The Small Print

The contents of these muses are my own opinions, should not be taken as a personal recommendation to invest in the areas mentioned and does not replace the need for individual independent advice.

Black Tuesday – The History and Legacy of the Wall Street Stock Market Crash of 1929

This little book by Charles Rivers Editors made very interesting reading for me over the Christmas period. It was not technical and was written in layman’s terms so it is well worth buying a copy if this brief summary piques your interest. I can only do scant justice to the lessons investors can draw from these historic events in an investment blog.

The crash in October 1929 was the culmination to what became known as the Roaring Twenties, as the US economy and stock market boomed, driven by strong industrial production and new technology. Employment was high and prices were stable. Prior to 1920 few ordinary Americans owned stocks but as prices rose through the 1920s middle class Americans piled in, often buying stocks on credit or margin. Stock prices had a momentum all of their own and became detached from the real economy and investment fundamentals. From 1922 they rose almost 20% p.a. on average, although not uniformly. Although concerns were raised in early 1929 the market continued to rise fuelled by speculators. From May 31st to August 31st 1929 Westinghouse Electric Corporation rose 89%, Steel was up 56% and the market overall rose by just under 25%.

On 5/9/29 Roger Babson, an entrepreneur and economist predicted a crash at a meeting of the National Business Conference. It was a repeat of an earlier warning he made at the same time in 1927 and 1928. Babson’s comments evoked retorts from economists and stock brokers. For example Professor Fisher, a noted Yale economist claimed, “stock prices are not high and Wall Street will not experience anything in the nature of a crash.” In early October 1929 Thomas Lamont, head of Morgan Bank wrote to President Hoover, “The future appears brilliant. Our securities are the most desirable in the world.” Almost every business leader and banker was saying how wonderful things were and the economy was only going in one direction, up.

The Dow Jones Industrial Average peaked at 381.17 on 3/9/29 and then declined to 320.91 by 21/10/17. The sharpest declines then occurred on Monday 28th October, with the index falling 12.82%. This was followed on Black Tuesday, 29th October by a further drop of 11.73%. Further losses occurred subsequently and the Dow finished the year at 248.48, a decline of 34.8% from the peak on 3/9/29. This was followed by the Great Depression with 50% declines in industrial output and international trade. Unemployment rose to 25% and around 9,000 banks collapsed. The stock market continued to fare badly. In 1930 the Dow fell a further 33.76%, in 1931 it lost 42.67% and in 1932 the market was down by 22.64% (Source: ). If the Roaring Twenties was a heck of a party the Thirties was the mother of all hangovers, with the Great Depression going global. The cause of the Great Depression is still not agreed by economists but it may not have been simply due to the 1929 Wall Street crash. One observer noted that the market slump reflected the change which was apparent in industry and the economy. In other words the stock market merely acts as a mirror on the economy i.e. cause and effect runs from the economy to the stock market, not the other way around. I am not convinced about this argument but space does not permit me to express my thoughts.

There are several other interesting facts to note. Firstly the Dow Jones did not recover back to its former peak until 1954, 25 years after the crash. Secondly the biggest ever one day fall was not in 1929 but on 19 October 1987 when the Dow fell 22.61%. What is it about October? This sell-off in contrast to 1929 did not lead to a recession. Thirdly on the reasons for the crash an article from the New York Times on Tuesday 22nd October 1929 was illuminating. This was before Black Monday and Black Tuesday but after three days of losses in which billions were wiped off the value of shares. Five reasons were given for the falls which I paraphrase:

*Readjustment of stock prices to levels that are justified by earnings, economic fundamentals and company prospects.

*Unanswered margin calls from thousands of small investors. In order to cover the loan repayments or interest payments stocks were sold. This downward pressure on the market was enhanced by stop-loss orders. These are where investors instruct sales once a floor in the stock price has been reached.

*Foreign selling on a large scale especially in railroad stocks as overseas investors protected their interests.

*Short selling by investors taking advantage of a falling market.

*Negative sentiment amongst stock holders even those with profits. This is about investor psychology, rushing on mass towards the exit.

This analysis more than 87 years ago feels like a modern commentary on the causes of stock market crashes in more recent times. Nothing has changed. Once the slide starts it is like a snowball gathering pace and size as it accelerates down the hillside. Big market crashes are sudden, (the warnings and red signals are not but the immediate triggers are), sharp and self-perpetuating. Nothing has changed and although we have not had a crash since 2008 why should we think another is not coming? John Templeton famously noted that the four most expensive words in the English language are – “This time it’s different.”

