The Thoughts of a Contrarian Investor

Contrarian investors challenge conventional wisdom; getting them to agree with the consensus is like trying to herd cats. They do not always get it right but mavericks are always worth listening to, if for no other reason than to question your understanding on a chosen investment strategy. Perhaps the most famous contrarian investor in the UK is Neil Woodford, subject of my last blog post, but in this article I want to share the thoughts of another, Alastair Mundy who manages the Investec Cautious Managed (ICM) fund amongst others. He is down to earth and his communications are interesting, clear and are not unnecessarily complicated by technical charts and analysis. I have recommended the ICM to many of my clients and whilst the long term returns have been excellent the fund has underperformed its peers in recent years.

One of the reasons the ICM has underperformed its competitors in the Investment Association Mixed Investment 20-60% shares sector is Mundy is bearish on the global economy and has taken a defensive position in his portfolio. So whilst the fund can invest a maximum of 60% in equities in recent years the ICM has had a significantly lower allocation compared to its peers and has consequently underperformed. Mundy also has a short position in US equities on the basis they are expensive. It means if the market tanks the fund will gain. To date however the short on the S&P 500 has detracted from performance.

Another reason why the ICM has underperformed is its allocation to complementary assets. These include Norwegian government bonds denominated in Kronor, gold and silver and index linked bonds. You generally will not find these in other portfolios. The former are safe haven assets, whilst precious metals and index linked bonds are traditional hedges against inflation. With “risk on” sentiment favouring equities, event risk subsiding, the dollar strengthening and inflation muted these complementary assets have underperformed. However Mundy’s argument for his asset allocation is compelling. Firstly he questions whether funds labelled as cautious really are cautious with their high weightings to equities which look expensive by conventional measures.

Further in a recent webcast Mundy presented some interesting data to support his cautious outlook. From the fourth quarter of 2007 to the second quarter of 2014 global debt has risen from $144 trillion to $199 trillion. This includes government debt up from $33 trillion to $58 trillion (Source: McKinsey & Company, February 2015). Debt is still clearly a big problem for the global economy. Mundy also argued that there are plenty of other things to worry about, a Greek exit from the Euro, interest rate rises in the US and UK and a slowdown in China, yet he considers equity valuations seem to be saying there is nothing to worry about at all! The one equity market where he sees value is in Japan and this is reflected in a 12.6% weighting in the portfolio at 30/6/15, quite a big bet for a cautious multi-asset fund.

Finally Mundy suggested that the markets are underestimating the potential for inflation. Data from 1915 & 1917; 1945 & 1947 and 1972 & 1974 showed how price inflation rocketed from nowhere over two years. For example from 1972 to 1974 it went from 2.9% to 12.3%. (Source: Incrementum AG). He questioned if  investors actually saw the catalysts for these inflationary surges? Finally Mundy suggested central bank policy could be used to keep interest rates below inflation in order to shrink debt, a process called “Financial Repression.” If inflation surprises on the upside index linked bonds at least should rally.

The inclusion and retention of a fund like the Investec Cautious Managed in client portfolios despite a period of underperformance serves several purposes. Firstly it has an easily understood target return of CPI + 4% p.a. meaning its goal is to beat inflation. For me the use of the Consumer Prices Index is preferable to the less understandable LIBOR (London Inter Bank Offers Rate) which other targeted return funds use.

The ICM is a genuine cautious managed fund and as such it is not recommended for “shoot the lights out” performance. It complements pure equity and indeed other multi-asset portfolios with its unique asset allocation. Low or negative correlations mean risk reduction. Given these points comparisons with the ICM’s so called peers in its IA sector should not be given too much significance.

Finally I like fund managers who are willing to back their convictions. As noted Mundy has a big position in Japanese equities. It is at first sight a puzzling contrarian allocation for a cautious risk fund. However when valuations and other factors are taken into consideration it makes perfect sense. The latter include money printing, a weaker Yen, more investment into equities from the government and other public pension schemes and increased dividends and share buy-backs.

This blog is intended as general investment commentary and reflects my own views. It is not an invitation to invest in the assets and  fund highlighted as these may not be suitable for you. You should seek individual advice before making investment decisions. 

Posted in Contrarian Investment, Japan | Comments Off

Woodford Beaten by a Machine

A few weeks ago I came across an article in the finance section of the Daily Telegraph online. It read “Man v Machine – How Neil Woodford was beaten by a computer.” Naturally as a supporter of Woodford, one of the very best UK equity managers the headline piqued my interest. As you may be aware Woodford managed highly successful UK equity income funds at Invesco Perpetual, including the flagship High Income before setting up his own investment company, just over a year ago. He is an extraordinarily successful contrarian and value investor, and over the years he has called the market correctly, famously avoiding tech stocks at the end of the 1990s.

