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

A Tale of Two Economies – Japan

This blog post is about how economies and the performance of equity markets are related with particular reference to Japan.

The Link Between Economies and Stockmarkets

It is often thought there is a close correlation between how well an economy is doing with the performance of its stockmarket; so if the former does well the latter will as well. A recent example is the US whose economy has been recovering and growing strongly in recent years whilst its equity markets have powered ahead to new highs. The causal factors linking the two are various, including recapitalisation of the banks, significant balance sheet repair at the corporate and personal level, falling unemployment and QE.

The relationship between economies and stockmarkets is however more complex and they may be uncorrelated. For example in the last 10 years China’s growth in GDP year on year, (a measure of the output of an economy) has been strong, albeit there have been declines from the double digit returns. In contrast stockmarket returns were poor on most of this period. Economic growth does not always translate to growth in company earnings. Similarly stockmarkets may rally despite underlying economic malaise. A clear example was in 2009 in the UK. Stockmarkets rallied in anticipation of economic recovery and investors bought equities for future earnings. Finally the corporate sector and stockmarkets may do well despite a flagging economy if overseas earnings are high and exposure to the domestic economy is minimal.

Misunderstanding the correlation between an economy and the prospects for its stockmarket can lead to poor decisions by investors in their asset allocations. For example Japan and Europe with sluggish economic growth, deflation and debt may be regarded as basket cases and avoided by investors. This may prove to be a mistake. Below I comment how this might apply in Japan, Europe is for another blog.


Earlier this week I listened to veteran Japan investor, Chris Taylor who runs the highly successful Neptune Japan Opportunities fund. Like a skilled surgeon he dissected a diseased economy which would have many investors running for the exit. I was unaware just how serious it is. Taylor argued that massive tax receipts are required to avoid national bankruptcy. Yes he used the B word. Japan has a massive problem with a budget deficit and mounting debt. Since 1989 GDP has been flat whilst debt as a percentage of GDP has rocketed. This is due to a collapse of tax revenues and increased spending due to an ageing population. Taylor stated that tax revenues are now at 1987 levels whilst GDP in 2012 was at the 1990 level!

Taylor then went on discuss corporate Japan. This was a very different story. He suggested that Japanese companies have led the way in global corporate earnings since 2008 and this is despite historic Yen strength. To remind you a strong currency makes exports more expensive and historically this has been a headwind for Japanese companies. More recently the Yen has fallen with QE or money printing.

The growth in corporate earnings has come from massive investment outside Japan and developed markets. Companies have shifted from being exporters to becoming global multinationals thereby avoiding Japan’s negative demographics, falling demand and high operating expenses. Overseas subsidiaries have almost doubled in 10 years. This is especially in the manufacturing sector. For example in the auto sector overseas car production has risen significantly since 2007 to 63% in 2013. In addition recent Yen weakness has been a tailwind when overseas earnings are converted back to Yen.

Another factor in favour of Japanese equities that Taylor highlighted was that company earnings are grossly underestimated. Causal factors are conservative projections, failure to account for Yen weakness and crucially too few or experienced analysts. Analysts are the bright young things that support fund managers and investment bankers and undertake important research on company balance sheets, markets and cashflow. These provide vital information that help determine investment decisions. According to Taylor 25% of companies have no analyst cover whilst a further 28% have only one analyst. The implications are clear, Japanese companies may be mis-priced and undiscovered gems can be unearthed by good stockpickers. Moreover active fund management is expected to outperform passive strategies in this market.

Taylor also says valuations are attractive in Japan compared to other markets and Japanese companies have high earnings per share growth. Finally an re-allocation from cash and bonds to equities in the Government Pension Investment Fund (GPIF), the world’s largest is very positive for the Japanese stockmarket.

So what do I conclude? Despite the poor state of the economy of Japan there is a good case for investment in its equity markets.

This blog is intended as a 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 Economy, Japan, Stockmarkets | Comments Off

Which Assets And Markets Will Fare Best in 2015?

For mere mortals accurately predicting the future of investments is probably as successful as consulting Mystic Meg with her crystal ball or the Oracle in BBC’s Saturday night drama Atlantis. For example I wonder who guessed the oil price would collapse to the extent it did in 2014? In the absence of Meg and Juliet Stevenson, their fees are too high for a personal consultation, I have turned to the raft of fund managers and other financial experts who have offered their predictions for 2015. In this blog I attempt to summarise briefly the consensus view from the disparate sources.

