Raw Finance

In formulating our outlook for 2010, we have noted the extraordinary challenges facing investors.  The rally in equities and bonds this year seems to have already priced in healthy economic recovery.  Yields on Treasuries are extremely low and, in some cases, near zero.  Municipal bond prices have also recovered, but many concerns remain about the ability of states and cities to raise taxes.  Where to invest?  It is always worth watching what the pros are doing, and Warren Buffett’s Berkshire-Hathaway recently purchased the Burlington Northern Railroad.  By spending almost all of Berkshire’s cash hoard on a railroad, which is much like a utility, Buffett appears to be signalling what others have suggested: we are in for an extended period of low returns.

Aim Low

Although not very thrilling or confidence-inspiring, “Aim Low” may be the mantra for 2010 and the years beyond.  As the sluggish economic recovery churns forward, the opportunities for high-growth will be few and far between.  On the other hand, interest rates and inflation should remain fairly low as well.  Thus, investors need to prepare themselves to accept lower nominal returns.

The Financial Times describes one prominent investor’s view: 

Bond guru Bill Gross makes this argument in his latest investment outlook, even though he admits he does not enjoy Mr Buffett’s long time horizon. Buying utility shares not only garners a yield nearly three times as high as the broader US stock market but often yields more than utilities’ own debt. Mr Gross reasons that, since governments seem inclined to allow all types of other businesses to earn only utility-type returns, one may as well invest in a sector already priced for such an outcome.

Inflation Can Harm Utility Investments

If high inflation does come to pass, however, due to easy monetary policy and extreme federal deficits, holding utilities can result in poor returns.  So, if one were to move funds into this area, it would be wise to hedge that position with Treasury Inflation-Protected Securities (TIPS) or some other type of inflation protection.  Gold has historically been used as a hedge against inflation, but the price of gold has already soared, making it a questionable investment for those with a moderate risk profile.

The Case for Utility Investment

Although high inflation is possible, it is not likely, at least not for a few years yet.  Thus, moving into the utility sector, or utility-like companies, such as railroads, does make some sense.  The Financial Times adds some figures to support the idea: 

Over the past decade, total returns of utilities in the S&P 500 have been 37 per cent versus a loss of 9.4 per cent for the index overall. Unless regulators are unreasonable, owning an indispensable natural monopoly is a way to get a return at least in line with an economy’s nominal growth rate plus a small premium. This would pale in comparison with Berkshire Hathaway’s historical returns, but perhaps now is no time for investors to be greedy. If the Oracle of Omaha is aiming low, the pickings must be slim indeed.