The logical conclusion from the headline is this is more evidence that passive index tracking outperforms active stock picking fund management. If Woodford can’t beat the market then what hope is there for the rest of the fund management industry, who by comparison with Woodford are mere mortals?

The article can be viewed via the link at the bottom of the page. It explained that an index tracking fund, the Vanguard FTSE Equity Income Index beat the St James’ Place High Income fund over a six year period since the former was launched on 23/6/09. The St James’s Place High Income was used for comparison rather than the Invesco Perpetual High Income fund as Woodford has run the former continuously over the period in question unlike the latter. With dividends re-invested, data from FE Trustnet showed the Vanguard tracker returned 133% against Woodford’s 107%.

So what should you conclude? Active fund management is now officially dead (RIP) and you should switch to investing in lower cost index trackers? Well that would be a perfectly understandable reaction and many investors and their IFAs have adopted passive investment strategies. However the industry has been divided about the merits of active versus passive strategies over many years and it was a subject I covered in an investment blog dated 10/6/14 (see link at the bottom).

It is an indisputable fact that Woodford was beaten by a tracker, the data does not lie, but it can hide some of the truth. So let’s look a bit deeper as the issue is more nuanced and complex. Whenever an analysis of returns is undertaken you have to consider the prevailing stockmarket conditions that applied over the relevant period in order to understand the context and significance of the data. The Vanguard fund was launched in June 2009 a few months after the nadir of equity markets following the financial crisis in 2008. This six year period to June 2015 has been marked by a period of unprecedented loose monetary policy from central banks, including ultra-low interest rates and money printing (QE). This has provided huge amounts of liquidity for markets and raised asset prices across the board, leading to a six year bull market for equities. “A rising tide float all boats,” is the oft use phrase to describe this phenomenon. One of the consequences of this rally has been the very high correlation of stock returns, good and bad companies have all benefited. In such markets it has been difficult for fund managers to outperform the index although a number of funds did so as the article explains.

The problem with index trackers is that equities do not always rise steadily nor do they always enjoy a bull market rally. In periods of high volatility, when markets move sideways or in recessions, disparity in stock returns increases significantly and stock picking comes to the fore. Index tracking tends not to do well in these market conditions and active fund management is likely to outperform. For example over the last year the new Woodford Equity Income returned 18.3% and the Vanguard tracker just 6.4%. The following chart of the FTSE 100 over the last year shows the market was volatile and has broadly moved sideways, precisely the conditions in which active fund management is expected to outperform.

Another issue that came to mind was whether charges been taken in account fairly in the comparison? I don’ think so when the costs are analysed. The Vanguard tracker is quoted as having an ongoing charge figure (OCF) of 0.22% p.a. It is dead cheap and this is one of the principal attractions of index trackers compared to actively managed funds where costs are higher and there is no guarantee of outperformance. The OCF for Woodford’s St James’ Place High Income is quoted in the article at 1.88% p.a. The higher costs are clearly a drag on returns and means active funds start with a handicap compared to index trackers. That said the Invesco Perpetual High Income fund, which my clients are invested in has a lower OCF of 1.67% p.a. although it is still much higher than the 0.22% payable to Vanguard.

However this is a simplistic charge comparison as it is does not take into account two cash benefits to clients from bundled share classes of actively managed funds such as the Invesco Perpetual High Income with an OCF of 1.67% p.a. This charge includes a payment of trail commission of 0.5% p.a. which I use to offset client fees for investment advice and typically a 0.25% p.a. rebate to the platform the investment is held on, to cover their administration costs. This means a comparison of charges of 0.22% v 1.88% (or 1.67% p.a.) is flawed. To have bought the Vanguard tracker with advice at the same rate and held it on a platform such as Fidelity FundsNetwork would have meant annual costs of 0.22+0.75% = 0.99% p.a. This extra 0.75% p.a. has not been priced into the returns data and exaggerates the differential performance over the six year period. In fact had the 0.75% been factored in the Vanguard fund’s I calculate the returns would have reduced from 133% to 124%, still enough though to beat Woodford’s fund.

So what do I conclude? Yes you can always find examples of where passive trackers outperform. However these normally occur in unique market conditions when equities are rising across the board. This has generally not been the case in the last 15 years. It is clear the timescales and hence market conditions over which investment performance of active and passive funds is compared has a strong bearing on the outcomes and caution is required in drawing conclusions on the best investment strategy.

This blog is intended as general investment commentary and principally reflects my own views. It is not an invitation to invest in the strategies or funds highlighted as these may not be suitable for you. You should seek individual advice before making investment decisions. 