Top of the picks are US assets including the dollar. With strong momentum, the best performing economy in the developed world and the likelihood of rising interest rates, this would appear to be a no brainer. One commentator tipped the consumer and domestic economy in the US to do well. This is again logical as exporters face headwinds from a strong dollar. If this assessment is correct US smaller and mid-caps stocks should benefit.

Surprisingly perhaps quite a few pundits predicted European assets to do well, though not all for the same reasons. One thought Europe would emerge from its deflationary pressures. Although the fall in the oil price has been a recent major contributor to deflation, there are many economic benefits for consumers and businesses with low energy costs. It was noted that liquidity is improving in the EuroZone and the ECB asset purchase programme will trigger a rally in asset backed securities. Moreover if full blown QE is undertaken there will be an additional tailwind for European equities and bonds. A weaker Euro is also expected and this will benefit exporters.

At least one expert suggested political risk in the UK from the General Election could impact adversely on UK stockmarket returns. Interestingly the FTSE 100 index has significantly underperformed the US S&P 500 index over the last four years. Arguably the FTSE 100 index is not a great proxy for the UK economy with a high weighting to commodities and global focus.

Views on Japan were mixed but as in Indonesia and India Japan has a very business friendly government. Whether these administrations can push through economic reforms will a key determinant of stock returns in these markets although it should be noted that India was best performing equity market in 2014.

The consensus view on bonds is not positive although it was suggested US high yield and emerging market debt have their attractions. In recent years there has been an expectation of a collapse in bond prices and a great rotation from bonds to equities. So far the rumours of the death of the bond has been greatly exaggerated and 2014 was no exception. Government bonds were surprisingly resilient and rallied. My view is that bonds, especially high yielding debts remain good investments for income investors whilst index linked bonds will benefit from rising inflation. Given the current deflationary pressures the latter is a longer term strategy than one for 2015.

Finally one commentator thought the oil price could fall to as low as $20 per barrel. Whatever happens interesting times are ahead for investors and their advisers.

This blog is intended as a 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 Asset Allocation, Market Commentary | Comments Off

National Pensioner Bonds

These new savings bonds from National Savings & Investments (NS&I) are to be launched in January. The date has yet to be announced. Their distinctive feature will be the market thumping fixed interest rates, 2.8% gross for the one year bond and 4.0% p.a. for the three year bond. There are however some important points to take into account before investing including a sting in the tail for higher rate taxpayers investing in the three year bond:

* The bonds are only available for those aged 65 or over.

* The allowance for each bond is £10,000 per person but a couple can pool their allowance and invest £20,000 in a joint bond and invest £40,000 in total. The minimum investment is £500.

* No interest is payable until the end of the term; there is no regular income facility and so these bonds are not suitable for income.

* If you cash in a bond early you will lose 90 days interest. It is therefore important to retain sufficient cash in an easy access account should you decide to invest.

One source stated the penalty can be waived if 90 days’ notice is provided but I have not seen anything to confirm this.

* The bonds are taxable. Tax at 20% will be deducted from interest in all cases. If you or your spouse are a non-taxpayer you cannot register by completing an R85 form, as you can for bank accounts to receive gross interest. Non taxpayers however can reclaim income tax deducted from HMRC after the bond has matured.

* The scorpion. Higher rate taxpayers buying a three year bond will be required to pay the additional higher rate tax of 20% at the end of year one and two even though the interest is not payable until the end of the term! This is an extraordinarily unfair arrangement, with a requirement to pay tax on income that investors have not received. It also raises an administration query. Will NS&I send investors a statement of notional gross interest earned and tax deducted at source at the end of the year? If not investors will have to calculate these figures for their tax returns. I assume that for people buying bonds in January the first year’s interest will arise in January 2016 and therefore will need to be disclosed on their 2015/16 tax return.

* NS&I have a limited amount of money allocated to this tranche of investment, £10 billion. The bonds are likely to be very popular and therefore if you think these bonds are suitable for you, you are advised to apply early.

* You can view information on the bonds at and pre-register to receive e-mail updates.

