June 2010
*Regulators make investing riskier*
The crash of 2008 was unique. It was not triggered by a war, a shortage of raw materials, a famine or indeed any external factors. It was caused by a massive expansion of credit that was condoned by regulators and the authorities. When cheap and readily available credit disappeared at the Minsky Moment (when consumers started to reduce debt rather than increase it) in the summer of 2007 it left everyone gasping for money. And no one could quite explain why it wasn’t there anymore. One day it was there and the next day it wasn’t. Why?
Bizarrely, it might have been the abundance and pervasiveness of the regulatory authorities that increased consumer appetite for debt that created the bubble in the first place. Could it be that the confidence from knowing that “some official has reviewed this product and therefore it is safe” actually put in place the conditions for a boom that had to be followed by a crash? Governments too fell into the trap that regulation was devolved and they need not concern themselves with the nuts and bolts, or even the larger impacts, of financial services. Unfortunately, it is governments, and taxpayers, who now have to cope with the consequences.
Although some fraud was committed the majority of the problems arose from activities that were legal and fully permitted by the regulators. Selling mortgages to people who clearly had no ability, or even intention, of repaying them was allowed. Banks that were already trading on low levels of capital adequacy were permitted to buy other banks. Investment banks in the US borrowed up to $29 for every $30 they invested, and financed that on loans that could be called at one day’s notice. While IFAs were forced to ask longstanding clients for evidence that they were who they said they were banks were under no obligation to secure evidence that borrowers earned what they claimed.
Foreign banks offered abnormally high rates of interest to UK depositors in order to fund balance sheets that dwarfed their domestic economy. No regulator seems to have questioned or prevented these or many other activities that at the time seemed odd to many. Even Warren Buffet claims he didn’t spot the bubble. Though it is hard to believe he was the only man on the planet not getting junk mail offering cheap finance in 2007?
Despite the abject failure of regulation the cost of maintaining the regulatory bodies has been paid by all consumers. The FSA took in £350m in 2009 and total UK compliance costs must surely exceed £1 billion. Paying for this service gave the public a false sense of security about the soundness of the institutions they were dealing with. Would consumers of financial services have been so eager to make transactions if they knew the provider was unregulated? Probably not, but the absence of a regulator did not hinder economic development in the past. There were of course spectacular bubbles and crashes before like the South Sea, Tulips and the railways. It was only in the twentieth century that the concept of regulating finance took solid form. It would be hard to argue for the total removal of all financial regulation. However, the current system has patently failed and the instinct of politicians to a crisis is simply to introduce more regulation. But the evidence from history suggests that more regulation will not solve the problem.
So what’s to be done?
Any advocate of capitalism would look for a market solution in preference to one imposed by the state. And there is one. At the peak, or depending on your point of view the nadir, of the crisis the authorities blamed the short sellers and acted to halt short selling. Yet it was people like Mike Burry and Steve Eisman who had actually spotted the incipient problem years before and had already acted on their views by going short. In fact the shorts were probably the only buyers of distressed financial companies during the crisis. Not only had they acted, out of self interest, to bet against the prevailing wisdom some of them went out of their way to tell the bulls they were wrong.
Two things are needed to help regulate the market and thus make it safer for simple investors. One is transparency and the second is the right incentive. Although Northern Rock did not fully disclose all its data on failing mortgages towards the end of its life most investors knew it was lending more as a percentage of house values than its competitors and that it was reliant on the wholesale market for funding. None of that was illegal. But there was little motivation for an averagely paid FSA official to sniff around and investigate whether the situation could get a lot worse. After all, lots of highly paid executives had strong incentives, like share options, to pretend everything was hunky-dory. In the US a modestly paid ratings agency apparatchik is likely to be outmanoeuvred by a Wall Street executive hoping for a multi-million dollar bonus if a deal works.
The problem is that regulators will always be paid less than the best in the industry so the game is never equal.
What society needs to do is harness the intellectual firepower of firms who take short positions and use that with the balance sheet of the state. That way it can help prevent valuations that reinforce risky behaviour. It was the ability to raise cheap finance to fund high risk trading that helped create the finance. After the crisis broke companies like Lehman Brothers, Northern Rock and RBS were unable to raise capital when they needed it. If their business models had been challenged earlier valuations might have been lower. In that case the capital would not have been there to fund such high risk activities. As a consequence they might have been obliged to change their balance sheets to use more conservative funding for a less aggressive business. That said, in a bull market the most highly levered company will always do best. Being short in that environment can be painful and expensive, so you need a big balance sheet. Eventually though the rewards will come through and once the crash happens the shorts will make money, and at just the right time to support those that need it.
So all we need do is change the name of the regulatory body to “The Financial Shorting Authority” and reduce its staff to a handful of retired practitioners. They will be mandated to allocate capital to hedge funds to trade as they wish, but for the ultimate benefit of the state, after performance fees of course. To ensure a level playing field each trade that a fund places on behalf of the FSA must be published the following day so everyone can see what is being done on its behalf. The process would naturally be self-funding and the FSA would be able to remit profits back to the Treasury.
One former Chancellor of the Exchequer claimed to have abolished “boom and bust”. In reality the business cycle is a part of the modern economy in just the same way as taxes and fashions. Regulation will not eliminate the economic ups and downs, nor will it ever eliminate all fraud and corruption. The best we can hope for is that if someone, or some business, claims to have discovered a new way to make gold from lead that it is subject to the full scrutiny of interested parties. There is more chance of anomalies and malpractice being discovered if the investigators have the right incentives. And there is no better motivation in finance than money.
May 2010
If you are that smart why are you trying to beat the market?