Posted in Active Fund Management, Index Tracking | Comments Off

Volatility & Interest Rate Sensitivity

A recent feature of global markets has been increased volatility in both equities and bonds. Clearly the Greek debt crisis has weighed on equity markets especially in Europe. Incidentally UK banks have very little exposure to Greek debt although the knock on effect of a default could be significant given the EU is our biggest trading partner and the potential for contagion. The negotiations in the next few days, the proposed Greek referendum and the markets’ response once the 30 June deadline is reached will prove interesting.

Elsewhere China’s Shanghai Composite Index fell 8% on Friday. The index is now a whopping 20% below its peak, reached just a few weeks ago. Fears about monetary policy easing were a factor but Chinese equities have risen strongly in the last year and I suspect that investors have been taking profits.

In the bond market there has been a huge spike in volatility. You may recall in my last blog at the end of June I reported a sell-off in government bonds. According to Bloomberg yield volatility on 10 year German government bunds has risen to nine times the 15 year average.

So what do I conclude? This increase in volatility could be the early signs of trouble ahead. Markets are clearly uncertain and nervous and could be tipped into a full blown crash. That trigger could be the start of rising interest rates, expected in the US later this year and to be followed shortly afterwards by the Bank of England. As you may be aware the prices of fixed interest securities which include government and corporate bonds tend to fall when interest rates rise because the relative value of future coupons is eroded. Long dated investment grade bonds are particularly sensitive to changing interest rates whilst short dated issues and high yield bonds are less affected. This nicely brings us on to an interesting feature of the bond market called “duration.” Duration is a measure of the interest rate sensitivity of  bonds. Bond fund managers can actively manage duration to reduce risk for investors. This will be a subject for a future post.

To wrap up I want to briefly cover action investors can take to mitigate risk in their portfolios. There is a case for doing nothing other than parking the portfolio. This is the classic buy and hold strategy appropriate for long term investors especially those who are not overly risk averse. The thinking is that markets may well crash but they will recover and such investors are happy to ride the short term volatility. Whilst I advocate long term investing I prefer employing active tactical overlays to complement this strategy. So in recent months I have been advising clients during annual investment reviews to undertake selected profit-taking, either to cash or to undervalued markets or sectors. I have also advised switching from bond funds with high durations, for example gilt funds to those with lower interest rate sensitivity.

Interesting times are ahead. It is never dull being an investment adviser.

This blog is intended as general investment commentary and principally reflects my own views.  You should seek individual advice before making investment decisions. 

Posted in China, Fixed Interest, Interest Rates, Risk & Volatility | Comments Off

Bond Sell Off, Investor Fears and Strategies

May has seen a sell-off in government bonds, in the UK, US and Germany. Yields had reached ultra-low figures and a correction was not unexpected. However investors are asking if this signifies the end of the bull market in bonds which has run for about 25 years. It commenced around 1990 when a secular long term trend of falling global inflation and interest rates started. Some of you will recall the double digit mortgage rates you were paying 25 years ago.

The sell-off in bonds does not appear to have been triggered by anything specific but investors are naturally concerned about the prospect that interest rate rises in the US will start shortly. The Bank of England is likely to follow suit shortly afterwards. Government bonds and investment grade corporates are especially interest rate sensitive as the value of the coupon, the rate of interest a bond pays is fixed, and its value therefore declines relative to cash when interest rates rise. A similar fall in bond prices is expected from rising inflation.

Clearly interest rate rises from historically low levels in the last six years is another step in the ending of “easy money.” The argument goes that bonds and other assets have risen indiscriminately on the back of loose central bank monetary policy including QE and low cost central bank finance, for example the UK’s Funding for Lending Scheme. Bonds have got drunk on liquidity and low interest rates but like all good parties it is coming to an end and a bar tab has to paid. Whilst the US is leading the way in normalising monetary policy, the “taper tantrum” in May 2014 caused by the Federal Reserve  giving notice that QE was ending was the first ruction, there is clear divergence globally. In many economies interest rates have been heading south whilst money printing continues in Japan and Europe. This reflects the fact that in many parts of the world economic growth is anaemic.

Most fund managers would argue that equities have better investment potential than bonds but investors are still nervous with stockmarket indices reaching new peaks, valuations in some markets and sectors looking expensive, company earnings growth not keeping pace with stock prices and fears of  a super taper tantrum and a Greek exit from the Euro. Whilst this in part a “wall of worry” syndrome, fundamentals do give cause for concern; there are systemic risks from a Grexit and potential for a major crash in the bond market. So how are investors positioning their portfolios in current market conditions? Here are a few perspectives from what I have been reading:

1. High Yield Corporate Bonds  

This type of fixed interest is less interest rate sensitive than government gilts and investment grade corporate bonds. This is due to their high coupons which provide a cushion against rising interest rates and falling prices. In addition high yield bonds have shorter maturities or durations than gilts. Duration or interest rate sensitivity is a function of maturity date of a bond. Long dated bonds such as gilts have high durations and hence are more vulnerable.

