Please don't, however.
The global economic turmoil which commenced in 2008 should have persuaded all investors that cash and debt instruments form a vital part of any portfolio. In fact, it was the absence of cash for many investors that resulted in huge write-downs in their net wealth and, in quite a few cases – financial wipe-out.
Bonds and cash can be an important part of your financial future and, believe us, they are not as boring as they may first appear. The appropriate allocation of cash to different currencies, across different banks and at differing dates of maturity in terms of deposit, can make a HUGE difference to your eventual financial outcomes.
Similarly bonds, ranging from those issued by governments to low grade so-called 'junk bonds', can have an equally positive or negative outcome on your portfolio.
When we first published this book in early 2008, our preferred currency was the Japanese yen. We are pleased to say that during 2008 this has outperformed every other currency in the world, including the newly renascent US dollar.
In this section we will update that advice and also our advice on government bonds and other bonds.
Currencies and bonds are dynamic instruments and active investors should subscribe to our newsletter to be found on our website
www.wakeupnewsletter.com for periodical updates.
So let's start with discussing cash ...
Cash is an important tool in building your fortune. It is the most 'liquid' – that is, saleable at short notice – of all our investment categories. When you have spare money and none of the other classes are of investment appeal – whether it's because they are too expensive or because market conditions are adverse – cash is your refuge. In 2008 there were literally millions of investors who wished that they had held onto more cash. The old motto 'cash is king' became the mantra of the year. We are at a juncture, however, where cash may not be so attractive and we will elaborate on this a little later.
Cash can be deployed in several ways. There are various deposits you can make and these tend to have different 'maturities', that is, the length of time for which you contract to leave your cash in a type of deposit. These deposits will typically (but not always) attract interest rates at a higher level the longer their duration. We will explain later why that is the case.
You can keep your cash in a variety of ways: notes and coins (which attract no interest but which you can keep nearby), and bank or other savings institutions' deposits of varying 'maturities', including instant access accounts which allow you to take your money out straight away. And, of course, you can keep your cash in a variety of currencies – anything from the Japanese yen to the South African rand. Please believe us: the currency which you keep your money in can make a BIG difference to your eventual financial outcome. Note for instance, the differing performances between the Japanese yen, the pound sterling and the Australian dollar during 2008.
Where you put your cash is also important – in terms of the maturity of the account, the currency of the cash, and the quality and type of financial institution. Where you hide your cash at home can also be important. Please think about all of those people who lost money in failed banks in 2008 and it becomes apparent just how important this choice is. When interest rates seem just too good to be true, they probably are. As an example, the failure of the Icelandic banks has landed a large number of European depositors with king-sized headaches.
In this section, we will show you how to choose an institution where you can leave your cash with confidence, and we will update our recommendation as to which currencies you should consider leaving your cash in for the remainder of the global financial crisis and beyond. We will also indicate what sort of cash levels you should think of holding depending on your circumstances (and for this please refer to the DiagnosticGrid in Chapter Nine).
We will also show that despite the fact that you should always have SOME cash – in notes, in accounts and in so-called pre-paid debit cards – cash should NEVER be the main investment you make. Cash is generally a relatively poor investment over the longer term, and that is mostly because it represents an obligation on governments. These days almost all money is so-called 'fiat money', i.e. it is issued by governments without the backing of gold or other physical reserves. So anyone who accepts cash is accepting the promise of a government, which is probably a dangerous thing to do over the longer term.
We are going to do three important things in this section in relation to cash:
Show you where to put it and for what maturities, i.e. duration of deposit
Show you how much cash you should have to hand for given circumstances and timeframes
Recommend a currency 'basket' for the next ten years which will likely outperform other currencies, in our opinion. This will be one of our BigIdeas. Our original idea back at the start of 2008 was the Japanese yen, but this has already performed so well that we are now taking the alternative 'basket' approach.
As far as bonds are concerned, these are equally important in the construction of a successful portfolio for the next ten years.
Durations are the dates on which the bonds have to be repaid by the borrowing institution. They also carry differing yields (the amount per bond that the borrower has to pay in interest annually). That interest can be paid semi-annually, annually, or even in one lump sum at the end of the duration of the bond.
The 'starting' yield of the bond is the yield at which it is priced when first sold to investors.
Most bonds, although not all, will then 'trade' on markets, and the yields will then vary according to how the price of the bond moves in those trades. We will explain how this happens later in this section.