* You will be able to apply online at , by phone paying with a debit card or by postal application. Call 0500 500 000 to apply or to obtain an application form. I am not sure if the latter will be available from post offices.

This blog is for information purposes only. NS&I Pensioner Bonds may not be suitable for you and this is not a recommendation to invest in them. The rates of tax on the bonds may change.

Posted in Cash Savings, NS&I | Comments Off

Fragile Confidence

Global stockmarket falls in the last few days have underlined how fragile confidence in the global economy is. A key factor is the plunging oil price which signals a weakening global economy. However on the theme of confidence I came across an interesting article on the Daily Mail website. They reported comments from the relatively unknown Bank of International Settlements (BIS). This is the world’s oldest financial institution, based in Switzerland and it acts as a central bank to the central banks and watchdog on the global financial system. You can read the short and readable article at:

What interested me was the comment from the BIS that “small pieces of news can generate outsize effects,” a point I made in my investment blog on the equity market sell-off dated 17/10/14. I was not aware of this fact but apparently on the 15/10/14 the yields on 10 year US Treasuries fell more than they did on 15/9/08 when Lehman Brothers filed for bankruptcy. To remind you Treasuries are bonds issued by the US government and are considered highly secure or even “risk free” investments, similar to UK gilts. When markets get edgy there is a flight to quality. In other words investors sell equities and pile into safe haven Treasuries. Prices rise and consequently yields tumble – you will recall there is an inverse relationship between bond prices and market yields.

What this suggests is the market’s reaction in October effectively meant investors assessed the risks to be as significant as the financial crisis of 2008. According to the BIS aside from weaker US retail sales data there were no major shocks to have warranted such market moves on 15/10/14. The BIS suggested fragility is becoming normal.

My conclusion is that the recovery in the global economy is still at a very early stage. Where there are green shoots it is patchy and fragile. As far as major economies are concerned only in the US does the recovery appear to entrenched. Even in the UK perversely income tax receipts have been weak despite the creation of new jobs, entirely consistent with many of these being low paid, part time or zero hours contracts. I am not as enthusiastic about the strength of the UK economy as Cameron and Osborne are!

If the BIS are right and I think they are we should expect more volatility in global stockmarkets. This poses both threats and opportunities for long term investors.

This blog is intended as a general investment commentary.  You should seek individual advice before making investment decisions.


Posted in Behavioural Finance, Global Economy | Comments Off

The Sage of Henley

The famous and highly successful US investor Warren Buffet is commonly known as the Sage of Omaha. He is noted as a shrewd and long term investor with a strong focus on value. He is also the source of insightful and humorous sayings on investment. It is worth googling and reading his quotes but two of my favourites, I have paraphrased, are:

“Rule 1 of investing – never lose money. Rule 2 never forget rule 1.”

“It is only when the tide goes out do you see who is swimming naked.” This is a reference to the scenario where market conditions are good and all investments do well. QE for example has lifted asset values indiscriminately. However when conditions deteriorate then you discover which are the good and bad companies.

Less well known is the Chief Economist of Invesco Ltd, called John Greenwood. He writes on the global economy and undertakes web based Q&A sessions with advisers. Although his delivery is dry and he lacks humour, he understands the big picture and addresses key economic questions succinctly and clearly with insights that are sharp and ring true.  So this morning after listening to a Greenwood podcast I have decided to award him the title of the Sage of Henley. Arise Sir John.

Here is a random sample of his economic insights from the podcast in my own words:

*The global economy is still at an early stage of recovery with balance sheet repair still occurring. The corporate sector has more flexibility to deal with debt than the consumer, for example by refinancing loans, selling assets and cutting labour costs. Although global trade has been flat in recent years companies have been able to grow their earnings. In contrast the consumer, notably in the UK has been limited by low wage growth.

*The US is further along the process of balance sheet repair and economic growth for the year to the end of the third quarter has been revised to an excellent 3.9% p.a.

*Imports account for just 15% of the US economy, in the UK it is double this. This means the US is fairly well insulated from the global economy and high commodity or other import prices. Naturally the rise of shale gas production in the US and lower global crude oil prices are a tailwind to the US economy.

*Whilst the dollar has been rising and global demand falling, both of which are ordinarily bad for exporters, exports only account for about 12% of the US economy. Again this is a positive.