For investors credit quality is the key issue with high yield bonds. In the US they are somewhat disingenuously referred to as junk bonds. Currently default rates are low and are expected to remain so in the early stages of global economic recovery. Smaller companies which are often issuers of high yield bonds historically underperform larger companies only in the late stages of the interest rate cycle as an economic slowdown approaches. We are at the beginning of the cycle so the outlook for high yield bonds is OK in my opinion. That said stock selection is key and I would not advocate the use of index trackers or ETFs.

2. Cash Weightings Rise

Fund managers fearing a crash have been increasing the cash weightings in their portfolios. Aside from this being a defensive measure, cash provides liquidity if investors sell up in their droves and gives scope for managers to add to their best investment ideas on the dips.

3. Targeted Absolute Return Funds

According to the Investment Association who monitor inflows and outflows of investor money in different sectors large allocations were made in April to cautious risk targeted absolute return and money market funds. This is a clear sign of investor sentiment being cautious.

4. Diversified Bond Portfolios

In a recent blog, M&G a leading bond fund manager argued (as others do) that flexible diversified bond portfolios are favoured for fixed interest exposure. This is because different types of fixed interest have different characteristics as noted above. They warned that interest rate rises or inflation could trigger further sharp falls in government bonds and the risks of this are high. Moreover the very low yields will not adequately compensate investors for capital losses. However M&G observed following negative returns from global government bonds the 12 months were great times to own them. There was a big bond sell off in 1994 but in the following year returns were 16.9%. I have always felt bonds have an inherent self-correcting mechanism. If prices fall, yields rise and this attracts buyers.

In another article I read, M&G suggested that UK inflation although muted now could rise in the medium term and the markets are underestimating the risks here with a pre-occupation on the short term. The bond markets are consequently pricing CPI inflation at an average of just 1.6% p.a. over the next five years. Inflation could surprise on the upside from UK wage growth, a falling pound and a recovery in oil prices. Index linked bonds offer attractive opportunities as an inflation hedge whilst a portfolio shorter dated inflation linked corporate bonds with low or negative duration provides protection against rising interest rates.

5. Investing in Earnings Growth

There has been a clear move in equity investment away from US equities. A six year bull run, a dip in economic growth in the first quarter, concerns about earnings growth, a strong dollar and high equity valuations have shifted sentiment from Uncle Sam. Of course the rest of the global equity market is not especially cheap, so where do you invest? Robin Geffen, a leading fund manager and CEO of Neptune Investment Management acknowledges this but observes equities are not worryingly expensive in the markets they specifically like. These are where company earnings have broadly kept pace with prices. For example in Japan the price to earnings ratio (P/E) ratio of the TOPIX* Index is a very reasonable 13.3. However the earnings per share (EPS) growth for the 2014/15 year has been a very strong 16.7%.

Geffen also observed that in a bull market it is not uncommon for the S&P 500 index to hit 50 new highs in a year and to sell on the back of a high being reached is not a great idea.

*TOPIX is the Tokyo Stock Price Index a broad based Japanese stockmarket index. I understand it has around 1,600 listed stocks.

This blog is intended as general investment commentary and principally reflects my own views. It is not an invitation to invest in the areas highlighted as these may not be suitable for you. You should seek individual advice before making investment decisions. 

Posted in Fixed Interest, Gilts, Investment Strategies, Stockmarkets | Comments Off

Post General Election Surge & Market Outlook

Whatever your political persuasion UK stockmarkets have given a resounding thumbs up to the Conservative victory today. As I write the FTSE 100 index is up 2.08% p.a. whilst the more domestically focused FTSE 250 index has surged by 2.68% p.a. Favoured sectors include house builders, utility companies, banks, financials and outsourcers such as Capita. This has been a relief rally that Labour’s statist policies such as the mansion tax and cap on energy prices have not come to fruition. Sterling has also has risen, a sign that the foreign currency markets think the result is good for the UK economy. Uncertainty had been a headwind for the pound with a predicted hung parliament.

Considering the wider global economy M&G’s multi-asset team predicted that the divergence between loose central bank monetary policy and strong global growth rates would lead foreign exchange rate volatility. The dollar has surged in 2015 and the Euro has depreciated. With loose monetary policy in Europe and interest rates heading down in China, India and South Korea, dollar strength should continue. Rising rates in the UK and the USA will however make cash more attractive and fixed interest vulnerable to a sell-off especially with ultra-low yields and a rising oil price.