Economists can always prove us wrong but, in general, smart people tend to be better off. This group, or HNWs in the modern politically correct age, have a lot of calls on their time whether related to work or leisure. The best way to quantify that worth is to express it as an hourly rate. Bearing in mind that the minimum wage is £5.80 an hour a wealthy individual should be valuing his time at a large multiple of that, say 10 fold, thus making each hour worth over £50. If this person’s time is so valuable why would he want to waste it doing something that adds no value, and in fact probably detracts value, from his net worth; like managing his own money?
Consider a wealthy individual with an equity portfolio of £100,000 that he manages himself. Let’s assume his portfolio outperforms a comparable index fund by 2% a year, every year. In his first year the market rises 10% and his portfolio rises 12% so he has added £2,000 to his net worth. The question to be asked is how much of his time did it take to achieve that? If he devotes an hour a week to the task over a year and assuming he takes a few weeks off over Christmas and the summer it is reasonable to suppose he devoted 50 hours. That means he made £40 for each hour devoted to his portfolio. That is about £10 less than his market rate.
Implicit is these assumptions are three crucial factors. First that he always beats the market and secondly, that he does it on a net basis after his dealing costs and thirdly that his return is achieved at no higher risk than a tracker fund. If his superior return is only 1% more than the market his one hour a week drops to a net value of £20. Even to achieve that net return he will probably have to achieve an additional gain of 0.2% to cover dealing costs and stamp on the assumption he trades once a month and to cover the fixed costs for his brokerage account. More worrying is the risk he has incurred. Higher returns, especially from small portfolios, are usually generated by taking more risk. In a down year that means his losses are likely to be worse than a tracker fund. If he suffers one down year in five then his average rate per hour falls 20% or possibly more.
An hour a week is not much time to research the stocks, place the trades and update his records, even using the Internet and a high degree of automation. An even bigger assumption is that an hour a week, or even two, is all that is needed to beat the market. Most professional money managers’ work considerably more than the normal working week of 40 hours and only one third of those manage to beat the index in any one year and a lot less over multiple years. If he spends twice as much time his hourly rate falls to £20 and it drops to the minimum wage if he devotes 8 hours a week to it. Hardly a good use of his time one would think. If he is average he will only beat the market one year in three. So that hourly rate should be reduced by a further 30%.
The trump card of course is that of scale. If his portfolio is worth £500,000 rather than £100,000, then his hourly rate jumps fivefold. Surely the exercise is worth it to make £200 an hour? The answer is yes only if he can always beat the market by a net 2% a year every year at no extra risk. An additional return of 2% over and above the index on a portfolio of £500,000 is worth £10,000. No one would argue that is not worth achieving but, as is already clear, that return is by no means guaranteed. Moreover, holding all your assets in one asset class, UK equities, is perhaps not the best idea. A portfolio of that size should at least have foreign shares and some fixed income. Would our DIY investor be able to manage those securities as well in his allotted hour or two a week?
On these numbers then it looks as if the private investor with between £100,000 and £500,000 in investable assets has probably got better uses for his time than hunched over his PC for a few hours a week.
If that logic applies to the private investor is it not also relevant to the investment adviser or private client fund manager? Does it really make sense for him to research stocks or active funds to enable his client to get a better return than the market? Take an adviser with funds under advice of £50m.This collection of securities will be more diverse than the pure UK equity portfolio of our DIY enthusiast. Holding fixed income and maybe structured products will make it that much harder to deliver superior returns than the index over many years. A consistent excess return of a net 1% would be excellent and would deliver an additional £500,000 over and above the asset class returns to his clients. His clients would doubtless be very grateful, but unless he is a hedge fund manager with a performance fee his only reward would be the additional £5,000 arising from the 1% annual charge on the increased asset base. If he can achieve that, on a consistent basis, for an input of 50 hours a year his time has been rewarded at £100 an hour. While that is not to be sneezed at it is probably less than he charges his clients on an hourly basis. So is he really adding value? Surely his time would be better spent on prospecting for new business?
Those figures only make sense if he consistently adds value, at no, or little additional risk. Any year that he underperforms the index is he taking value out of his clients and of his own advisory business. That is hardly a good business proposition. Like the DIY enthusiast in the spare room his time is more valuable than that. Rather than going to conferences listening to fund managers giving their views of a particular stock, sector or economic trend he would be financially better off simply buying a tracker fund and prospecting for new clients to grow his business. It might be interesting hearing a talk about the prospect for the UK economy or oil prices but, for the adviser, it is time badly spent.
There is one last point to bear in mind for the adviser. Only one third of active managers beat the index so how does a prospective client identify an adviser who can pick this subset of the cohort? It’s the same exercise again and is a game where the odds are against the adviser using active funds. Conversely, the adviser using a passive approach with tracker funds can guarantee delivering the bulk of the returns of the markets each year every year. That is a simple pitch to the client, and allows both of them more time to go fishing.
April 2010
What is the best way to measure dividends?
Dividends, it is generally agreed, are a good thing. Indeed, the majority view is that the more the better. Long term research by Barclays, Credit Suisse, Société Générale and Professor Jeremy Siegel all provide convincing evidence that the bulk of equity returns over the long term, five years and more, actually comes from dividends, growth in dividends and from reinvesting dividends.
On the basis of these data then it should be a straightforward process to construct a market beating portfolio. Simply buy a collection of the highest dividend paying shares and away you go. Indeed, for many investors over the last decade that has been a winning strategy. A number of professional money managers made great careers running high yield funds; until 2008 and 2009 that is. The last two years have been very painful for income funds with catastrophic falls in 2008 for many and lacklustre returns in 2009 when market recovered very sharply.