Bonds are a form of debt for the companies or governments that issue them. They are graded by RATING AGENCIES according to their perceived relative risk; in other words, the ability of the borrowers to repay the debt.
These ratings are important to investors, although certainly not infallible. Rating agencies have got it wrong in the past (Enron is a good example and, more recently, the likes of AIG and Lehman Brothers have had their bonds hugely over-rated by the agencies). However, these ratings are important guides. The main rating agencies are Standard & Poor's and Moody's, and many funds sold to the public investing in bonds demand that their investments be rated by one of these two. These agencies appear to have taken their eye off the ball in respect of securitized mortgage paper (for instance the so-called sub-prime debt now seared in investors' memory); they certainly didn't see the bankruptcy of the big investment banks that have so far failed in the financial crisis. But to ignore what they say now would be foolish – it's like ignoring the police just because they have made some past mistakes. So although investors should not solely consider the views of the rating agencies, they should certainly take good account of them in their investment considerations.
The problem with the earlier over-reliance by many investors on the views of rating agencies was twofold: first, there has been a huge increase in the amount of bond 'paper' issued in recent years, particularly of the 'structured' sort (the complex stuff involving securitization of mortgages, etc.) put together for the most part by investment banks for large profits. These were the famous bits of paper that turned 'toxic' and heralded our current financial crisis.
Second, the ratings agencies were typically paid for their services, not by the investors in the bonds, but by the issuers, including the large investment banks. This created an obvious potential conflict of interest.
Nonetheless, the rating of a bond can have a huge effect on its yield. Depending on their ratings, bonds offer higher or lower yields – that is, the amount of interest to be paid to the bondholder divided into the price of the bond.
Typically, a riskier bond (one with a lesser rating than a 'higher quality' bond) will yield more than a blue-chip (or cast-iron quality bond). These blue-chip bonds are issued by borrowers whose creditworthiness is perceived to be impeccable – the world's leading governments, for instance, the supranational agencies such as the World Bank, and the largest corporations with the strongest balance sheets. These would typically be rated as 'AAA' (or 'triple A') bonds.
The ratings ascribed to bonds, and by inference to the companies and governments that issue them, are very important to those institutions because they largely determine the amount they have to pay lenders to borrow their money.
It is a bit of paper (although, like shares, they are typically electronically registered now) that states the borrower (say, company X) will repay the FACE VALUE of the bond on a due date sometime in the future.
This due date can be anywhere from one month (so-called money market instruments or T-Bills) to 50 years. These straight bonds carry a 'coupon' which is the interest rate that they pay to borrowers. In the case of very short-dated bonds, this is typically reflected in the price at which the bond is to be eventually repurchased.
So, for instance, a one-month money market instrument might be issued at 100 and bought back at 100.5 in a month's time, the 0.5 being the interest that has 'accrued' on the debt over the period.
A longer-dated straight bond will pay interest, typically every six months or annually, to its holders. In some cases, such as with so-called zero coupon bonds, the interest is 'rolled up' and added to the eventual redemption price of the bond, in other words the price at which the bond is redeemed or 'paid back' at the end of its term or 'maturity'.
Governments around the world regularly issue bonds to finance their activities that cannot be met out of taxation or other sources of income. The developed world economies are, for the most part, big issuers of bonds, or at least have been in the past. For many governments, bonds are also a vital instrument of monetary policy and are used to control the supply of credit in an economy.
This is not something that needs to concern us at the moment, but it is important to note that the range of government bonds in issue is simply staggering, and the volumes traded in these bonds are extraordinarily high.
There are also all sorts of sub-government bonds; for instance US municipalities can issue their own bonds (so-called 'Munis' which can carry tax advantages for US citizens). There are also, in many countries, state and provincial bonds, as well as city bonds. There are also supranational organizational bonds (e.g. World Bank bonds) and bonds backed by government guarantees (e.g. for rail networks or for housing loans). Many of these bonds are pitched to investors with specific tax advantages.
Typically, companies issue bonds because they can raise money more cheaply by doing so than by borrowing from a bank. Also, bonds tend to be for a longer duration than a bank loan, so a company can work out more easily what the 'cost of its capital' is; i.e. the interest it has to pay over a period of time, without worrying about interest rate changes which can affect the rate paid on bank debt.