M&G are overweight equities, a position I broadly concur with. I currently favour Japan, Europe and US medium and small companies. Unlike global mega-caps with overseas earnings smaller US firms are oriented to the domestic economy and are less impacted by dollar strength. In fact US companies importing materials from overseas and then selling to US consumers gain from lower import costs.

Finally given the result of the General Election I would now include UK equities in my list of preferred markets, principally again small and mid-caps. These sold off last year but with mega-cap dividend payers looking vulnerable, a lack of analyst coverage of smaller companies and a domestic focus they look attractive.

This blog is intended as general investment commentary and principally reflects my own views. It is not an invitation to invest in the areas highlighted as these may not be suitable for you. You should seek individual advice before making investment decisions. 

Posted in Currencies, Equities, Fixed Interest, Interest Rates | Comments Off

Super Taper Tantrum?

You may recall back in May 2013 there was a sharp sell-off in equities and fixed interest when Ben Bernanke, the chairman of the Federal Reserve, the US central bank announced that tapering of QE was ready to start. The market ignored the good news that the patient, the US economy could come off its money printing life support and viewed the announcement as bad news. The sell-off was humorously called a “taper tantrum.” In the end the markets saw sense, investors focused on fundamentals, realised the US economy was in good shape and equities and bond prices rallied.

However the International Monetary Fund (IMF) has recently warned that global markets could suffer from a worse turmoil than in May 2013, when the US raises interest rates. This is expected later this year. According to the IMF it could increase 10 year US Treasury yields by as much as 100 basis points or 1%. To remind you with fixed interest which includes UK gilts and corporate bonds, prices and yields have an inverse relationship – when prices fall, yields rise and vice versa. Rising interest rates results in falling bond prices because the relative income from fixed interest is less attractive compared to cash. If US Treasuries prices fall the ructions will filter into other fixed interest markets and herein lies a related problem; liquidity in the corporate bond market has been a concern for a while. Selling in a falling market to meet redemptions will become difficult for fund managers and prices may plummet in the absence of a functioning market.

Whilst there are no liquidity issues in major equity markets there is still likely to be a broad based sell-off with capital exiting from emerging markets. Risk-off assets will benefit with a flight to quality, including safe haven currencies such as the US dollar, the Swiss franc and Japanese Yen, cash and potentially gold. Defensive blue chip equities are likely to ride the storm better than smaller and medium sized companies.

Essentially these events are consequences of the normalisation of monetary policy in the US. Unprecedented ultra-low interest rates and money printing have been a feature of the global economy since the financial crisis more than six years ago. Economies and markets will have to adapt to the return of more normal interest rates.

So what are the consequences for investors? In my view volatility will increase later in the year and a sell-off is not unlikely. Moreover it could be sharp. However many investors can afford to adopt a long term buy and hold investment strategy riding the volatility. Equities will fall but they should recover given the general trend of global economic recovery. Some investors however may wish to review their portfolios and take profits whilst markets are riding high. Switches can be to cash or cautious risk investments with a focus on, though not a guarantee of, capital preservation.

Whilst it is clear the IMF have identified a serious systemic risk in the global financial system I do not sense we are heading for a catastrophe and this is a sell all and head for the hills moment. Time will tell.

This blog is intended as general investment commentary and principally reflects my own views. It is not an invitation to invest in the areas highlighted as these may not be suitable for you. You should seek individual advice before making investment decisions. 


Posted in Fixed Interest, Liquidity, Market Commentary, Risk & Volatility, US | Comments Off

Fears about Dividends from UK Blue Chips

According to an article in “Investment Week,” UK equity income fund managers have expressed concern about a squeeze on dividends from FTSE 100 companies. Larger companies came back into favour last year on the back of rotation from US equities, attractive valuations and a sell-off in smaller companies and mid-caps. However the sustainability of dividends has been questioned as first quarter earnings are struggling to match pay outs. Certain sectors are expensive and utilities face political risk from a Labour pledge to cap energy prices.

Five companies in the FTSE 100 index including Tesco and Capita have cut dividends this year and others are likely to follow. Concerns have been raised about giants Shell and Glaxo. It is important to note that a very high percentage of UK dividends is paid by a small number of mega-caps. The impact of one or two of these stocks cutting dividends will impact significantly on yields for investors. Prices are likely to fall as a result.

Fund managers have been looking to diversify their portfolios by investing in smaller and medium sized companies where dividends are often overlooked. This however is not a new strategy. Some fund managers such as Standard Life Investments and Unicorn have been successfully investing for income down the cap scale for years.

In conclusion investors need to be cautious when investing for income. An alternative source of dividends is from Europe where earnings growth is expected to better that from the US in 2015. Naturally other income options exist.

This blog is intended as general investment commentary. It is not an invitation to invest in the areas highlighted as these may not be suitable for you. You should seek individual advice before making investment decisions. 