To the detached observer these events simply proved the validity of stock market aphorisms like “There’s no such thing as a free lunch” “You can’t beat the market” or “Higher returns only come with higher risk”.
To understand better why income and yield funds have been so disappointing over the last two years it might help to do a little analysis on what exactly a high yield share is. Yield is the product of two figures divided together. The top line is the dividend a company pays, usually expressed in pence per share. That number is then divided by a second figure, the share price, to calculate the yield. Although they are related there is no direct correlation between the two except through the yield calculation. It might therefore make sense to look at each figure separately to see how they originate and what they are telling us.
A dividend is the amount of money a company feels it can afford to pay out to its shareholders after it has paid all its creditors and invested enough to sustain and grow the business. Although it represents a cash payment of several tens or hundreds of millions of pounds it is invariably referred to in pence per share. The figure is set by the board in relation to the reported earnings per share and by what the company has paid in the past. Determination of the dividend may also be impacted by the board’s view of the future. A particularly worrisome outlook may persuade the directors to leave the dividend unchanged, cut it or reduce it.
Alternatively, the board may be so confident in the future of the company it might want to send a signal to the market that things are great, and are going to get better. An earnings per share figure is, more or less, simply a record of what the company has done and does not send a message about future prospects. Even though two of the options open to the board are reducing or not paying a dividend in practice boards are reluctant to do this and will often pay the same dividend as the previous year even when its financial circumstances might indicate otherwise.
Much is made of the dividend cover. This is the difference between the earnings per share figure and the dividends per share. Typically boards and investors like a figure of around two or more as this provides some scope for maintaining the dividend even if the company has a bad year. In practice these days the many distortions to profits from exceptional and or non-recurring items often makes the earnings figure a poor guide to what the company can pay out to its shareholders. A better understanding can be gained from analysis of the cash flow statement, although that too can be fraught with issues around lumpy capital expenditure and corporate activity.
The dividend that a company actually pays is thus a complex blend of what the company can afford and what the directors think is appropriate given the current business conditions.
In contrast the directors have no control over the share price. That said directors now are all acutely aware of the requirement to inform the market if they believe current consensus forecasts are more than five percent adrift from what they think will happen. In essence share prices are set by “Mr Market” as sagacious investor Warren Buffet calls it. All the available data is collected and assessed by existing and potential holders of the stock to discover the most accurate price for the shares. Except in periods of extreme market dislocation exactly half the market will think the shares too expensive while the other half will view them as too cheap. Share prices can therefore best be viewed as an opinion while a dividend is very definitely a fact. The question is what happens when we divide a fact by an opinion. Surely, it must just be another opinion.
And that is where income and yield funds run into problems. High yielding stocks are trying to balance the conflict between the fact of the last dividend payment and the opinion of the market over the size of the next dividend. In many cases, especially over the last few years, the market opinion that a dividend will be cut, or reduced, has been correct. Even when that downside has been priced in a dividend cut usually triggers a further fall. And that is painful for funds that hold the shares. In practice the effect is compounded because income and high yield funds will migrate to stocks that, on paper, offer a high yield and ignore stocks where the income is safer, but smaller. In effect what is happening is that dividends are being valued by price and these funds over-invest in shares whose income has a low value; in many cases for good reasons.
Investors buying conventional tracker funds ignore share prices when they invest. So what happens if we ignore the price of dividends? Why don’t we use some other measure to assess them? The simplest way to do that is to rank companies by the gross cash dividend they pay out. In other words you measure dividends by volume rather than price.
When we compare a portfolio constructed in this way we see a lot of similarities with a conventional portfolio ranked by market capitalisation. After all a company paying out several billion pounds in dividends is hardly likely to be lurking in the Small Cap sector. It is therefore no surprise to see that companies like Vodafone and BP that constitute the largest companies in the market are also the largest dividend payers. Moreover, assessing dividends in this way gives an excellent mechanism for determining how much of each stock a portfolio should hold. Using each company’s contribution to the total income of the market provides a logical basis for calculating portfolio weights.
Using dividend data in this way provides a neat riposte to Oscar Wilde’s accusation that some men know the price of everything and the value of nothing. It is more important to know the value of dividends than their price.
March 2010
*For Sale: A one year old rally, no careful owners*
March 3rd 2009 marked the bottom of the UK bear market. One year later the FTSE 100 is up 51%. While that is pleasing it is outclassed by the FTSE 250 Index that is up 63% while the FTSE Small Cap is a staggering 69% higher. Have these gains arisen because profits in the constituent companies have risen by that much? Alas no.
In the case of the large companies profits have actually been pretty pedestrian over the last twelve months. Indeed, mining companies probably reported profits in 2009 that were about half the levels of 2008. Oil companies too all had much lower profits as oil prices fell. The saving grace for these global megacap stocks was their international exposure that enabled them to benefit from strong growth in emerging markets. Nevertheless, overall profits certainly did not rise by over a third.
In the case of the Mid Caps the performance was, if anything, even worse. This group of companies has a much stronger focus on the UK and includes sectors like house building, car retailers and many consumer facing industries. Most importantly over a quarter of the sector is financial stocks. Overall, they had a torrid time in 2009, and profits are, in many cases, sharply down on 2008. Finally, last but not least, the Small Caps are a mixed bag of companies that are much more sensitive to the economic winds because of their small size and can be best be described as the canaries of the financial world. They too had a tough time in 2009 and certainly did not increase profits, let alone anything like 69%.
So why then did the smaller companies do so much better in this rally than the big caps? The answer lies in the events leading up to the market trough. In 2008 the financial crisis led to a dramatic reappraisal of risk and it suddenly become important to price it correctly after years when it had been ignored.