Also, companies can do fancy things when they issue bonds. For instance, they can sell what are called 'convertible bonds'. These are bonds which the borrower can convert into shares of the company at various times, rather than getting paid back in cash. This gives the bondholder two rights: one is to an income stream from the 'coupon' on the bond, as well as the right to be paid back in cash if the company's shares don't perform to plan (and also because they are bond holders, convertible owners tend to have greater rights than common shareholders); the second is convertible bond shareholders have the right if they choose to convert the bonds into the company's shares.
Put simply, a typical convertible bond will allow the bond holder to convert the value of their bond into the issuer's shares at a fixed price for a period of time, so if the shares of the company go up way beyond that fixed price, it will typically make a lot of sense for the holder to 'convert' the bond into shares.
For the company that issues them, convertible bonds carry several benefits.
A typical one is that because they can be converted into common shares, the company will tend to pay less interest on its bonds, because the bondholder is getting something 'extra'. Also, if the bondholders convert into shares, the company no longer has to redeem its bonds for cash, saving the 'repayment of the principal'. In other words the debt will have been extinguished.
Convertible bonds, therefore, can be mutually beneficial to both investors and companies. If one of the companies relating to a BigIdea that you have or that you read about in this book has issued or is issuing convertible bonds, it might be a good idea to check them out.
There are ways of knowing whether a convertible bond is a good buy or not and we will provide some simple rules in respect of this at the end of this chapter.
Just to make life more complicated, there are lots of other permutations of bonds issued by companies: bonds with warrants attached (where the warrants allow the holder to buy shares at a fixed price), bonds which have certain specific security (i.e. they are not just secured against the assets of the whole company, as is typical of most bonds, but against some specific income stream or asset), etc.
In truth, most of these permutations are of no interest to the individual investor, partly because the bonds tend to be sold exclusively to institutions and are not generally readily accessible to smaller investors; and partly because the arcane nature of these instruments would demand too much attention and deflect us from our simple theme which is to preserve and enhance capital by pursing a disciplined investment approach based on the BigIdea strategy.
There are books on the subject if investors do want to take it further – bonds are fascinating and definitely an area worth exploring – but let us now turn to practicalities. Having gone through the types of bonds and of cash alternatives available to investors building a long-term portfolio, what do we specifically recommend?
When this book was first published at the start of 2008, our opinion was that, generally speaking, bonds around the world were more or less priced to perfection. In other words, the yield-spread (the difference in yields) between good quality blue-chip bonds and lower-grade bonds was not sufficiently high to compensate investors for the risks of default. This has proved to be correct – and in spades. The blowout in spreads has been incredible. Government bonds in major economies (not developing economies, where the opposite has occurred) have soared in price. Meanwhile corporate bonds, bonds of municipalities and of minor nations have fallen in price precipitously, which has made for the biggest ever spreads between so-called low risk bonds (e.g. US or UK government bonds) and other types of bonds.
This is despite the fact that the Anglo-Saxon governments are issuing record amounts of bonds as they seek to pay for ballooning deficits brought on by the profligacy of their governments and the failure of large swathes of their financial systems. This is counterintuitive, but has happened in periods of great financial stress before, although not to the same extent.
In Japan, interest rates have continued to decline over the past 20 years with very long-term government bonds yielding not much more than 1 per cent, reflecting deflationary conditions and an absence of alternative investments.
For investors in US and UK bonds, however, the situation is in our opinion very different.
First of all, the recovery of their economies is likely to be much faster than the Japanese one because the policy responses of governments to the current crisis have been much more rapid than in Japan. We expect, as we say elsewhere, that the deflationary headlines will abate sometime in 2010 and inflation will start appearing. At this stage US and UK, as well as European government bonds, will look like very bad investments indeed.
The volume of government bond issuance in the current crisis will be of such a tsunami-like scale that governments will have no option but to create inflation to reduce the effect of the burden of bond repayment by effectively debauching the value of fiat or paper money.
Furthermore, because of risk aversion by insurance companies and other institutions, yields themselves on even the safest bonds do not take into account potential inflationary risks and even, dare we say it, blue-chip and governmental default or partial default risk, over the coming years.
For this reason, our broad recommendation has now changed. We believe that investors should become much more wary of government bonds and start to look at the bonds of companies which are likely to survive under almost any circumstances and which now – because of the blowout on 'spreads' – are relatively speaking much more attractive.