Posted in Investing for Income, UK Equities | Comments Off

The Importance of Valuations and Value Investing

You could not have failed to notice that the FTSE 100 index has pushed past its previous all-time high of 6,930 in December 1999. As I write this morning it is trading at 6,952 up on the back of news that the date of US interest rate rises is likely to be pushed back. With equities doing well investors may well be asking if what followed 15 years ago could happen again. It is the wall of worry syndrome, as equities climb higher investors increasingly fear the drop. You will recall back in the early noughties the technology bubble burst, a recession followed and the FTSE 100 index collapsed to around 3,600 in February 2003. It would be fair to argue however that this time it is different.

Will 2015 repeat 1999?

I think not for several reasons. Firstly the UK equity market today is not subject to excessively unjustified valuations from a technology or other sector with no earnings as it was at the end of 1999 and in early 2000.

Secondly the valuation of the FTSE 100 index as a whole is close to its long term average. You may recall that the Price to Earnings (P/E) ratio is an oft quoted measure of the value of a stock or a market. It is calculated by dividing the share price by the earnings per share, typically trailing earnings in the last year. The higher the P/E, the more the market values a stock or index. During the technology bubble the FTSE 100 P/E ratio peaked at just over 30. Today it trades at around 16. The key conclusion is that the largest UK companies are not expensive because earnings have grown significantly since 1999.

The third reason for optimism is that the global economic cycle is still in the recovery phase. We are emerging from the worst financial and debt crisis in a generation. The UK economy is not overheating from excessive growth nor rampant inflation of wages or prices. It is not unreasonable to expect further expansion of equity prices as earnings grow. These will come from the UK as well as recovery in key overseas markets such as Europe, which is further behind the economic curve.

Value Investing

This broad based assessment of the valuation of UK equity market above does not account for differences in valuations between different sectors or stocks. There is considerable disparity as explained below. Before I do I need to explain a major style of fund management called value investing. Schroders define this as:

Value investing is the art of buying stocks which trade at a significant discount to their intrinsic value. Value investors achieve this by looking for companies on cheap valuation metrics, typically low multiples of their profits or assets, for reasons which are not justified over the longer term. This approach requires a contrarian mind set and a long term investment horizon. Over the last 100 years a value investment strategy has a consistent history of outperforming index returns across multiple equity markets. (Schroders – The Value Perspective).

The CAPE Crusader

To understand value investing we need to consider a more sophisticated measure of stock market valuation. I refer to CAPE, the Cyclically Adjusted Price to Earnings ratio. This measure is also called the Shiller P/E  after the economist Robert Shiller who popularised its use and shared a Nobel Prize in 2013 for his work on asset prices. The standard P/E ratio is limited as it takes into account one year earnings only and these can be distorted by an atypical trading period or they are a function of the current phase of the economic cycle. Earnings may be depressed if there has been a recession or if a company had a particularly bad year, but one which is unlikely to be repeated. This may lead to a distorted P/E. CAPE is calculated taking into account the previous 10 year earnings which irons out the anomalies of market cycles or one off company factors.

The Use of CAPE in Investment Decisions

A few weeks ago I listened to an excellent presentation from a manager of the Schroder Recovery fund. This fund adopts a value investment style. The principal learning point about value investing was the stark relationship between CAPE and future returns. The following link supplied courtesy of Schroders illustrates this very clearly.

The chart shows rolling 10 year annualised returns from UK equities since 1927 based on the CAPE valuations at the start of the 10 year period. Companies that started with the lowest CAPEs i.e. in the 0-7 range had the highest 10 year investment returns with lower returns achieved as the CAPE ranges increased. Although there will be  variations within each “bucket” so that not all companies with CAPEs between 0-7 returned more than 10% p.a. the conclusion is clear. Valuations matter and are a primary driver of future returns. This is not to suggest that stock specific issues do not need to be taken in account. Some companies are value traps; they are cheap for good reasons and should be avoided. That is why value investors are typically bottom up stockpickers who seek to identify stocks with attractive valuations that the market has not recognised. In contrast passive index tracking strategies will be required to buy the basket cases.

Sector Variations

Schroders demonstrated in the webinar that CAPEs vary between sectors of the market. Back in 2000, tobacco companies had CAPEs between 7-14, whilst the oil and gas, media and technology sectors had CAPEs in excess of 35 (Source: Schroders. From Datastream. Data at 1/1/00). Over the next 10 years stocks in the 7-14 bucket returned 763% whereas those with CAPEs of 35+ lost 46% (Source: as above). Those sectors in the 14-21 bucket returned 156% and whilst those with CAPEs of 21-28, 38%. This inverse relationship between CAPE and 10 year performance reflects a tendency for valuations to revert to mean.