Risk is associated with many things but an important factor is liquidity, the ability to get out of an asset when you want. Small cap stocks have famously been described as lobster pot stocks; easy to get into, impossible to get out of. As the true scale of the financial crisis became apparent at the end of 2008 the small cap and mid cap sectors cratered as investors exited the riskiest assets. A lack of liquidity meant brokers could not find buyers and prices were marked down sharply. The process continued in the first few months of 2009 and valuations of all equity markets, but especially small and mid caps, reached distress levels in the first week of March. It was then the Bank of England started its programme of quantitative easing. Although it had been flagged in advance the start of the programme gave investors the confidence to reprice stocks on a going concern basis rather than as basket cases only an accountant away from liquidation.
Over the next six months investors started to look at the whole market, but especially the small and mid cap stocks, on the assumption that eventually business conditions would normalise and that the recession would end eventually, even if no one knew when. So the market did what it loves to do, but is actually very bad at, which was to “vote” on all the beaten up shares and revalue them on expectations that they would return to profitability. All the evidence from long term studies on stock market returns, such as those from Barclays and Credit Suisse, show conclusively that the bulk of returns comes from reinvesting dividends and allowing the magic of compound interest to do its work. It does not come from chasing capital growth.
In the rally of 2009 all that was forgotten as investors clambered about car dealers and house builders in the expectation that profits would return to previous levels. However, by anticipating the recovery, the market has risen on valuation rather than earnings. It is the expectation of profits rather than actual delivery of earnings that has boosted share prices. Nowhere is that hope higher than in the mid and small caps.
This rally has been a painful experience for value investors who prefer the tangible evidence of dividends rather than the faith of recovery investors who expect balance sheets to deliver the same profits as before. The bounce has put the market on a much higher valuation than a year ago and has left more conservative investors behind. This is best measured by comparing the dividend yields of the three size categories. The FTSE 100 yields 3.4%, the FTSE 250 2.6% while the FTSE Small Cap yields 2.7%. It will take time for compound interest to work in favour of dividend paying stocks again. But there is no doubt it will happen and, as it does, funds with a value bias will start to close the performance gap on growth and momentum funds.
February 2010
Agents versus principals
In all the outpourings of angst over the global financial crisis there is one group that has suffered more than any other, yet its voice has been drowned out by politicians, the media and taxpayers. It is shareholders in banks that have been the hardest hit by this financial Armageddon. Some commentators would argue that speculators holding bank shares simply got their just desserts for holding such risky investments. That is unfair though because for most of the last half century bank shares were regarded as rather boring and less risky than other sectors such as technology and commodities. Moreover, many individual shareholders became accidental capitalists as a consequence of the demutualisation of a number of building societies. Few could accuse those venerable institutions of playing fast and loose in the world of finance in their original form.
The reality was that banks shares formed the bedrock of a great many portfolios ranging from individuals, income funds and pension funds. For those investors to have avoided a sector that was generating about £20 billion of dividend income, about one third of the total cash flow from the market, would have been nonsensical. Two years ago, before the great implosion, this sector was valued by the market at about £200 billion. That was a staggering large amount of capital.
So who was responsible for vaporising it? The simple answer is that it was largely in the hands of a small group of people who were, for a while, on the front pages of newspapers up and down the land. Sir Fred Goodwin, Andy Hornby, Sir Victor Blank and so on. In fact these men were not custodians of that capital but the agents responsible for deploying it. They, in the truest sense of the phrase, were merely managers. They did not represent the owners of that capital but were deploying it for the greater good of the shareholders.
The agents deployed the capital on behalf of the principals. But the rewards for the risks incurred went to the agents who organised the trade, not to those who took the risk. No wonder the system blew up. If the principals, the shareholders, had been properly rewarded for the risk, and kept the proceeds, the banks would all have had stronger balance sheets.
Of course history records that then, and even now, the executives made themselves very rich in the process. Not only did they reward themselves very handsomely through wages and bonuses they also decided that they would like to become shareholders as well. So they awarded themselves options enabling them to become part owners of the business. Unlike other shareholders though, they did not have to write out a cheque for their investment. They got the shares for free just for turning up and doing their job as directed by the owners. It’s not a perfect analogy but it is a bit like a window cleaner turning up on a regular basis, cleaning the windows of your house and, in addition to being paid, demanding and being given a small share in your house.
Most householders would not contemplate such an agreement. Why should they give up a part share of an asset to someone who is merely following orders? Yet this transfer of ownership is precisely what happened at the banks, and it is still going on. When Barclays sold its iShares business in 2009 Bob Diamond received millions of pounds for the shares he owned in that division. Did he buy them? I don’t think so.
It is this insidious dilution of the original owners of the business that is at the core of the financial crisis. Managers, the agents, acquired part ownership from the shareholders, the principals, by stealth and then treated all the capital in the same way. As if it was free.
In theory the rights of the shareholders are protected by the watchful eye of the non-executive directors. But take a look at the board of Barclays as an example. CEO John Varley, with 622,000 shares and Bob Diamond with 8.3m shares are executives, as is Finance Director Chris Lucas with 101,700 shares. They have to explain their actions to the shareholders and take instructions from the non-executives. But who are they?
The Chairman is Marcus Agius, a Swiss banker, so he doesn’t represent British shareholders but has 113,500 shares. John Sunderland, with 80,000 shares used to run Cadbury. David Booth owns 73,000 and used to work for Morgan Stanley. Simon Fraser with 46,000 shares was a fund manager at Fidelity before he retired. Fulvio Conti has 39,000 shares and currently runs Enel, the Italian energy company. Leigh Clifford with 35,000 shares used to run Rio Tinto and is now Chairman of Qantas. Richard Broadbent with 34,500 shares is Chairman of Arriva. Andrew Likierman with 23,000 shares is Chairman of the National Audit Office. Michael Rake with 15,000 shares used to work for KPMG and is now Chairman of BT. Finally there is Reuben Jeffery who spent 18 years at Goldman Sachs.
