and Finnish government bonds trading with negative yields in mid-2012: Investors bought the bonds despite the full knowledge that they would get less money back when the bonds mature.

In the United States, three venture capital firms are vying for Dell Inc., a company with falling earnings growth but relatively steady cash flow. The bidding war demonstrates the enormous appetite for even lacklustre investments.

In global terms, capital is not scarce anywhere. This implies that future returns will be muted.

Bullish investors may argue that earnings growth, particularly in the United States, has been strong. However, a significant portion of that earnings growth has come from re-financing debt to take advantage of lower interest rates. Revenue growth has been in short supply. While companies can wring higher profits from stagnant revenues for a while, they can't do so forever.

The huge amount of capital chasing scarce returns means that any sector where profits are consistent and dependable - think consumer staples, telecom services, health care and utilities - is becoming prohibitively expensive.

Central bank stimulus has been a double-edged sword for investors. Excess liquidity prevented the global economy from falling into the abyss in 2008 and 2009 and, barring incident, should continue to support asset prices. But it has also created a market where abundant capital has no place to go.

The best advice now is to avoid temptation. Don't chase growth. Get comfortable holding cash.

The end game for this market cycle will provide opportunities for patient investors. Next week, we'll attempt to predict what the next stage might look like and its effects on portfolios.

Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Read more of his Insights at tgam.ca/ROB-Insight, and follow Scott on Twitter at @SBarlow_ROB