Today Schroders consider banks to be very attractively valued with CAPEs up to seven (at 31/12/14). They argue that bank balance sheets have vastly improved yet valuations are still depressed. This sector is a prime candidate for value investors albeit with the stock picking due diligence that is needed.

Basic resources, food and general retailers, insurance, oil and gas fall have CAPEs between 7-14. Technology and chemicals are examples of more highly valued sectors.


Investors should not assume the whole of the UK equity market is expensive based on the performance of stockmarket indices. Headline record figures for an index like the FTSE 100 mask good investment opportunities. This is because there is a wide disparity of valuations within sectors and stocks.

CAPEs are an excellent tool that can be used by investors to assess value and for asset allocation purposes not-withstanding the requirement for good stock picking.

With UK equities riding high a value investment style is an entirely appropriate strategy for investors.

This blog is intended as general investment commentary and reflects my own views. It is not an invitation to invest in the areas highlighted as these may not be suitable for you. You should seek individual advice before making investment decisions. 

Posted in Investment Styles, UK Equities, Value Investment | Comments Off

Positive on Europe

Despite the ongoing uncertainty surrounding Greece’s debt problem, Invesco Perpetual’s European equity team are upbeat on Europe. In a Q&A session today with two leading fund managers although it was noted Europe has been uniquely impacted from a double whammy  – the global banking crisis and more latterly the Euro crisis, the good fundamentals were highlighted. Money printing or QE which has weakened the Euro clearly benefits exporters, whilst core inflation is relatively stable. This means higher import costs from the weak Euro are not damaging to domestic economies. In fact the fall in the oil price has acted like a tax cut. Money supply and bank lending have risen and economic growth is evident.

The fundamental case for European equities however are the excellent valuations in economically sensitive cyclical stocks and the banking sector whilst generally the market is valued below its 30 year average. Defensive stocks in contrast are less attractively valued. Moreover Invesco believe earnings in 2015 have been underestimated and are likely to be upgraded. If so dividends will rise especially as the corporate sector holds high levels of cash.

In summary for value investors like Invesco (more on this in the next blog) Europe offers plenty of good investment opportunities. Whilst they take account of macro-economic conditions Invesco are principally stock-pickers. I concur this is a market for active fund management given the disparity of valuations and earnings upgrade potential.

My penny’s worth is that good dividend yields, in major part due to low valuations, coupled with dividend growth potential will attract money to European equities from more highly valued markets like the US or even from government bond investors. Monetary policy such as QE has driven government bond yields to very low levels, some bonds even have negative interest rates (see for an explanation). With an appetite for yield European equities should be attractive for income investors.

This blog is intended as general investment commentary.  It is not an invitation to invest in the areas highlighted as these may not be suitable for you. You should seek individual advice before making investment decisions.

Posted in Europe, EuroZone | Comments Off

Investment & Tax Avoidance – George Approves

With tax avoidance being a hot topic in the news and the end of the tax year on the 5th April approaching this is an apposite blog post. The confusion between tax avoidance which is legal and tax evasion which is illegal is not helped by a loose interchange between the two terms, for example the oft banded phrase “aggressive tax avoidance.” For my part the onus is on the government to tighten the tax code and close loopholes not attack legal avoidance as immoral.

More importantly what is often forgotten in the debate is that the government actively encourages and incentivises selected tax avoidance schemes for sound economic reasons. Investment in cash ISAs encourages savings and provides capital for banks to lend to businesses and homebuyers. Investment in Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EISs) attracts very generous income tax relief in order to provide much needed capital investment into very small and fledgling companies. The potential for these to grow, employ more people and generate high levels of tax for the Treasury in the future means the tax incentives are a logical investment on its part.

This blog briefly covers investment opportunities for tax avoidance. Yes they are all legal and Mr Osborne approves! No Swiss bank accounts are required.

Individual Savings Accounts (ISAs)

The allowance was raised to £15,000 last July and it can be allocated to cash or stocks and shares in any proportion. Interest rates on cash remain miniscule with the date for expected interest rate rises increasingly being pushed out by falling inflation.

Whilst ISAs are tax efficient for all investors, the use of qualifying fixed interest or corporate bond funds is particularly tax efficient within a stocks and shares ISA as the plan manager can reclaim the 20% tax deducted from interest, unlike the 10% tax credit from dividends. For those requiring a high tax free income corporate bond ISAs are excellent investments with rates of 5% or 6% p.a. from high yielding corporate bond funds (Source: FE Trustnet). It is important to note yields are variable and capital values are not guaranteed unlike cash.