The cheapest and most liquid way to invest in corporate bonds is through an ETF. We suggest readers consider the iShares Sterling Corporate Bond Fund (listed in London, symbol SLXX). There is no initial fee, the expense ratio is only 0.2 per cent and at the time of writing (January 2009), it offered a yield of 8 per cent. For those interested in US dollar-denominated bonds, there is the iShares iBoxx Corporate Bond Fund (listed in New York, symbol HYG), which has an expense ratio of 0.5 per cent and yielded 11 per cent at the time of writing this.
When this book was first published, some serious cracks were already emerging in the long halcyon period that bond investors had enjoyed in recent years. In mid-2007, two highly leveraged funds managed by Bear Stearns got into trouble, presaging the beginnings of the end of a benign period for so-called 'junk' or low-rated debt.
These funds, known as the Enhanced Leverage Fund and the High-Grade Fund (a misnomer if there ever was one), were wiped out in all but name – even though Bear Stearns put in US$1.6 billion of its own money to try to shore them up. Then one of Europe's banks, BNP Paribas, followed with its own multi-billion-dollar fund disaster. The dominos had started to tumble. This then led on to the outright failure and takeover of Bear Stearns, the failure of Lehman Brothers, Northern Rock, the part nationalization of many banks around the world – and the biggest financial story of the post-war period.
What went wrong? Well, these Bear Stearns funds had four things going against them: first, in a rising interest-rate environment investing in so-called 'collateralized debt obligations' linked to sub-prime mortgages wasn't a great idea; second, borrowing on top of those already-risky investments wasn't bright-spark stuff either; third, investors demanded their money back; and fourth, other banks – sensing blood – began to make 'margin' calls or emergency cash calls. Not a pretty picture.
All of this happened just as everything seemed great, the garden for bond investors was rosy, and yields hovered at low levels. When all seems too good to be true, it generally is.
Indeed, in the preceding year (2006), the default rate (i.e. the failure to pay either interest or principal on the part of the borrower) on so-called 'high-yield' (i.e. junk, or non-investment grade) investments was the lowest for 25 years.
But strains in the US housing market started to alter this – and it is now evident that the Bear Stearns funds debacle represented a kind of fatal turning point for the merry game played in bond markets in the past 20 or so years.
The Bear Stearns funds specialized in investing in the most exotic segments of 'sub-prime' mortgage paper, i.e. basically mortgages where the credit quality of the individuals taking them out was the poorest in the market. In some cases, no credit checks were undertaken at all on these types of mortgages, which often were advanced against the full (i.e. 100 per cent) value of the properties backing them.
Because the sub-prime US mortgage market started running into trouble in early 2007, it was only a matter of time before the funds that 'played' in them also experienced difficulties. Bear Stearns not only took on the riskiest kinds of loans for their funds, but they also borrowed on top of them to add extra risk.
As US interest rates started to go up, these and other types of incendiary bond-related investments began to be exposed for what they were: dangerous.
The huge explosion in the private equity field, and particularly in the buy-out area, was a major contributory factor in the growth of lesser-quality bond debt in world markets. This abundance of second-rate debt had been enhanced by a culture of 'easy money' policies pursued by many of the central banks of major economies.
This has meant that credit growth generally outpaced economic growth, which led to systemic over-borrowing. In these circumstances, one day the chickens will always come home to roost, and the inflection point for these chickens was sometime mid-2007.
In the first publication of this book, we generally believed that investors should stay away from corporate and other forms of lesser quality bonds because of the huge risks associated with the 'easy money' period that looked to us to be coming to an end.
We also indicated that we thought that the most interesting long bonds for our readers to monitor were those of the US government at the so-called 'long' end (30-year Treasury bonds) and those of the Japanese government (called JGBs) of ten years' duration. We gave some price points on these that were not directly reached. Nonetheless, these have been by far the best investments in the bond universe since the book was published.
It is now time to take a contrary view.
Our new, updated view is that Anglo-Saxon government bonds represent poor value and are likely to decline in price.
Some corporate bonds (those of what we call 'proxy governments' such as huge companies like BP andUnilever) represent much better value than government bonds. Bonds of these companies are liquid (i.e. easy to buy and sell) and brokers can advise on which are the best to buy.
However, overall we think that investors should look out for significant falls in developed government bond prices at some time in the next few years.
Some reasons why bond prices in general might fall sharply could be as follows.