The non-executive directors are clearly there to cement business relationships. It is patently clear that none of them represent large, long term shareholders. There is no one on the board of Barclays Bank who is actively involved in managing money. There is no representative from Schroders, Prudential, Standard Life or Aviva, the biggest money managers in the UK. Neither is there any representation from hedge funds or sovereign wealth funds, many of whom will have capital invested in the bank. Traditional fund managers will of course declaim that they cannot be directors because it would generate a conflict of interest and would inhibit their ability to trade if they became privy to inside information. That is less relevant now because so much money these days is run on a passive basis. Portfolios are constructed totally independently of any “information” that fund managers might be able to acquire from a board meeting or anywhere else.
Passive mangers now have the worst of all worlds. They are custodians for pensions and ISAs yet can only stand and watch, passively, as large banks deploy that capital in a way that could destroy it.
Alan Greenspan, former chairman of the US Federal Reserve, was surprised by the financial crisis. He thought the self interest of all the participants would inhibit them from undertaking activities that were likely to result in such a catastrophe. The problem was that the agents of the crisis were not risking their own capital. The principals, whose capital was being risked, never got a chance to express their opinion.
There will be other financial crises, it is human nature. But it is possible to ensure that this one is not repeated. The first step would be to ban the use of share options as a means of incentivising bank executives. The second is for shareholders to ensure that they are adequately represented on the boards of banks. Once there they need to understand the risks that are incurred and ensure the return is sufficient compensation. Most importantly, they need to make sure the risk takers are rewarded, not the agents.
January 2010
As a conversation stopper telling someone you are a tracker fund manager is about as good as saying you are a traffic warden. It makes a good excuse to edge closer to the canapés and drinks. But not all tracker funds are the same and the portfolio of a fundamental tracker fund, such as The Munro Fund, has significant differences from a conventional market capitalisation weighted fund. It is this difference that creates the potential for a better return than conventional trackers.
Examples make explanations easier. Anglo American has a market weight of 2.37% yet only 0.36% of the Munro Fund is invested in it. Why the discrepancy? In 2009 Anglo American surprised investors by suspending dividend payments and said they would be reinstated when market conditions allowed. It did not pay an interim dividend and few analysts are expecting a final dividend to be declared when it reports results for 2009 in February 2010. Dividends are a key part of the covenant between investors and managers. Investors supply capital to the managers in order for them to generate cash, not just profit. That cash can be then be used to grow the business but there is usually a clear understanding, especially in mature businesses, that some of that cash will be returned to investors as a reward for the use of that capital and as a gesture of good faith. Banks have dramatically proved in the last few years that the inherent tension between principals and agents can be stretched too far.
Managers have day to day control of the cash and it is often easier to find new and exciting projects to spend the cash than return it to the providers of capital. In the case of Anglo American its immediate downfall was the multi-billion dollar iron ore project in Brazil. But that was just one of many problems. The sharp contraction in the world economy at the end of 2008 sent commodity, and especially diamond prices plunging. Anglo American has a 45% stake in De Beers which needed emergency financing after closing all its diamond mines due to the financial crash. Even though diamond prices have recovered a little volumes are still low and how De Beers will refinance itself is unclear. Will it need a rights issue?
Then there is the 80% stake in Anglo Platinum. It is has $3b in debt and is struggling to find cash flow for capital expenditure. Will it too need a rights issue? All these, and other, pressures on Anglo American convince analysts that a meaningful dividend is unlikely for some time. Instead it has to decide how to ration the pot it has and consider whether to ask for more. The stock market has placed this company in the select group of corporations that are expected to pay out over a £1billion pounds in dividends next year. Our data indicates that even a quarter of that would be overly generous which is why the fund has a modest exposure. The question is why do other trackers hold so much?
December 2009
Fourth Quartile: the phrase that is supposed to strike terror into the heart of every fund manager. In essence it means that three quarters of the funds in its peer group have delivered better returns over that time period. Believers in the Efficient Market Hypothesis (that the market is always perfectly priced) would therefore assume that a fourth quartile fund has done something seriously wrong. Others, and that includes us, prefer Ben Graham’s view that the market is a voting machine in the short term but a weighing machine in the long term. Data from Barclays, Credit Suisse and Professor Jeremy Siegel convincingly proves that the stock market weighs dividends more than any other measure.
Let us remind ourselves of what has happened over the last year? The top ten performers in the FTSE 350 over the last 12 months include Avis Europe, Taylor Wimpey, DSG International. None are currently paying dividends and only one of them is forecast to pay one next year. Even after rising by 440% Avis Europe is still only valued at £248m. It is a tiny business and, on a price to book ratio of 4, a demanding valuation. Needless to say it is not held by The Munro Fund. Contrast it to Standard Life which the fund does hold. Over the last year it has fallen by 20% and is one of the worst ten stocks in the FTSE 350 index. It has a lowly valuation of 1.3 times book value and is paying out 11.8p a share in dividends giving it a yield of 5.7%. It is perfectly fair to say that holding Standard Life instead of Avis Europe has given a worse return over the last twelve months. But will that be the case for the next twelve? In the short term changes in capital values are important as the market reassesses its views on stocks. In the longer term though it is the income those stocks generate that is far more important.