Personal Pensions for the Retired

Those without earnings can still invest £3,600 into a personal pension and still get tax relief at their highest rate. Even a non-taxpayer can receive 20% tax relief! The rationale for a pension investment for the retired is to benefit from an immediately vesting annuity (IVA) and receipt of a high guaranteed lifetime income. This is  leveraged by the tax relief. Here is how it works:

Net Pension Contribution:           £2,880                      Cheque from applicant’s bank account

Tax Relief Added:                           £720                          Government gift

Gross Pension:                                £3,600                       Received by the pension provider

Tax Free Cash:                                 £900                          Paid immediately to the investor by the pension provider

Amount Invested in Annuity:      £2,700                        The balance of the £3,600 after tax free cash is paid out

Net Cost to Investor:                     £1,980                         This is £2,880 paid minus the £900 tax free cash received.

So what could you get in terms of annual annuity payments? It will depend on your age and annuity rates but as an example a client of mine in her late 60s last March bought an IVA and receives a level annuity of £127.40 p.a. gross. This equates to a gross yield of 6.43% p.a. (£127.40/£1,980), pretty good for a guaranteed lifetime income. Please note annuities payments are subject to tax, on death there is no capital return and the annuity is not medically underwritten. Those with certain medical conditions could get a higher rate elsewhere. For those with earnings including from self-employment larger sums can be invested into an IVA.

Venture Capital Trusts

These are especially attractive for income investors looking for high tax free yields and those seeking to reduce their income tax bill in 2014/15.

VCTs are collective investments similar to investment trusts. As with unit trusts a VCT holds a range of different qualifying smaller company stocks to provide investment diversity and risk reduction. The tax benefits are quite remarkable. Investors receive 30% income tax relief on investment up to £200,000 p.a. even if they are basic rate taxpayers, provided the VCT meets HMRC qualifying rules, the investor holds the shares in the VCT for five years and the investor has paid enough income tax in the relevant tax year. For example consider an investor who pays £5,000 income tax each year and buys new shares in a VCT for £10,000 in 2014/15. He or she will receive a tax rebate of £3,000 at the end of the tax year through their tax assessment. Please note substantial Gift Aid payments will affect the tax relief payable.

In addition VCTs pay tax free dividends and there is no capital gains tax to pay on shares when they are sold. These are similar to the tax benefits of ISAs although it must be stressed that shares in VCTs may be difficult to sell after five years. This is because there is no market for second hand VCT shares as investors do not receive tax relief on buying these. To mitigate against this many VCT providers offer a buy back facility, typically at a discount of 5-10% of the net asset value of the shares.

VCTs which buy very small companies naturally carry significant investment risk, notably volatility, default and illiquidity. However as noted the pooled structure reduces risks whilst the range of qualifying smaller companies varies from fledgling unquoted stocks to established companies like Majestic Wines, online retailer ASOS and Prezzo, all listed on the London Stock Exchange’s Alternative Investment Market (AIM). These more established companies are naturally less risky than unquoted companies not listed on stock exchanges.

In terms of suitability, VCTs are most suitable for adventurous risk and experienced investors. The FCA typically state this means high net worth and sophisticated investors. However some VCTs are managed cautiously with an emphasis on capital preservation. Moreover I consider an cautious risk investor can reasonably buy small holdings in adventurous risk investments provided the balance of their portfolio is weighted to cautious risk holdings and cash. A uniform portfolio will be undiversified and this carries significant investment risk.

And Finally – Good News for Couples

A little known transferrable personal allowance for married couples and civil partner is being introduced by HMRC next tax year starting on 6/4/15. The standard personal allowance rises to £10,600 but many people will have taxable earnings below this threshold. Low paid part time workers and pensioners with a small state pension are examples. Providing your spouse is not a higher rate taxpayer you can elect to transfer up to £1,060 of your unused personal allowance to your partner. This effectively increases their personal allowance to £11,660. The maximum tax saving in 2015/16 will be £212 p.a. (20% x £1,060). OK it is not a great deal of money but it is still worth the investment in time to make a claim. However I am not sure how the application process which opened at end of last week  works.


The government is fully supportive of the use of legal tax breaks that it has created. Of course they expect knock on benefits for the economy and that tax generated in the future will recoup and even exceed the upfront tax relief. For example money lent from ISA investors will result in new house buyers paying stamp duty and VAT on DIY.

The old maxim “use it or lose it,” applies to annual allowances and tax reliefs. From a moral perspective use of them to reduce personal taxation indirectly benefits the economy. I also think that people are better judges on how to spend the tax relief than governments. However that is another issue.

This blog is intended as a general guide to investment and tax reliefs available for UK residents only.  It is not an invitation to invest in the areas highlighted as these may not be suitable for you and your personal tax position. You should seek individual advice before making investment and tax planning decisions.


Posted in Investing for Income, NISA, Pension Investment, Tax Avoidance, Tax on Investments, VCT | Comments Off