*China’s economic growth may fall from 7.5% p.a. to 6% p.a. in the next few years. Wages are too low to rebalance the economy from export and investment led to the consumer. China’s imports are still driven by commodities and plant rather than domestic demand for consumer goods.

*Abenomics, the economic policies of Prime Minister, Shinzo Abe has had one real benefit, driving down the value of the Yen. As previously explained in an earlier blog post this is good for Japanese exporters and for the Bank of Japan’s inflation target.

*Monetary policy including QE has been more effective in the US and UK than Europe and Japan. Resistance to full blown QE in Europe is mainly due to German fears of inflation. German memories of money printing and hyperinflation in the 1930s are deeply ingrained despite evidence to the contrary, for example in Japan where buying government debt has not fuelled inflation. However Greenwood does expect the European Central Bank to undertake QE.

*Interest rate rises in the UK are unlikely to precede those in the US as they would lead to a stronger pound and impact on UK exporters.

*Equities and bonds have risen in the early stages of the recovery. As it develops equities are expected to outperform bonds as the latter will be impacted by higher inflation and interest rates.

So what do I conclude? Global economic recovery is still patchy and anaemic but equities are still a good long term investment. The US remains a favoured stockmarket for me despite the high valuations. Europe could get a boost from QE. Wage growth in China is required to provide a boost to the global economy.

This blog is intended as a general investment commentary.  You should seek individual advice before making investment decisions.

Posted in China, Global Economy, Japan, Quantitative Easing, US | Comments Off

Investment Risk, Volatility and Loss

Due diligence on the risk of investment is fundamental to investors, advisers and fund managers. No one wants to lose money, whilst the holy grail is to obtain strong investment returns with minimal risk. The problem is defining what risk is, especially as the term is variously understood by different commentators. The key message in this blog is that volatility and risk are not the same. It is my contention that risk is more complex and nuanced than volatility, whilst the latter can be used as a beneficial investment strategy or even as an asset class in its own right.

Risk Defined

I define risk as the potential of losing some or all of your original investment. For single stocks, especially smaller companies there is a risk of complete loss whilst for pooled investments or funds the chances of complete loss are extremely low. We’ll look at volatility before explaining why I consider it does not necessarily equate to loss.

Volatility & Loss

Volatility measures the up and downs of stockmarket returns, the sizes of the peaks and troughs. For the technicians amongst you volatility is the standard deviation around a mean.  Naturally you would expect commodity stocks to be more volatile than utility companies or pharmaceuticals. The former invest in the highly cyclical and economically sensitive resources sector whilst the latter are defensive companies with stable cash flows. However if we define risk as the chances of losing all your money, a commodity company investing in a highly volatile sector is not inherently more at risk of becoming insolvent. It may have a very strong balance sheet and other strong fundamentals.

Similarly gilts backed by the UK Treasury are less volatile than high yield corporate bonds because UK PLC has a higher creditworthiness than corporate issuers of low grade debt. However here volatility is a good measure of the risk of loss. This is because a company issuing high yield debt is more likely to default with investors losing money compared to holding UK government debt or a company bond with a higher credit rating.

Volatility & SRRI Ratings

The most common measure of risk in respect of collective investments such as unit trusts is volatility and this appears in the Synthetic Risk & Reward Indicator (SRRI) in Key Investor Information Documents (KIIDs). As you may be aware these are statutory fund disclosure documents that must be issued to clients prior to investment under EU regulations.  Each fund is risk rated on a scale of one to seven based on volatility of returns over the previous five years. I have several issues with SRRIs. Firstly the ratings are based on historic volatility; they do not take into account current market conditions nor are they forward looking. As such using the well-worn adage, they are not necessarily a guide to future returns. A fund with high volatility in the last five years may not be so volatile in future if market conditions or the management style of the fund changes.

Secondly in my experience SRRI ratings of most equity funds almost always a six and this includes UK equity income funds as well as global emerging markets funds. Whilst there are complexities of comparing the risks of these two sectors, for example UK companies have considerable overseas earnings including from emerging markets, it cannot be right in my view to conclude the risks are identical. For example global emerging equities tend fall sharply with “risk-off” sentiment, with a flight to quality and there is typically greater currency risk, political and corporate governance risk. In conclusion SRRI ratings do not distinguish the true risks of investment in different equity markets and if used in isolation they provide an incomplete assessment of the potential for volatility or loss.