So what do I conclude and why have I raised this subject now as my first blog in 2018? It is certainly not because I wrongly called a correction in late 2017 and am seeking justification for my view. Moreover I don’t believe the economy and stock markets in 2018 are anything like they were in the US in 1929. I don’t think there is a bubble in equities in general nor have prices become universally detached from economic reality. My concern is due to a bullish and perhaps complacent attitude amongst investors. The global economy is going through a synchronised recovery, central banks are cautious and accommodative and people made money in 2017 from equities. So why not again in 2018? My message is investors need to keep in mind a sell-off will happen again, no-one knows when, and plan accordingly. That does not mean avoiding equities completely but being cautious and investing a significant part of a portfolio in defensive assets. This will require adjusting expectation of returns from “shoot the lights out” performance to beating inflation or cash, more modest outcomes. Of course individual needs and circumstances will dictate the correct investment strategy and asset allocation, notably investment timescales, attitude to risk, capacity for loss and cash reserves. There is no one solution for all.

Finally it is worth Babson got it wrong calling a crash in 1927 and 1928 but then it happened in 1929. I got it wrong in 2017. I hope I also am wrong in 2018 and I would take no pleasure should 2019 prove to be a terrible year for equity investors.

The content of this blog is my own understanding of the 1929 Wall Street crash and the global economy and stock markets today. My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.

Synchronised Global Economic Growth & Stock Returns

There is a wide consensus that in 2017 we have witnessed a broad based global economic pick-up. This has been accompanied by all major equity market indices posting strong gains with many hitting new highs. Emerging markets, Europe, the US and Japan have led the way. However within markets there has been a wide dispersion of returns. Leading UK fund manager Neil Woodford recently highlighted that in the year to 31/8/17, eight stocks accounted for just over 50% of the gain of the FTSE All Share index returns with the remaining 650 stocks making up the rest. These eight stocks were Unilever, Diageo, Glencore, Vodafone, Prudential, British American Tobacco, Rio Tinto and HSBC. Woodford concludes the UK equity market has been narrowly led by stocks exposed to Chinese credit growth.

On a similar theme Bill MacQuaker from Fidelity noted that just four stocks accounted for the two-thirds of the move in the MSCI Asia Pacific (excluding Japan) Index over the last year and if you missed out on holding these companies your returns would appear pedestrian. MSCI have created a very wide range of global and regional stock indices which tracker funds invest in. The MSCI World Index is a market capitalisation weighted index of 1,652 global stocks from 23 developed markets. The index rose approximately 18% over the first 11 months of 2017, a decent return. Whilst I do not have full data I suspect much of this rise is due to strong gains from a few companies. For example Apple the largest constituent of the index at around 2.27% is up nearly 47.5% in 2017 whilst the next biggest stock, Microsoft at about 1.44% of the index is up around 34.6%.

So what do I conclude from these observations? First it is clear that the broad based global equity rally reflected by index returns masks a wide disparity of stock returns within each market. This challenges the view that equity markets are universally expensive across the board. Certain sectors and stocks clearly are but good stock-picking fund managers will find opportunities to invest at decent prices in strong undervalued companies with good earnings growth. At the same time savvy investors might avoid the current winners. For example Woodford observed that whilst the share prices of the super eight stocks (my phrase), have risen sharply, earnings forecasts have lagged. For example HSBC has rallied around 66% since the June 2016 lows even though the earnings forecast is up only 5% in the current year. Conversely Woodford highlighted other companies such as Lloyds Bank and the AA where earnings growth has been good but share prices have fallen, in the case of Lloyds since its May 2017 peak. Domestic UK stocks now trade at a rare discount to UK exporters and it is in these domestic sectors such as healthcare that Woodford is investing. Aside from the opportunity set here, sector and stock selection is also about mitigating risk. If the Chinese economy stalls and the burgeoning bad debt bites the biggest stock fallers in the UK may well be the super eight. The positive side here is that other parts of the market with less bloated valuations should offer defensive qualities.