Holding or not holding stocks is black and white. The grey area is how much a fund holds in a stock relative to the index. There are two large stocks where The Munro Fund differs substantially from the index; one is Vodafone and the other is BG Group. Vodafone makes up 4.79% of the FTSE 350 Index but The Munro Fund has a holding of 7.71%. A forecast dividend of 8.4p per share for its next financial year means it will be paying out £4.4 billion in gross cash dividends if the company pays out as expected. That means it will constitute 7.3% of the total £60.7 billion that companies in the FTSE 350 index are forecast to throw off in their next financial year.
In contrast BG Group is forecast to pay 14.1p a share to generate a gross cash payout of £475 million. That constitutes only 0.78% of that £60.7 billion total for the index. Today the market thinks those dividends from BG are worth a lot more than the dividends from Vodafone. That is why BG accounts for 2.36% of the FTSE 350 Index and trades on 3.1 times book value while Vodafone is only valued at 0.85 times book value. Put another way every pound of sales made by Vodafone is valued at £1.80 but each time BG takes in one pound of revenue the market values it at £3.50. No one really knows if investors are too optimistic about BG and too pessimistic about Vodafone. Trying to assess how much revenues or book values are worth keeps many analysts on both the buy and sell side happily engaged for long period of time. In the end though, the answer is always subjective. What we do know is that the magic of compound interest on dividends will probably give income investors a better return in Vodafone than in BG over time whatever capital value the market puts on their companies.
November 2009
Such is modern life that the conference centre at Meriden subsidises the motorbike museum next door. Yet a walk around that museum is instructive for today’s fund manager. The museum has over 700 bikes, all British, mostly made in Birmingham and dating from the very beginning of the 20th century. What is truly staggering is the sheer range and diversity of designs that were produced around the fairly basic concept of two wheels and an engine. This variety was a direct function of the large number of manufacturers. As the man with the rag halfway through polishing several hundred bikes remarked “There was one for every letter of the alphabet”. It was not just Nortons and Triumphs or even less familiar ones like Vincent and Brough but names that are hardly remembered like Wooler and AJS.
Each manufacturer had its own special ideas and each model its own features. Some of them were truly bizarre like the one with twin back tyres. How would that corner? There were shaft drives, belt drives, chain drives, one cylinder, two cylinder, four cylinders, some in Vs, some squares and controls in all sorts of places. Today, save for two, they have only one common feature; none of them are in business now. A motorbike today from a major manufacturer will have a chain drive, probably a parallel twin layout and a control system that is common to all. Oh, and it will probably be Japanese.
In the end all consumers wanted was a bike that was reliable and reasonably priced. British bikes were idiosyncratic and leaked oil. Japanese bikes were reliable, well priced and did the job. At the finish consumers cared less about the complexities of the engine layout than the fact that the machine did what it was supposed to do: start, go fast, corner and stop.
What, you might wonder, has this got to do with fund management? Consider this. Most active fund managers today can be compared to those Midland manufacturers between the wars. Each is an individual, even if they work for a large firm. They all have their own approach and try and maintain a competitive edge over their rivals by having a secret recipe of how they build a portfolio. Little of it is written down and few fund management firms can even claim to have an in-house style. Indeed, if the media are to be believed, one well known firm contains two sharply contrasting views on the oil market; a bearish one from its equity fund manager and a bullish one from its bond managers. Fund managers could learn a thing or two from bike builders about brand management.
This wide variety of products is reminiscent of those bespoke, virtually handmade motorbikes from old middle England. Most of the time they do the job of giving investors the equity market returns they are seeking. However, those returns can be a bit lumpy and the ride can be wild. Sometimes, like New Star, they crash spectacularly. They are in the great British tradition of amateurism.
Motorbike manufacturing changed when pricing power moved from the producer to the consumer. Fund management is fortunate that prices are still set by the producers, not by the consumers. But, as with airlines, that situation is changing and pricing power is moving to the consumer. Part and parcel of that process is the growing realisation that what investors want is a cheap reliable product that delivers the returns of the asset class.
Motorbike buyers in 1929 were offered a plethora of choices about the design of the motorcycle. In the same way investors today have to choose from a bewildering array of active funds but, unlike bike buyers of 70 years ago, they have very little data on which to base their choice. With little information on how the process at fund A differs from that of fund B intermediaries have to rely on the simple output data of performance. That is like comparing a 1,000 cc square 4 with a single cylinder 125 cc. Both might do 60 mph but they achieve it in vastly different ways. An informed buyer could form a judgement as to which might be more reliable.
Apart from historic data like TERs, tracking errors and a few other ratios such information is lacking for active funds. It is only the new breed of modern tightly defined passive funds that define exactly what they do and how they do it. For the investors who simply wants a fund that does what it says on the tin, delivers the returns of the market cheaply and reliably, passive funds are the only solution. Of course, there will always be a demand for the sporty bike and the sporty fund. But both are uncomfortable to ride and can bring you out in a cold sweat. For the serious long term rider and the long term investor reliability is the key. To get that you need to know exactly what you are buying.
October 2009
What’s the difference between buying shares and buying collective investments? In theory there should be none, but in practice it is clear that very different processes are at work.
A share represents part ownership of a company that has its value determined in the market against certain measures such as sales, profits, cash flow and book value. Moreover, investors can make an assessment of the prospects for that industry whether it is making steam trains or wind turbines. Using this data an investor can form his own view of the valuation and determine if it is cheap or dear and trade accordingly. He may also seek social proof from other investors in magazines and websites that his views are shared by others. The best proof of all is to see the share price going up providing clear evidence to confirm that his view is correct and acts to reinforce his decision to buy.
