Q&A with Barry Hyman March 2012

Saturday, March 10, 2012

Q: I noticed on my most recent statement there is a lot more “idle cash” in money market than normal. Why have so much cash?

A: The current higher than normal cash levels in portfolios we manage is an intentional but temporary condition. We are not using cash passively as an asset class allocation decision. That is not always the case but it is now. When money markets are paying rates well above the rate of inflation plus the cost of management fees, we may hold money market cash as a strategic investment. But currently at zero percent interest rates holding cash is not an effective use of assets. There are several reasons we have more cash than normal currently including 1) having sold some positions recently that reached our sell targets, 2) having sold one or two whose fundamentals and outlook no longer warrant their imbedded risks, 3) to deploy in assets we are planning to purchase imminently after having completed due diligence, especially several Asia based securities with whose management we have recently met.

Q: Why have there been several sells in the past few months but few “new” buys?

A: See 3) above. We have several planned investments in our sights but after completing our “in office” homework on these investments we want to do additional due diligence on all of them. In the mean time, we do not wait to sell investments that warrant being sold.

Q: Why has the yield declined in my portfolio?

A: Again this is related to the prior questions. With cash (money market) yielding zero and the vast majority of the investments we own yielding 3-8% in dividends and/or interest, each time we sell an income producing investment and temporarily leave the money in cash, the dividend yield of the portfolio declines. But rest assured this will be temporary. It is likely overall portfolio income yields will rise back to or above their yields of a few months ago because almost all of the positions we are exploring are high income producers.

Q: Why are there so few bonds and Treasuries in my portfolio?

A: Short answer: at current yields bonds in general are very risky. They present the worst risk/return ratio in history. In technical terms, long term returns on bonds have a 95% correlation with their interest rates and in the long term their downside risk is inversely correlated with their yields. In other words, with yields under 2% on 10-year US Treasuries, after fees these bonds should earn less than 1% annually over the next 10 years. After inflation that means they will generate negative real returns. Yet if interest rates rise, the market prices of such bonds have the potential of falling dramatically. It is important to understand why bonds have done so well during the past 20-30 years, to understand why they are likely to perform poorly from this point forward. With the starting points for interest rates at much higher levels in past years, followed by falling rates, bonds paid high levels of income and generated additional capital gains as their prices rose as a result of falling rates. With starting rates now at very low levels with the distinct possibility of them rising in the future, the higher than average returns of recent decades will likely “revert to the mean” providing extremely low returns going forward with very high potential for downside shocks. Unfortunately many investors look backwards to estimate future returns. As a result buy moving out of global stocks and into bonds, they are taking on excessive risk thinking they are decreasing their risk exposure. The measure of risk in bonds is called “duration”. A shorthand definition of duration is the number of percentage points the price of a stock moves in response to a 1% move in interest rates in the opposite direction. For example a bond with a duration of 15 will move down in price by approximately 15% for each 1% increase in yields. So if interest rates on such a bond move from 2% up to 4%, the market value of that bond would drop by 30%. It is very doubtful that most investors are aware bonds possess this much risk.

Q: Why sell some of the high income yielding investments that have recently been sold.

A: Yield is only half of the story in investment returns. Very seldom do we make an investment only for its dividend or interest yield. In addition to yield, we typically intend to earn some growth as well. This holds for so-called “fixed income” investments as well! A simple example would be to buy bonds selling at prices below their maturity values due to various market factors. Because the purchase price is below the face value of the bonds, but the coupon payment is still the stated coupon, the yield is higher than its stated yield. In addition, if the market price of the bond price moves back toward (or in some cases above) its maturity value, investors also get growth from that bond. For example take a BB rated corporate bond with a 7% coupon (i.e. pays $7 per year for each $100 of face value) selling at $90 that matures in 10 years at $100. The current yield is $7 / $90 = 7.78%. If the issuer of the bond pays down some other debt and/or improves its financial condition for other reasons such as an increase in profits, the ratings agencies might upgrade the bond from a rating of BB to BBB or even to A. When that happens the market price for that bond increases. In that example above, let’s say the market price of that bond jumps to $100. If we were to sell it a year after purchasing it, the total return over that year would have been 7.78% in interest plus 10% in growth for a total return of 17.78% in a year. Of course this will not happen with every investment but the point is we do not hold most investments just for the income they generate. There is also a price component. Remember the potential downside volatility in the price explained above as duration. So when the price reaches a point where the total expected future return doesn’t warrant our estimate of its price risk, we will sell despite passing up what appears to be a decent yield, in favor of owning other investments we determine to offer better risk adjusted opportunity.



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