As we approach the year end I am pleased to have been proved wrong that I called a stock market crash, which didn’t happen. I think with hindsight I misjudged the equity markets to be universally highly valued. Indices might have peaked in 2017 but most stocks seem not to have joined the party, enviously watching from the side lines as the likes of Apple and the super eight jived merrily on the dance floor. Looking forward into 2018 I see selective opportunities for these bridesmaid equities. The word selective is key here. Active fund management should be favoured over passive index tracking. At the same time the risk of a hangover for the dancers could lead to a market correction.

The content of this blog is my own understanding of the global economy and stock markets. My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice, including to buy shares such as Lloyds Bank. You should seek individual advice based on your own financial circumstances before making investment decisions.

Investment Intelligence

I regularly attend investment seminars for IFAs run by Invesco Perpetual called “Investment Intelligence.” In a presentation last week the speaker reviewed the global economy and markets and addressed the issue of the US Federal Reserve unwinding its Quantitative Easing or QE programme. As you are aware central banks in the USA, UK, EU and Japan have undertaken considerable asset purchases since the financial crisis to support the economy and their balance sheets have ballooned. The unwinding of QE called Quantitative Tightening or QT should not be confused with tapering. The latter is the reduction in QE purchases – the European Central Bank (ECB) will begin to do this in January 2018 whilst QT is the next step i.e. the disposal of assets that central banks have acquired. This has to be done carefully and slowly as wholesale dumping of bonds onto the market could trigger a collapse in prices. Instead in the US is as bonds mature there will be a reduction in the amounts re-invested by the Federal Reserve. Whatever the methods deployed and stages that different economies are at, tapering and QT are both clearly signs of recovery in the global economy.

This conclusion was a key message from the seminar. A recent OECD (The Organisation for Economic Co-operation and Development) study showed broad based economic recovery in all 45 countries surveyed with many exceeding forecasts. Whilst global equities have been the best performing asset in 2017, emerging market equities have outperformed. This is a reversal of a five trend of declines compared to developed market equities, a whopping 50% in relative returns. Improved fundamentals and a weaker US dollar have contributed to the turnaround. In summary the bull market in equities could continue as economic growth is anaemic and central bank policy is accommodative. The speaker observed that bull markets don’t die of old age, a phrase that is clearly catching on, and he cited Australia which has not had a recession for 26 years. The message I am hearing from various investment companies is we have a Goldilocks economy, even if that phrase is not used – one that is not too hot and not too cold.

In the UK, Invesco’s view is that inflationary pressures are easing. Technology is keeping down prices although unsecured consumer debt, for example car financing is a concern. Brexit considerations will of course be a key factor for the UK economy as markets hate uncertainty. Surprisingly UK larger companies have underperformed smaller ones despite the tail wind of a weaker pound which boosts the value of overseas earnings. This is because 60% of overseas earnings are derived from the US and the $ has fallen against the £ in 2017. In another presentation by Prudential I listened to last week the lack of dividend cover and profits warnings from FTSE 350 companies was highlighted. Dividend cover is the ratio of earnings to dividends. If too high a level of earnings is paid out to shareholders it can leave companies financial vulnerable and shareholders at risk of future dividend cuts.

Other takeaways were very high asset correlations and very low volatility. Gold however may be a hedge against equity market falls and can play a useful role in a portfolio. Whilst there are political risks overall the back drop for the global economy is benign. I have no truck with this analysis but I have said on various occasions previously stock market crashes may be triggered not by deteriorating economic fundamentals but irrational investor psychology. Caution remains the order of the day for me.

The content of this blog is my own understanding of the global economy and stock markets. My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice, including to buy gold. You should seek individual advice based on your own financial circumstances before making investment decisions.

Eeyore Gets Onto The Dance Floor

Following a house and home office move just over a month ago I am slowly surfacing from the many distractions and I am starting to think about investment again. The equity sell-off I expected hasn’t materialised and so it was with interest I read an upbeat assessment for global and UK equities in a trade magazine by Trevor Greetham of Royal London Asset Management. He countered the fears of the more bearish amongst us about the length of the bull market with the pithy remark that they don’t die of old age! However he did back up his observation with sound analysis.

He noted that inflation in recent years has run well ahead of interest rates. With sluggish economic growth and a recovery which central banks do not wish to derail, interest rate policy has been very dovish. Rising inflation and static interest rates are the perfect storm for cash whose value is eroded in real terms without the compensation of rising interest rates. The disincentive to hold cash which has been prevalent since the financial crash is very supportive for equities. It pays to stay invested Greetham concludes.