Investing in a collective investment is more difficult. For active funds it represents the amalgamation of two views, one about the market and one about the manager. Few funds provide much data to assist with valuation, such as aggregate ratios for price to earnings, sales or book value. If it is an income fund the yield can provide a guide and maybe that is why these funds have proved so popular in recent years. Having at least one tangible measure is better than nothing. Even so this data needs to be treated with caution if the fund invests outside its core market and or uses different asset classes, such as fixed income.
For many funds there is no such data. That leaves investors relying on the concept of social proof, the actions of others, to provide the evidence they need to make a decision and buy a fund. In fact of course the return of any fund is a product of two factors; the movement of the underlying asset class and the performance of the fund relative to it. The relative movement of the fund itself is usually more a function of the amount of risk a fund has taken rather than a measure of stock picking skills. High beta funds do better in a rising market and worse in a falling market. Selecting a fund with the beta you want is usually a lot easier than trying to determine if we are in a bull or a bear market. Right now high beta funds are flying after a six month rally in the stock market that has pushed everything up, especially growth stocks.
Naturally many of these funds now appear at the top of performance league tables. But is now the right time to invest in them? That is a difficult call for the adviser. He has to determine the likely course of the market in the short to medium term and then decide how much risk to take on. Does he want to beat the market, but take the risk of a double whammy if the market corrects and his high beta fund falls even more? Or does he recommend a fund that only does well, in a relative sense, when the market is weak or treading water? While the latter may not be instantly appealing it has been shown over time that shares with lower valuations consistently provide better returns over the long term than expensive ones.
It might go against the grain to select funds that have underperformed in this rally. But stockbrokers right now are sifting through the market to see which shares have been left behind in this recovery. The same logic applies to funds. If a fund can demonstrates it offers the same exposure, at a lower valuation, then there is a good argument for making the switch. There is no reason to rely solely on social proof to choose funds when there are data out there to prove they are cheap and less volatile than others.
September 2009
Few people in March expected the FTSE 100 Index to be within a percent of so of 5,000 at the end of August. The mood then was one of uniform bearishness even though most observers agreed that the market was cheap. While it is true that some sages, like Buffet and Bolton, were calling the bottom of the market they had said the same six months earlier. The problem with forecasting is that you need to get it right every time.
As a tracker fund we don’t make forecasts.
All we offer is a simple, transparent and cheap vehicle for investors to get equity exposure. And, as this rally has demonstrated, no one quite knows when equities will take off. What is obvious is that anyone without equity exposure six months ago has been denied a 30 to 50% gain on part of their portfolio. If the average yearly return for equities is about 6% that could mean that the last six months have given us the returns of the next five years already. Then again, will the market see 6,000 before it sees 4,000?
No one knows.
Clearly, it is sensible to maintain some exposure to equities; but how? Traditionally it was through active management but the volatility from individual stocks is high. Trackers reduce that risk through diversity. The problem with cap weighted trackers is that as shares rise the biggest gainers become a larger component of the index. That means they attract a bigger slice of the next injection of capital into the market and a strong positive feedback effect is established that makes big companies even bigger.
Consequently cap weighted funds are always overweight expensive shares at any point in time.
That might seem a little odd and it merits a brief explanation. Although we will never know for sure which stocks are expensive the example below demonstrates the difference between weighting stocks by price compared to a fundamental measure.
Assume the components of a stock index have aggregate earnings of £100m and the whole market is valued on a PE ratio of 10. Therefore the total market is valued at £1,000m. We might not know exactly which stocks are cheap and which are expensive. But let’s assume half the stocks have an above average PE of 15. That means the other half must be valued at 5 times earnings. It follows therefore that the expensive half of the market is valued at £750m and the cheap half at £250m. Consequently any cap weighted index fund will have 75% of its assets in the expensive stocks and only 25% in the cheap stocks. While this effect is reduced when the range of valuations is lower, it will always be present.
History tells us that cheap stocks outperform expensive stocks over time, yet the cap weighted index fund is underweight in them. In fact, because such a fund is overweight expensive shares it has a higher PE ratio than the market, in this example it has a PE ratio of 12.5; a quarter more than the index itself. You might be buying £100m worth of earnings, but doing it this way you are paying 25% more than the average and that is bad for long term returns.
Dividends are a proxy for earnings and that is why the fundamentally weighted Munro Fund has a lower valuation than the market. While the FTSE 350 is valued on a price to book ratio of 1.84 that of the fund is 1.69 and on price to sales the figures are 0.98 against 0.85.
No one can accurately call the direction of the market. But maintaining an exposure to it makes sense. Doing that through a low risk vehicle that is cheaper than the market makes even more sense.
July 2009
Last week the FSA released its consultation paper on the Retail Distribution Review which is aimed at improving the quality of advice delivered by financial advisers. It seeks to achieve this largely by banning the use of commission as a marketing tool in the expectation that this will reduce prices and eliminate the bias towards high commission paying products.
Such a single track approach overlooks other deficiencies in the existing market place, the largest of which is the paucity of data to assist intermediaries in assessing the quality of funds. Even though it is widely accepted that past performance is no guide to future returns the industry and the media largely concentrate on returns over various periods. Little mention is made of how much risk is incurred to make those returns. It is easy for a fund to increase its risk by, for example, taking large positions in small stocks. But unless it is rewarded by having better returns than its peers then the fund has failed to do its job. Even if such a fund does match the returns of the index or its peers it has delivered it with more risk than was needed. That makes it lower quality than a fund that can deliver the same returns at less risk.
Gatekeepers at the large networks and private client managers have access to a great deal of data from companies such as Lipper and Morningstar. This gives them the information they need to assess the riskiness of funds. But not all intermediaries have this data and most clients are not familiar with the measures. Moreover, the trade press totally ignores such data, preferring to focus on historic returns and calls on the market, sectors or stocks.
