SERIOUS MONEY:For the first time in several years, investment opportunities are now plentiful, writes Charlie Fell

PENSION FUND clients have been cautioned by their investment managers following the stunning declines of the past year that successful investing is a long-term pursuit.

They are likely to question such wisdom, however, when they discover that stocks have delivered negative returns over the past decade and failed to outpace treasury bonds over the past quarter-century.

The professionals have invested in risk assets on behalf of their clients but have failed to deliver credible risk-adjusted performance.

Investors should note that much of the damage to long-term returns has occurred in the past year as managers chose to ignore the warnings emanating from the credit markets that included an inverted yield curve and rising debt spreads while valuations provided no margin of safety. The result is now plain to see.

Active investment is a losing proposition in aggregate and without a clear understanding of the rules of the game or a well-developed process thereof it is almost certain to be a fruitless pursuit.

Investors need to be aware that they operate in a probabilistic field just like professional gamblers and in order to be successful must always seek to turn the odds in their favour.

Unfortunately, there are many who appear incapable of calculating their odds of success, unlike the professional blackjack player, but appear more than able to play a successful bluff like a seasoned poker player.

Investors must recognise that price is what you pay but value is what you get. Warren Buffett stresses the point and notes that he and partner Charlie Munger "detest taking even small risks unless we feel we are being adequately compensated for doing so. About as far as we will go down that path is to occasionally eat cottage cheese a day after the expiration date on the carton."

It's all about value.

Valuation drives long-term returns and should therefore be the primary determinant of strategic allocation. Recognition of this basic fact increases the probability of success but only if applied rigorously such that the herd-like mentality so evident at market tops and bottoms is avoided.

This is easier said than done as human beings are social animals and the survival instinct deeply ingrained in our psyche promotes the ancestral need to seek safety in numbers. The instinct that ensured species survival, however, is anathema to successful investing as group-think often overrides common sense at market extremes.

The dramatic increase in risk aversion over the past year has delivered stunning losses to holders of risk assets of all varieties but valuations have been driven to extremes. The dividend yield on US stocks recently jumped above 3 per cent for the first time in 16 years and traded just half a percentage point below the yield available on 10-year treasuries for the first time since 1963.

The dividend yield is a real variable and adjusting the nominal yield on treasuries for long-term inflation expectations reveals that stocks are offering an incremental return of 1½ percentage points over bonds before any consideration of future growth potential. It is clear that stocks are cheap and reasons to be fearful have passed.

The current valuation of corporate bonds paints a similar picture. Investment-grade bonds are available at yields of more than 9 per cent or 5½ percentage points above 10-year treasuries.

The break-even default rates implied by such lofty spreads reach double-digit levels assuming a recovery rate of 35 per cent - a level of default that is unprecedented in the modern era and exceeds the worst of the Great Depression in the 1930s.

The incremental return on offer actually exceeds the historical average spread available on high-yield bonds while the real returns are paralleled only by those registered close to the stock market bottom in 1932.

The word "value" disappeared from the investment lexicon for stocks in the late 90s and corporate bonds followed down the same path during the great credit bubble as new-era thinking gravitated from one asset class to another.

The great leveller that is the financial markets has dealt a crushing blow to those investors who disregarded value, as it always does eventually. However, opportunities are now plentiful for the first time in several years. But which asset class should investors turn to first - common stocks or corporate bonds?

The trusted probability calculator reveals that the odds of both asset classes outpacing the risk-free asset over the next five to 10 years are significant.

The probability of stocks producing superior returns versus the risk-free asset is roughly 75 per cent over five years and 85 per cent over 10 years.

The odds in favour of equity investment are compelling but are underwhelming when compared with investment-grade corporate bonds whose chances are roughly 85 and 95 per cent over the respective periods.

Probability analysis clearly favours investment-grade corporate bonds over equities and this viewpoint is corroborated by the fundamental forensics.

The current economic and financial market climate means that management focus is on balance sheets and cash flow rather than the pursuit of growth.

Indeed, the high cost of capital as currently reflected in cheap valuations means that capital investment undertaken today is unlikely to be economically profitable while share repurchases conducted at the current cost of debt make little sense.

Corporate actions are likely to be decidedly bondholder friendly such that investors should increase their tactical and strategic allocations to investment-grade bonds.

Don't let the opportunity pass you by - buy investment-grade corporate bonds now.

www.sequoia.ie