The US is heavily indebted to foreigners. If, as we expect, the US dollar resumes its long-term devaluation in response to trade deficits and to a move to diversify foreign exchange reserves away from US dollars by the major Asian central banks, then bond yields in the US could expand.
This would be because the US could be forced to raise interest rates to defend a plunging currency. This is counterintuitive to what is happening at the moment, when investors are seeking safe havens for their money and paying almost any price for the debts of major economies.
At the right PRICE and at the RIGHT exchange rates, US government bonds would be an attractive proposition, but that price is much lower than today's levels. Keep a watching brief and follow our newsletter for updates.
We also mentioned in the earlier edition of this book that the euro was a sell against the dollar at a rate of €1 = US$1.55. As it happened, it reached a level of US$1.60 = €1 in the summer of 2008.
It is now, at the time of publication, about €1.30 = US$1, so that has worked out as a good sale. Our view currently is that the US dollar and the euro are both vulnerable, for similar as well as different reasons, to falls against other currencies.
In the case of the euro, it is because it is fundamentally overvalued and countries such as France, Italy and Spain cannot compete internationally in export markets at these levels of the exchange rate.
For that reason the euro is likely to fall further against the US dollar and other currencies – but the US dollar will have its own issues which will soon become evident.
The ultimate debauching of the US currency by the excessive creation of new paper will lead in time to the US dollar falling against just about EVERY currency and the main currency recommendation of this section is to get OUT of US dollars. The printing presses have been and are running hot in the United States, and while the velocity (or circulation) of money remains low, a simple spark of confidence will set the US off an inflationary course that it both desires and needs to reduce its external indebtedness. This will be accompanied by a fall in the US dollar against almost everything. The recent rallies in the US dollar, which we heralded in the first edition of this book, provide an excellent opportunity to sell the currency.
In the case of the pound sterling, we recommended selling the currency as it approached £2.20 to the US dollar. It got very near to there. At that level, we stated that the UK economy would be deeply uncompetitive and the pound grossly overvalued – therefore it would be time to sell. Sure enough, the pound fell precipitously through the winter of 2008 and is now, in our opinion, undervalued against the dollar. The headlines of pessimism about the UK economy are so universal as to cause us to pause for thought – and indeed we think that at about US$1.45 to £1, the pound should be a buy.
We are not saying that the UK economy is in a great shape – it isn't. But relative to the US and to the euro zone, it may have advantages. One of these is its flexibility, and the rapid response of its exchange rate in adjusting to the external and internal pressures of the economy. In our view, the long-term value of the euro and of the dollar is more perilous than that of the pound.
The UK's public debt stands at around 44 per cent of GDP, making it the lowest of the G7 countries. The most indebted G7 nation as a percentage of its GDP is Japan (170 per cent) followed by Italy (104 per cent). US public debt stands at around 61 per cent of GDP. We believe that Britain's Conservative Party will win the next election and this will result in a return to balanced budgets and tax cuts over time.
We can't say the same for the euro zone which is run by many governments yet by one central bank.
The whole of the so-called euro zone is vulnerable to what Leuven University's Professor Paul de Grauwe calls 'asymmetric shocks'. All of the euro zone countries pursue differing wage policies and these lead to divergent trends.
The problem for the euro is more complex than that for sterling; there are 21 countries that use the euro as their currency (including the likes of Monaco, the Vatican City and San Marino) – and all of them move at different speeds. In recent years, Germany has been squeezing wage costs through improved productivity; Ireland and Spain enjoyed booms which proved unsustainable; and France and Italy have got themselves into big messes.
Now that a serious recession has developed in several of these key countries, this is beginning to put an intolerable strain on the monetary union. It is why we do not recommend the euro as anything other than a shorter-term 'punt' (or gamble) for investors.
Within the euro zone the only 'safe' economies are Holland, Germany, Luxembourg and, possibly, Belgium. In general, the higher the euro goes against other major currencies, the worse the other economies of the euro zone will be in terms of potential crisis and, for this reason, we generally recommend that investors currently avoid euro-denominated investments in countries such as Greece, Italy, France, Portugal, Spain and Ireland. Some of these countries would be better off leaving the euro and reverting to their former currencies to allow them to devalue and establish a competitive exchange rate. For instance, Italy's unit labour costs are 40 per cent higher today than in 1995. Unfortunately, such a move is likely to be too politically sensitive and thus unlikely to happen. But in the long term, it would be better for the euro as well as these ailing, uncompetitive economies.