Contrast the data presented in the back pages of financial magazines with that in car magazines. A prospective car buyer can easily find out how fast a car goes and its acceleration time. More importantly he can also discover what the fuel consumption is, how many seats it has, how much luggage it can take, an estimate of running and insurance costs and how safe it will be in a crash. Consumers looking to invest as much as they might spend on a car, or considerably more, are curiously unquestioning about the nature of the investment vehicles they might use.
All funds have data such as total expense ratio, tracking error, alpha, beta and information ratio. Why is this data not disclosed more widely in league tables or when funds are described by journalists? If the FSA really wants to increase the quality of advice it should demand that all funds publish a lot more data, such as tracking error and excess return. Then it will be clear exactly how much risk a fund has incurred and whether it was worth it. That way consumers will be able form their own judgements of the quality of advice and products they are being offered.
June 2009
Managing money is easy; doing it better than others is extraordinarily difficult because there is simply so much competition. A measure of that competition is the size of the IMA UK All Companies sector in which The Munro Fund sits. It contains 354 funds and over the year to the end of April the average return was a decline of 26.3%. That sounds pretty awful and the last twelve months have certainly been one of the most painful for investors in recent decades. A demonstration of just how bad is the 26.9% decline in the FT All Share Total Return index. On the face of it then the average fund did well to beat the index, especially when we remember that fees will probably reduce average returns by at least one or two percent over a year.
But how can the cohort of funds be better, on average, than the benchmark it is measured against? After all this is real data, not opinions subject to the Lake Wobegone effect, the town where every child is above average. Every fund manager might think they are above average, but performance data is not subjective. The answer is that a great many of the funds in the UK All Companies Sector include stocks that are not UK listed. To make matters more complicated some funds derive significant returns from using derivatives. The manager of one of the highest profile funds in the UK admitted to me at a recent conference that a fifth of his return came from using derivatives. How you compare that with a conventional long only fund beats me. However, once we understand that we are dealing with a heterogeneous group the reason for the discrepancy in returns becomes obvious. There will always be some fund at each point in time that has the right mix to perform better than its rivals.
There is an obvious incentive for a fund manager to pinch outperformance against his peers by selecting stocks that his rivals don’t own. Measuring yourself against the UK index when up to 20% of your fund is in foreign stocks is a simple way of pinching beta from another market and claiming it as alpha in your own.
That is the reason the performance data we quote for the Munro Fund is not expressed in quartiles or assessed in relation to its peers through IMA sectors. This fund only contains stocks in the FTSE 350 index. Comparing The Munro Fund against funds that do all manner of other things, like using derivatives or overseas stocks, is akin to comparing a sports car to a family estate. No car dealer would rank the performance of a two-seater against a load-lugger without factoring in the different tasks they might be purchased for. Unfortunately, no such discrimination takes place within the UK All Companies sector. Only capital gain is measured.
Cynics might think we avoid the comparison because it reflects badly on the fund. That is not the case. This page on Trustnet shows that the fund is in the top quartile in performance but, equally as important, in the top quartile for risk and risk adjusted returns. In other words three quarters of our competitors are taking more risk than us but are not being rewarded for it. Of the funds that are ahead of us one wonders how many are true long-only funds limited to UK listed stocks and eschew derivatives.
The only performance data we quote is against the FTSE 350 Total Return index. That is our benchmark and the only relevant measure is how well we do in comparison. It is of course impossible to invest directly in the index itself, but we hope this fund is the next best thing.
May 2009
The last month has seen a substantial rally in share prices. These capital gains are encouraging and give us a warm feeling. Nevertheless, the reality, and the investment philosophy of this fund, is that the bulk of our equity investment returns comes from dividends and the reinvestment of dividends. The Barclays Equity Gilt study says dividends generated 90% of the return from UK equities since 1945. Société Générale, in another study, asserts that even over a short period of five years that dividends and growth of dividends accounts for 80% of returns.
Theoretically then the variations of the capital value of that income stream should be of only cursory interest to the long-term investor. In much the same way a boat owner is only mildly curious about whether it is high tide or low tide as long as his boat is still afloat.
Even so, changes in indices are fascinating. What is curious is the sharp increase in the small cap index. A rise of 42% since its low on the 3rd of March leaves that index on a yield of 4.7%. The FTSE 250 index has risen slightly more with a gain of 43%, although that is since November, giving it a yield of 3.7%. It is the FTSE 100 that is the latecomer to the party with a rise of only 24%. Nevertheless, it still yields more than it is smaller siblings at 5.0%.
The Munro Fund weights dividends by volume not price. So we find it interesting that the value of the £944m of dividends from the small caps and the £5.1b in dividends from the mid caps has risen twice as much as the £55b in dividends from the large caps.
Given that the prospects of all dividends can never be known with any certainty one wonders why the market has decided that dividends from small and mid caps are now more prized than those from large caps.
Over the last two years a good argument could be made for the 40% fall in the FTSE 350 as forecast dividends have fallen 18% from £74b to £61b with doubts there could be worse to come. That reflected a fall in both the volume and the value of dividends.
Although estimates are still slipping it seems that the worst of the dividend cuts have been made. Even so it is hard to envisage substantial increases in dividends from here. In which case there is not much of an argument for paying more in anticipation of higher payouts. What the market seems to have decided is that those dividends, while smaller, now have a higher value. What is unclear to us is why the smallest cohort of dividend payers has been re-priced more than the larger ones. Are small UK companies really offering more secure income than large diversified internationals?