Fixed interest, including government and corporate bond funds have lower risk ratings on the SRRI scale than equity funds and are typically rated a four. So does the lower historic volatility mean fixed interest is lower risk than equities? Not necessarily. Government bonds are subject to interest rate risk, also referred to as duration risk, whilst corporate bonds are subject to interest rate risk, credit or default risk and liquidity risk. The latter has been a problem in recent years and will be covered in a future blog. The risks with bond investment are clear. If there is an unexpected spike in inflation or interest rates rise there could be a sharp sell-off in government bonds as in 1994 whilst the corporate bond market could seize up. Volatility would spike.

In summary an SRRI rating can be a poor measure of the potential for loss as it does not account for current systemic risk issues. A bond fund may have demonstrated lower volatility than an equity fund in the past but this does not necessarily make it a less risky investment given that interest rate risk, credit risk or default risk are not features of equity investment.

Finally an SRRI rating discounts current risk mitigation measures by fund managers who naturally take a forward view. Options to reduce interest rate risk include investing in short dated or high yield bonds, which are less interest rate sensitive or by shorting the market.

Risk & Loss

Many investors define risk quite simply, succinctly and correctly, “What are the chances of me losing money?”  This accords with my definition of risk above.

However consider the following scenario. You invest £50,000 and six months later you receive a valuation statement showing the portfolio is worth £45,000. You are advised that stockmarket returns have been poor due to a global sell-off of equities. The question here is, “Have you actually lost money?” The answer is no unless you cash out and thereby crystallise the loss. If you continue to hold the investments your loss is a technical or paper loss based on a valuation snapshot at a specific point in time. The following week, month or six months the position will be different. A year later the portfolio may be valued at £55,000. Now I don’t want to trivialise this downside scenario; no-one likes to see a paper loss but fortunately most of my clients have a long term investment timescale and understand that volatility does not mean a real loss unless it is crystallised.

In some cases it is prudent to sell a loss making investment to re-invest elsewhere because the sector, asset class or current fund management has poor prospects for recovery. In many cases however a long term buy and hold strategy is required. That said to avoid being a forced seller at low valuations because money is needed urgently it is advisable to hold sufficient emergency cash savings. This acts as a portfolio protector permitting flexibility to delay encashment until values recover.

Despite these comments some investors are so cautious that they cannot accept a valuation lower than the amount that has been invested and hence equities may be unsuitable investments for them.

Trading Volatility

Volatility should not always be seen as an enemy as it provides potential for greater investment returns. It is used by traders and fund managers alike. Frequently the latter say they have added to their best stock ideas on the dips and troughs. Volatility can also create valuation anomalies if the market over reacts on the sell side whilst volatility is the friend of the regular monthly investor who acquires more units in a fund when buying on the dips.

This blog is intended as a general investment commentary.  You should seek individual advice before making investment decisions.

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Japan Revisted

The last blog post covered Japan, today’s is a brief update. It was recently announced that Japan’s economy contracted by 1.6% on an annualised basis in the third quarter meaning the country is now technically in recession. To remind you this occurs when there are two consecutive quarters of negative growth. It is widely accepted a principal cause was the controversial sales tax hike in April which has curbed consumer spending. This in turn acts as a headwind to reflating the economy and hitting the 2% inflation target.

Politics and economics are closely entwined and in response to Japan going into recession Prime Minister Shinzo Abe dissolved parliament and called a snap general election. This will permit a delay to the second sales tax hike that was due in October 2015. Abe has proposed it is put back until April 2017. The postponement makes economic sense as well as being a face saving exercise. Abe’s ruling party is expected to comfortably win the election. This will enable him to extend his term in power and assist pushing through economic reform.

In other news the Yen has fallen to its lowest level against the dollar for seven years and the Euro for six years (Source: Reuters). As pointed out previously a weak Yen is good for Japanese exporters. It also encourages repatriation of overseas assets that may be invested in Japan. Finally it is a tailwind for reflation as import costs rise.

In conclusion these events are likely to be positive for Japanese equities.

This blog is intended as a general investment commentary.  It is not an invitation to buy Japanese equities as these may not be suitable for you. You should seek individual advice before making investment decisions.

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