Greetham also argues correctly that none of the obvious triggers are evident to send equities into a tailspin. The economy is not overheating with excessive wage growth or consumer spending, there is no evidence of excessive valuations as in the dot com boom of the late 80s and early 1990s nor are there signs of excessive financial debt or a banking crisis as in 2008. Bank balance sheets and regulation are now stronger. Although there are political risks such as with North Korea, Greetham argued that the macro-economic fundamentals are supportive of equities. For example he showed graphs of the inverse of the US unemployment rate and global stock performance relative to bonds. The two charts were highly correlated. In other words when unemployment is falling equities do well.

It would be hard not to conclude that Greetham thinks we are in a Goldilocks phase of the economy, not too hot and not too cold. You might even conclude “this time is different,” although I must stress these words are mine not his. In the past other economists and investors have made the error in assuming that past excesses or flaws in the financial system have been cured, only to be disappointed. Greetham is certainly not saying that a crash can’t or won’t happen, just that he does not see an obvious trigger at this stage in the cycle, although he does expect a bumpy ride from political risk or hawkish central bank concerns.

I have no truck with Greetham’s fundamental arguments and conclusion. He presents a reasonable bullish case for equities and there is not much between us. However many of the new jobs created especially in the UK are poor quality and interest rate rises may shock markets as they did in 1994. Crucially though it is not really the fundamentals that concern me but the potential for irrational investor behaviour facing a “wall of worry” syndrome about ever climbing equity prices. An unexpected trigger could send everyone to head for the exit.

Finally I said above that the equity sell-off hasn’t materialised. I could have added the word “yet.” I sincerely hope for the sake of my clients that Greetham is right and I am wrong. We might then see two iconic pessimists Eeyore and Private Fraser from Dad’s Army both getting to the dance floor to do a tango.

The content of this blog is my own understanding of equity markets. My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.

Crying Wolf?

When I came across an article by Jon Cunliffe, Chief Investment Officer of Charles Stanley entitled “Worries over an equity correction are overdone,” my interest was naturally piqued. As many of you are aware I am currently cautious on equities with concerns about stock market indices hitting new highs and the so called “wall of worry,” syndrome. Although I feel a crash is more likely than not, long term I am strategically biased towards equities.

Whilst Cunliffe acknowledged post-Brexit uncertainty he observed in the UK we have had the best corporate earnings season in six years. As you are probably aware rising earnings are supportive of rising equity prices and valuations. Moreover the low level of bond yields means equities are attractive relative to bonds. As of mid-June the yield on the FTSE All Share Index was just under 4% whereas the benchmark UK 10-year gilt yield was just 1%. In an environment where yields are scarce dividends from equities are attractive for income investors. However as the Bank of England recently finished its latest QE programme bond yields could rise narrowing the gap. An inflation spike or unwinding of the Bank’s asset purchases would act as a catalyst for this. Cunliffe is not overly fazed by this threat citing the fact that many UK companies generate most of their revenue from abroad and the global backdrop is supportive with a broad based economic recovery. Consequently Charles Stanley favour equities.

I cannot fault Cunliffe’s logic and would add that the recent fall in the pound boosts overseas earnings for UK companies. So have I got it wrong and am I just crying wolf in suggesting a stock market crash might be on the cards? I don’t think so even though I agree the underlying economic fundamentals are supportive. My concern is more about investor psychology and the tendency for markets to over-react to bad news and tank irrationally. This threat has been highlighted by the observation that client portfolios are laden with profits. As a result I have taken the view that selected risk reduction and profit-taking should be undertaken by switching from pure equity to multi-asset and other cautious risk funds. This takes into account that profits are merely paper profits until crystallised. That said I have proposed in my investment reviews a light form of risk reduction, slimming but not eliminating equity exposure. In this sense I have been hedging my bets.

Finally I have taken the view that in my advice to clients that the risk of calling a crash and getting that wrong will be less damaging to investment portfolios than the risk of getting the opposite scenario wrong i.e. advising clients stay fully invested in equities because a crash is not coming. In the event that markets don’t fall but continue to rise, clients who have reduced their equity exposure will enjoy lower returns but values will still rise. For me this reduced upside potential is better than a portfolio that loses a large chunk of its value from a stock market crash.