So, if investors are thinking about bonds in the construction of their portfolios, we have the following two points for you to consider:
For your cash holdings, we recommend that you hold at least 30 per cent of your cash deposits in your base currency, i.e. the currency used where you live or where your greatest outgoings are. For the remaining 70 per cent, create a basket of up to four additional currencies from the following list (obviously exclude your base currency if it is in this list): UK pounds, Japanese yen, Australian dollars, Canadian dollars, Swiss francs and Brazilian real. Do not allocate more than 20 per cent to any one currency.
For example, if you live in the UK, your currency basket may look like this: 30 per cent UK pounds, 20 per cent Swiss francs, 20 per cent Australian dollars, 15 per cent Japanese yen and 15 per cent Canadian dollars.
Secondly, we would avoid euros at current levels and also the US dollar. Please feel free to visit our website for up-to-the-moment reviews of these recommendations.
US government bonds are to be avoided until the US dollar has run the full course of its fall against other currencies, and this could take some time. We believe that over the next five years, the US dollar could fall 30 per cent against a basket of other major currencies. In addition, if your search for BigIdeas throws up companies which have convertible bonds in issue which are readily accessible to private investors, we do recommend that you consult a stockbroker, but it may be worthwhile buying those convertibles as a safer way of investing in that business.
The bond should have preferential status in the event of a corporate liquidation to common equity (or ordinary shares). This means that you stand a better chance of getting something back if the company goes bust.
The convertible bond should carry a 'coupon' or interest payment higher than the yield on the company's ordinary shares; so for instance if SOLAR Limited (a mythical company) issues a convertible bond at a 4 per cent annual 'coupon' but its ordinary shares' dividend yield (the dividend payment annually divided by the share price currently prevailing) is less than 4 per cent, then that particular box can be positively ticked.
The convertible bond should allow you to convert into the company's shares at a 'premium' to the share price that is not too great to the current prevailing share price. So for instance, if the share price is $10, and the price at which you can 'convert' your bonds is $12.50, the premium will be 25 per cent. Generally, we don't like convertible bonds that have a premium of more than 25 per cent because it means that there is a high hurdle for the shares to reach before it becomes worthwhile for bond holders to convert to becoming shareholders.
The terms of the timing of conversion should be straightforward, as should be the method. In other words, if you want to convert because the share price has gone above the level at which it becomes worthwhile, it should be easy for you or your stockbroker to do so. Here, professional advice from a stockbroker would be invaluable as sometimes these conversion terms can be arcane.
But in principle we like convertible bonds as a class. They offer some downside protection in the form of better security over the assets of the company than a straightforward investment in shares. They also typically have a yield which is superior to the yield on common shares and they offer convertibility into shares if the share price rises, so they also have the prevailing feature of being potentially common or ordinary shares.
However, investors should not simply invest in a convertible bond because it is available. Many companies haven't issued them and if the only way for you to take advantage of one of your own BigIdeas is to invest in ordinary shares, then so be it. But 'converts' can be a neat way of making an investment into a company that you like the look of.
As far as cash is concerned, we believe that the paramount issue for investors should be safety and also the deployment of your cash in the best positioned currencies.
Most people live in one place. So for most readers of this book, one currency will be the most important in their lives. It's pretty evident that, in our everyday life, we will need our local currency for spending purposes. Unless you live in a banana republic, where rampant inflation prevails (say Zimbabwe), then your local currency will tend to be RELATIVELY stable.
Because all of us should aim to match our assets and our liabilities in life, we should keep some emergency reserves in our 'home' currency.
These reserves should be kept in banks with strong credit (and even then, spread around so as to take maximum advantage of various government depositor protection schemes), or in money market funds or such which have equivalent ratings. Cash in itself tends to be a poor performer over time; it is eroded in purchasing power by inflation, and rarely does it generate real returns after tax for prolonged periods.
So cash in your 'home' currency should be limited to the following:
As a reserve for other emergencies and as a contingency, you should keep about six months' worth of cash in your bank – in an account that pays interest. Don't shop around too much on the interest rate for this particular cash hoard – typically higher rates of interest carry higher degrees of risk, and you really shouldn't take any risk with your contingency cash.
As a strategic reserve – in other words, as a long-term hedge against the possible decline of your own currency and as a way of holding funds when you are not fully invested – consider a foreign currency.
