23 Sep Diamonds are forever

Choosing the Building Blocks

In the mid-nineties I had the opportunity to teach a young guy who had just completed his service in the IDF and arrived on the Israeli financial market, motivated to learn the business.

I tried to challenge him, with fundamental questions about the essence of investments and their purpose. I asked him if he could describe in one word the purpose of investing. The word he chose was interest.

Today, I examine investments in two ways: what happens to the principal, and the interim yield, interest or dividends paid along the way.

In simple words, our goal is to reap as many fruit as possible, without compromising the principal.

The combination of the two along a timeline of several years is the total return.

The problem today is low interest rates. So low that is does not compensate for the loss of buying power, and investors are hard pressed to find a mechanism for capital preservation.

And how is this related to banks?

For hundreds of years the banks have been giving out loans to thousands of clients, and these in turn usually repay much more than they’ve taken.

Clients range from a small company with a big idea, to an individual who needs a loan. Sometimes the bank loans money to those who do not intend to repay.

Another important detail, the bank attempts to secure the loan, thereby becoming somewhat of a partner of the client, by imposing a lien on client assets. In this way the bank ensures that even in the event the client fails, the bank will still have some assets to fall back on that will at least partly cover the loan.

If we remove from the bank model all the big words including “leverage”, “credit risk”, ״ provision for bad debt”, we remain with the basic concept which reads as follows: I have money, I will lend it many people, and they will pay me much more than if I deposit this money safely, where I am guaranteed to receive my entire principal but with minimal interest.

The banks are aware of the balance of power and therefore do not take the risk of loaning money at a fixed interest rate, but rather tend to offer most of their loans at a floating rate. This is due to the fact that the strongest player on the board, the government, can raise or lower interest rates, thus causing significant damage to a bank who is on the wrong side of an interest rate decision.

You might say, and rightfully so, that the banks nearly collapsed. To this I will answer – there are no bad banks, only bankers with dubious abilities.

One of the asset classes we invest in is bank loans ranked lower than investment grade, BBB, but first in the line of debtors of the corporation. In other words, if a company is unable to serve its loan, the bank is usually the first debtor. These loans are based on floating interest rates and the spread is 500 bp over Libor, or 5%.

In the last decade, bank loans were the third best asset class after high yield bonds and equity, and all this while interest rates declined steadily.

Today, when the Libor is at 0.25%, so low that it can only go up, my sense is that bank loans, as an asset class, is well positioned, offering ongoing return of 5% with an option to receive even more should interest rates go up.

Yours,

Michael

Dedicated to my friend Erez, the young guy who now manages a successful investment firm.