The content of this blog is my own understanding of market conditions. My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions. Cautious risk funds may fall in value during a stock market crash although normally less than pure equity funds. Cash is the only asset that provides 100% downside protection

Turkeys and the vote for Christmas

For investors in equity, bond and property funds volatility of value is an occupational hazard. In fact volatility is normally viewed as negative, a risk to be avoided if possible. This has led to a proliferation of volatility managed funds in the last few years which have targets for limiting downside movements in prices, so much so that the Investment Association, who group funds with similar investment mandates, permitting meaningful comparisons of performance, have recently created a brand new sector to accommodate them.

Volatility only damages portfolio returns if investors sell funds during the troughs as they may end up crystallising losses. Until then they are sitting on paper losses. If they ignore the short term noise and sit tight their equity investments normally recover and deliver good returns in the longer term. It is for this reason that investors need a cash buffer, accessible savings that avoid them becoming forced sellers at bad prices. Of course you could invest entirely in cash where there is no volatility. Although very cautious risk investors might sleep well at night during a stock market crash they are exposed to a different type of risk. With paltry interest rates, cash is unsuitable for income and in time its real value or purchasing power is eroded by inflation. Cash is not a great asset to be 100% invested in for the long term.

All this is standard stuff which you have probably heard me say before, however over the weekend I read an interesting article with some interesting new perspectives on volatility. It was written by Didier Saint-Georges, managing director and member of the investment committee of Carmignac Risk Managers. He argued that an asset moving in opposite directions quickly, the meaning of volatility, does not mean it is fragile. It could be a sign of flexibility. In contrast a stable asset might collapse suddenly or lose value little by little. Saint-Georges gave the example of safe-haven German government bonds. Investors expecting stable values and very low volatility got a shock when German bond prices fell 9% between 20 April and 10 June 2015 due to a brighter outlook on the European economy. He also cited Bernie Madoff’s pyramid investments which had extremely low volatility. This should have been a red flag for savvy investors. Saint-Georges referred to these examples as the “Turkey Syndrome.” A turkey fed regularly through the year comes to view the world as a stable and predictable place until the week before Christmas when this state of affairs proves to be an illusion!

There are other benefits of volatility. First it may help remove some of the froth in equity valuations – this is euphemistically called a “correction.” It may also drive out speculators who pile in to a good story and drive a wedge between prices and fundamentals. The classic example here was the technology bubble of the late 1980s. We all know how that ended. Conversely a sharp fall in a stock may be a sign that investors have sold out irrationally and have misjudged its true value, providing an opportunity for fund managers to add to their best holdings at lower prices. Finally if an index crashes it may signal a good time for investors to deploy cash to the market. Volatility does not need necessarily need to be seen as a foe.

The content of this blog is my own understanding of market volatility in part based on Carmignac Risk Managers’ article “Volatility is not to be feared.” My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.

Japan – Land of the Rising Sun or False Dawn?

In the last six months or so I have generally not been recommending my clients buy equities, instead sell them. My advice has been to take profits and reduce risk in an expectation of a stock market sell off, euphemistically called a “correction.” This is investment speak suggesting a collapse in equity prices is actually a good thing. In some senses it is, in paring back overpriced stock valuations to more justifiable levels and reminding over confident investors that shares can down as well as up. But major sell-offs are rarely pleasant as investors discovered in 2008 when portfolio values tumbled.

Anyway back to my main point, the case for Japanese equities, an exception to my advice to reduce equity exposure. Last week I listened to an interesting webinar from the manager of the JP Morgan Japan fund, Nicholas Weindling, someone I had not heard before. He argued the case for Japan was good citing stable government, positive company earnings growth and a growing culture of shareholder value, historically a weakness in corporate Japan. With inflation below target of 2% p.a. ongoing quantitative easing is likely to continue to be supportive of asset prices. In contrast in Europe the European Central Bank (ECB) will begin to taper its bond buying programme in the autumn as economic growth has surprised on the up side. European equities have been the bright spot in 2017.

Weindling argued that corporate governance improvements in Japan were structural with almost all companies on the TSE1 (Tokyo Stock Exchange, large companies) have an independent director, a huge rise since 2010. There has also been a significant increase since 2014 in companies having targets for ROE (return on equity) and ROA (return on asset) in their medium term plans.