BigIdea # 5
Investing in the Japanese yen WAS our BigIdea number 5.
The problem is that since the book was first published, the yen has risen by about 25 per cent against the dollar, and over 40 per cent against the pound. It is now no longer as attractive as it was then.
So our BigIdea number 5 now is – sell the US dollar against almost anything. In another section, we talk about gold as a great idea, and that is one of the substitutes; but we also now like commodity proxies which have been very badly beaten up, such as the Canadian dollar and the Australian dollar.
And because we don't think the fundamentals of the UK economy are as bad as many do – and we believe that there will be a positive change of government – the pound is a buy against the US dollar also.
BigIdea # 6
On the subject of cash, consider this: when you travel and use credit cards, or even when you carry cash, you are subject to all sorts of risks – theft and fraud amongst them.
So we bring you our next BigIdea: the prepaid debit card. Issued by an 'offshore' bank, it is a good alternative to carrying cash around. These prepaid debit cards function just as ordinary debit or credit cards do: they can be used at ATMs around the world, and used in stores, restaurants, etc.
But they carry a finite ('pre-loaded') amount of money – in most major currencies – and they carry relatively low transaction fees. Furthermore, they can be 'topped up' on the internet and be made to look like business or ID cards.
They are the modern equivalent of travellers' cheques – anonymous, portable and relatively safe.
In the United States, many banks issue prepaid debit cards to US citizens, and indeed there are an estimated 300 million now in circulation, many of them gift cards.
This BigIdea was, in fact, directly prompted by the review of bonds and cash undertaken in this section.
Money and its transmission is a huge international business – think of the literally billions of dollars or equivalent that whizz around the international banking system on a daily basis. Furthermore, each of us regularly spends money in shops, bars and restaurants using credit cards, debit cards, cheques or cash.
All of these payments systems have evolved over time (in our book, Wake Up!, we describe the development of money over the millennia) but it is only relatively recently, in the past 50 years or so, that plastic payment solutions, led by the ubiquitous credit card, have come to the fore.
These payment solutions use a highly sophisticated network of banks, processors and umbrella organizations (such as MasterCard, Visa and American Express) to facilitate transactions internationally and on a vast scale.
These 'plastic' based ways of paying will increasingly be supplanted by surrogates – not necessarily replacing the existing organizations that move money and credit around, but by employing different methods of transmission.
For instance, the use of mobile phones to pay bills will become increasingly prominent. In Japan and elsewhere in Asia, many small transactions are accomplished by putting a mobile phone into a cradle that then deducts small amounts from an implanted chip in the mobile phone. Increasingly, mobile phones will come to be important all-in-one alternatives to carrying cash.
Apart from prepaid cards and mobile phones, a whole raft of new technologies is being developed which in time – and we believe about 20 years will be plenty in this respect – will edge out cash as the preferred way of making small transactions. And this development applies to the whole world.
The market opportunity for new methods of money transfer is phenomenally large. Beneficiaries will be companies that develop the relevant technology, companies that displace banks that currently make excess profits from their credit card businesses, and so-called 'e-wallet' and 'tap and go' payment solutions.
To give readers an idea of the scale of the opportunity:
In the UK, the prepaid debit card market is expected to grow from 2 million cards in issue today to about 44 million by 2010.
Already, trials are under way in Europe where people are having tiny data chips implanted under their skin to enable them to simply 'wave and pay'. Yes really. For the moment, we think this technology may be a step too far.
But more realistically, the use of mobile phones to pay bills will become more and more ubiquitous. 'Pay by Mobile', using cradles installed in shops and SMS/texting based systems are already prevalent in Japan.
Although traditional banks might, on the surface, seem not to be so keen on these new payment solutions developing, this is not the case. The old-style banks are, in many cases, at the vanguard of encouraging the move to a cashless society as it is very much in their interest.
This is because the cost of transferring physical cash is a high one for banks everywhere. For example, it has been estimated by McKinsey, a consultancy, that in Europe, the total cost of moving money around is about $30 billion a year, or about 8 per cent of all banks' total operational expenses. So it makes clear sense for banks to encourage the use of new and cashless payments solutions.
The fact is that over the next ten years or so the following will occur:
Personal cheques will become obsolete in almost every major jurisdiction.
Prepaid debit cards will continue to grow at a very fast rate, particularly in Europe and Asia.