Another compelling observation was on the fact that the Japanese equity market is under-researched, in absolute terms and relative to the US and Europe. For example take Japan’s TOPIX index with 2012 companies, a broader index than the better known Nikkei 225. Around 2/3rd of the companies have either one analyst or no analyst cover. The equivalent figures for the US Russell 3000 index and the S&P Europe BMI index with 1,862 names were 10% or less, whilst 50% or more had 2-10 analysts in both regions. What this means is that strong Japanese companies are likely to go under the radar and many of these will be under-valued. This inefficiency strongly favours active stock picking fund management based in Japan, something Weindling claims is rare.

Finally Weindling cited a significant rise in-bound tourism since 2012 and a growing participation of women in the labour market as being good for the economy. Both of these facts I was unaware of.

Of course not all is rosy in Japan, economic growth is sluggish, debt to GDP remains high, consumers are notoriously reluctant spenders and Japan’s demographic is ageing. Moreover Japan has a history of disappointing investors since the great crash in 1990. The land of the rising sun has more often proved to be a false dawn. That said many fund managers and asset allocators see good potential in Japan and are talking this market up.

To conclude a small or additional allocation to Japanese equities may be appropriate for many investors and given the choice I favour unhedged share classes i.e. those that do not hedge the currency risk of investing in a non-Sterling currency. What this means is that if the Yen strengthens against Sterling UK investors will benefit from the currency move as well as the underlying gains in share prices. With the Yen being a traditional safe haven currency, in a global equity sell-off it is likely to strengthen whilst problems and uncertainty with Brexit could weaken the pound. Currency risk is one all UK investors face whenever they buy overseas funds and it is another issue that needs to be considered.

The content of this blog is my own understanding of the JP Morgan Japan fund manager’s views on the Japanese economy and market prospects and my comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice for example to invest in Japanese equities. You should seek individual advice based on your own financial circumstances before making investment decisions.

The Warning of a Canary or Cry of a Wolf?

I had put writing investment blogs on the back burner during a very busy period of advising clients but having recently read dire warnings of impending financial crisis I thought I had better put pen to paper.

Firstly a few weeks ago veteran US investor Jim Rogers expressed fears of a financial crash on a scale that will be the worst in a lifetime. You can read the interview he gave in Business Insider via the following link:

The size of global debt especially in China and the US is a real concern to Rogers. This is not exactly an unknown but a related issue is the unprecedented experiment in global money printing or QE which will need to be unwound. Central bank balance sheets have expanded massively since the crash of 2008 with their bond buying programmes and it is fair to say offloading this debt has unknown consequences that could be very damaging to the global economy and financial system.

What I found especially interesting was Rogers’ view that the although debt is the problem the trigger for a crash could come from an unexpected source as happened in 2008, for example a US pension fund going broke.

On a similar theme the accumulation of household debt is an increasing concern in the UK. According to Professor Paul Cheshire of the London School of Economics we are on the verge of a house price crash, of up to 40% making it the worst slump since the 1990s. Many of us remember that and the resulting recession. Aside from plunging recent house buyers into negative equity a property crash will be highly damaging for the UK economy. There is a correlation here between people’s confidence to spend and changes to asset prices. If house and share prices are rising consumers feel wealthier and are more willing to spend and vice versa.

There are two key questions for me. Firstly are Rogers and Cheshire right? Are they canaries giving warnings of real dangers or merely crying wolf? Who knows? We will surely do so in a few years’ time. Secondly what impact will a crash have on asset values? If history and conventional wisdom repeats itself a crash on the scale of 2008 will send investors scurrying into highly quality AAA or AA rated government debt and safe haven currencies such as the Yen and the Swiss Franc. The price of gold may soar. In contrast property, shares and corporate bonds will collapse.

The conclusion for me is with stock markets riding high adopting a cautious risk approach in my advice to investment clients is sensible. Calling a sell-off which doesn’t happen will be less damaging to portfolio values than thinking equity markets will continue their upward trend and getting that wrong.

This blog post is my own assessment of the risks of a market sell-off. Nothing in this article should be construed as investment advice for example to invest in safe haven assets. You should seek individual advice based on your own financial circumstances before making investment decisions.

Investment in Smaller Companies

Many of you know that I am a strong advocate of long term investment in smaller companies, not just in the UK but also in the US, Europe and Japan. The principal reasons for my view are that small companies are dynamic, fast growing and under-researched. The latter means great companies go under the radar and are often mis-priced. Owners of small businesses spearhead the company and often have large stakes of their own money invested in it. They are driven and entrepreneurial people with a big incentive for their businesses to succeed. Finally smaller companies are more likely beneficiaries of take-overs and mergers.