The use of mobile phones to effect payments will explode – first, for small transactions, using 'tap and go' cradle technology (which can also be used with prepaid cards, incidentally), and second with the use of web-enabled phones to effect payments.
Online payment solutions – so called e-wallets – will be perfected and online transfers of money will become the major way in which money is transmitted.
Over time, cash will be displaced in almost every market – though its 'abolition' is at least 20 years away.
So how do we as investors benefit from this next BigIdea– the incontrovertible growth of the cashless society?
One way is to 'play' the growth of prepaid cards.
There are several ways in which a bank can make money out of the fast-growing prepaid debit card market.
First, there is the 'float' – that is, the money loaded onto cards but not yet spent. The interest on this, which can be considerable, belongs to the issuing bank.
Then there are the various fees – such as issuing fees, transaction fees and foreign exchange fees, which the issuing bank benefits from.
Another beneficiary of this prospective boom in prepaid cards will be the issuing networks. Visa and MasterCard, which are owned in part by member banks, are the leaders in providing the payments networks through which such cards operate.
MasterCard in particular is interesting. It is listed in the US and, although a large company, appears to us to have considerable growth ahead of it. This is a share that readers might consider as a 'safe' way of participating in the move towards a cashless society.
This uses a hidden embedded computer chip (in a card, a phone or your body), linked to radio frequency antennae. After the NFC-enabled device (or body) is passed at the point-of-sale, payment details are sent wirelessly to the payment scheme network. Moments after payment is initiated, confirmation is received both by the vendor and by the buyer.
As an example of this, MasterCard operates a system called Pay Pass which allows users to 'tap and go'. This is faster than cash, enabling retailers to handle more customers in less time. It is faster than a swipe, and has been found to encourage sales where, for instance, customers don't have enough ready cash on them.
But, of course, NFC can and will be used in conjunction with other delivery methods other than cards; this, for instance, can be through the mobile phone or a key fob.
One way of keeping an eye on this technology is through the website of the industry forum; most of the mobile handset manufacturers are already members of this. Look at
www.nfc-forum.org to keep a general eye on industry developments.
In Japan, as of mid 2008, over 12 million units of so-called 'wallet phones' have already been shipped, with Sony as the market leader with a technology called 'Felica', where the handsets have been sold through the leading mobile company, DoCoMo.
In the US, NFC is as yet confined to limited trials on cards, and in Europe it is a year or two away from being implemented.
But make no mistake, dear reader: within a year or two, there will be a move worldwide to adopt this technology as a preferred form of payment. With over 500 million mobile phones sold worldwide every year, and with developing economy usage of mobile technology fast catching up with that of the developed world – this technology will be EVERYWHERE.
And soon, this technology will morph into a world in which we have fully integrated mobile payment solutions. This, in our opinion, is by far the best opportunity for future payment solutions as an area for investment.
This solution literally provides an 'e-wallet' – a means of carrying 'electronic cash' with you wherever you go. The main difference between this and all previous technology is that the mobile phone is actually the payment delivery system itself.
The key feature of this is that the payment facility is one directly linked to the retailer, bypassing the payment network infrastructure (e.g. banks, MasterCard and Visa), thereby saving on what are known as 'interchange fees'.
One company that is a leader in this field is C-SAM, based in Chicago in the US. See
www.c-sam.com for updated information. This company was one of the first to see the benefits of convergence between mobile and payments technology.
Early on, C-SAM viewed money transfer, bill payments, prepaid phone cards, person-to-person transactions and stored cash applications as key entry points to the mobile commerce market and developed products for each of these. Now it and a number of other companies are ready to bring genuine 'cashless' technology to the world of everyday transactions.
C-SAM uses a product called OneWallet, which replaces all physical cards, letting users conduct all their payments through their phones or the web. It is complex in terms of system implementation but is simple for the user; it is also a 'white label' product, enabling existing card or retail companies to retain their customers with 'virtual' cards.
The companies to watch in this dynamic and exciting area are:
C-SAM. This company is not listed, but may be one day. Readers should check its website for regular updates on any financing that it may be undertaking (
Sony. A leader in cradle and point-of-sale (POS) phone technology. The problem is that this company does a multiplicity of other things, but having a few shares of Sony, listed in Japan and in the US, will probably be no bad thing.
TxtTrans Ltd. Another unlisted company, this time one from the UK, this is a leader in banking verification systems. This is another company that readers should watch, both to observe industry trends and to see if the company does a public financing. The company's website is