Not unexpectedly there is clear evidence that in the long term smaller companies outperform large companies and mega-caps. This is not to say they do not carry considerable risk. They are not diversified businesses and have limited markets, they can be damaged badly by earnings recessions and interest rate rises, whilst their balance sheets tend to be weaker than larger companies. Finally larger companies have scope to downsize or sell assets in a recession. Smaller companies are more prone to going bust and have a reputation for being more volatile.

Recently I have received some e-mails from Axa Investment Managers on the theme of investing in smaller companies. They highlighted some very interesting facts and figures, which I want to put to you for your consideration. You may be surprised at what you read.

1. Smaller companies have significantly outperformed large and mid-caps since 2000 – Source: MSCI based on index returns.

2. European smaller companies have only been 4% more volatile than larger companies since 2005 and less volatile than emerging market equities.

3. Whilst there is no single definition on what defines a small company according to Axa they can have a stock market value of up $10 billion. These are hardly tiddlers. In reality there is a vast spread from unlisted start-ups and fledgling companies to established businesses listed on the Alternative Investment Market (AIM) market or the FTSE All Share Index. Examples of small companies include ASOS, Majestic Wine, Flybe, Mothercare and Oxford Instruments.

4. Smaller companies make up 15% of the market capitalisation of global equities although 90% of all companies are considered small. Investors who avoid smaller companies are missing out on a huge tranche of the investment universe.

5. In the US the average larger company has 19 analysts compared to just two for smaller companies. I once recall hearing that in Japan some smaller companies have no dedicated analysts. Fund managers searching for mis-priced gems are likely to find them.

6. Smaller companies are masters of their own destinies. Axa Investment Managers explain:

Whereas Large Caps’ share price movements are predominantly driven by macro factors, Small Caps’ share prices are 60% correlated to stock-specific factors. So Small Caps can better shape their own growth trajectories.

Macro factors include the health of the global economy, political events, global commodity prices and currency movements. Large companies are more impacted as a high percentage of their earnings are global. In contrast smaller companies are domestically focused. Incidentally macro factors can be positive or negative.

7. In 23 out of the past 27 years smaller company earnings have outperformed those from larger earnings (Source JP Morgan – June 2015).

8. Smaller companies may be sharply impacted by an earnings recession but historically recover very quickly.

9. Data from the last 100 years shows smaller companies have historically posted better risk-adjusted returns over the long term. Axa conclude the longer you look the better they get.

In conclusion Axa Investment Managers believe there are myths surrounding investment in smaller companies i.e. that they are too risky. The evidence suggests small caps are misunderstood and have a place for many investors in balanced portfolios.

This blog post is my own assessment of investment in smaller companies, in part based on Axa Investment Managers’views. Nothing in this article should be construed as investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.

Fund Selection – Philosophy & Process

Recently I read an article in a trade paper that I subscribe to called Money Marketing. It was about IFAs’ research and due diligence in fund selection, or lack of it. Like much of what I read from the regulator and financial journalists (Paul Lewis from Moneybox has a weekly column in the paper) it highlighted the short comings of advisers. With the front cover posing the question, “Are advisers doing their homework on fund selection?” and the article itself entitled, “Fears grow over advisers’ investment due diligence,” it was clear IFAs were going to come in for criticism.

The article highlighted too much reliance on ratings agencies, shallow research and a lack of allocation to low cost passive index tracking funds. One commentator argued that fees are the one thing that advisers can control when they select funds and went on to say that it is difficult to justify why advisers still recommend active funds. He could have been criticizing me as I have an instinctive preference for conviction led actively managed funds.

Survey results were cited and few IFAs considered portfolio turnover important or very important. This observation follows the same theme, after all turnover is another fund cost. Other factors deemed essential in research were fund size, fund manager tenure, investment company brand and investment processes. Finally a lack of IFA firms having investment committees and meeting fund managers was also highlighted.

Naturally the article got me thinking about how I go about researching and selecting funds. I was left feeling that the thrust of the article did not accord with my own philosophy and practice and missed key high level considerations that I consider essential, so I penned a letter to the editor to explain how I go about it. The letter was published the following week in Money Marketing. It then occurred to me I couldn’t recall writing an investment blog about the subject. The following is an edited version of my letter that hopefully gives you a flavour on how I go about fund research i.e. my philosophy and process.

Whilst your recent article about IFA fund selection research made some good points it did not accord with my experience and reality. Firstly the observation about the dearth of advisers with investment committees and personal meetings with fund managers may be valid in large practices but it is a different world for me as a one man band and I suspect most very small firms. We lack the resources for investment committees and the clout to warrant audiences with fund managers. Interestingly I do occasionally get the opportunity to talk to fund managers at seminars or webinars but it is rare and they are not available to me at my beck and call.

I also query Mick McAteer’s belief (he is from the Financial Inclusion Centre) that the key determinant of fund selection should be low costs, based on the principle that fees are the only certainty. The implication is passives and index trackers should be the default choice at all times. In my experience differences in fund performance are far more significant than differences in charges, meaning investment process and potential is most important. However my main objection here is that evidence suggests that index trackers perform poorly compared to active funds in falling, volatile and sideways moving markets. Where I have used index trackers successfully is when advising clients to buy in at market troughs. The point here is that fund selection needs to be in the context of where we are in the stock market cycle not divorced from it. For example I would be very wary of recommending a FTSE 100 or S&P 500 index tracker right now for obvious reasons.

Another key point for me is that fund selection and asset allocation are inextricably linked. I can’t recall asset allocation being highlighted in your article. I subscribe to the view as many investors do that asset allocation is the single most important determinant of investment returns. There are assets I favour, those I don’t; equity regions I like, those I don’t and investment styles I prefer and those I don’t. My choice of fund in part is determined by how close a fund’s investment style and asset allocation accords with own investment convictions. To sharpen and express these beliefs I write an investment blog published on my website.

Whilst consideration of charges, turnover rates, active share, fund size etc. have value, a principle factor for me in investment choice is that I buy fund managers as much as I do funds. I spend a lot of time listening to webinars and reading fund manager commentaries. I am attracted to managers with clear and compelling investment processes backed by strong evidence and logic. Often but not always these are contrarians with out of the box thinking. Whilst my fund selection must be rooted in objectivity, fact and logic I see an emotional or even artistic dimension to my fund choices. Writing blogs ensures I can explain these beliefs which I consider an important element of my due diligence process.

In addition my fund selection process is driven by a belief that I go from client to product or fund, not the other way around. In other words it is a client’s objectives, needs and existing portfolio that largely determines fund selection. For example one client of mine has an absolute no animal testing requirement for her portfolio. That rules out 75% of funds that even have an ethical label. Index trackers may be ruled out automatically for cautious risk investors when equity markets have peaked as at present. Investment in adventurous risk funds may be appropriate for long term investors or regular savers even if they are cautious risk clients and the balance of their portfolio reflects that profile.

Finally there is an important practical implication of research being client focused for advisers like me who charge on a time cost basis. I could shortlist five funds for a more detailed assessment including meetings with fund managers but who am I going to charge my time to? Logically if it is individual work for a client it is the client who should pay. I do not think my clients will be happy to pay lawyer scale mega-charges if I billed them for 10-15 hours work on detailed “due diligence” on these five funds on top of everything else. My choice of fee structure requires me to work efficiently and smart, not to perfection, that a fixed fee could demand. If fund fees are important for clients so are adviser charges for research and I try to keep these to a minimum.

In conclusion I see high level research i.e. considerations such as a fund’s asset allocation, fund manager convictions and client needs as being much more important than the nitty gritty of fund details such as portfolio turnover, Beta* or annual management charges. The former list screens out a vast number of funds. Once the basics are established I try not to spend too much time on getting perfect specific fund choices as I see a search for perfection is subject to the law of diminishing of returns.

It would be unfair if I did not state that I don’t always get fund selection right. At times I get it spectacularly wrong and recommend investments that turn out to be dogs. This is why balanced portfolios need to constructed with diverse and complementary fund holdings. It is the same principle of spreading risk when managers buy 50-100 stocks for their funds. It is also why investment reviews are crucial. Holding a bad fund for too long is a drag on portfolio returns and an unnecessary one at that.

*Beta is a common statistical measure of the expected return of a fund or stock in relation to an index. For example a Beta of 1.0 means a fund is expected to rise and fall as much as the market as a whole. A Beta of less than one means the fund is less volatile than the market and vice versa.

This blog post are my own views about fund selection. Nothing in this article should be construed as investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.