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.

Europe – An Opportunity or Basket Case?

It would be fair to say in the last five years or so the European economy has hardly had a great press nor been high on investors’ buy lists. The seemingly endless Greek debt crisis, very high youth unemployment in southern Europe, issues with Italian banks, political woes and now a fractious divorce as the UK exits the EU have all resulted in weak economic growth and uncertainty. It was therefore of interest to hear two fund management companies broadly expressing positive noises about Europe with the most upbeat message coming from Hector Kilpatrick, the Chief Investment Officer for Cornelian Asset Management and his colleague David Appleton the Investment Director.

The webinar I attended highlighted concerns with the US economy and markets. Essentially valuations are very high compared to history, corporate debt has risen sharply, interest rates are expected to rise, volatility is low and business confidence is very high with a potential for disappointment. The case for Europe is more interesting. Compared to global equities, European shares have fallen significantly since the financial crisis whilst on a historical basis European equities are not especially expensive. Moreover less expensive value companies are more represented in the Stoxx Europe 600 Index compared to the S&P 500 Index which holds more defensive growth stocks for example healthcare, utilities and staples. In addition there has been a sharp rise in the Citi Economic Surprise Index for the Eurozone since September 2016, a sign that the economy is improving faster than expectation. However the most interesting data for me from an investment perspective was that company earnings have been rising in Europe but declining in the US since October 2016. Earnings growth is a big driver of equity returns.

My conclusion is that dismissing Europe as a basket case would be wrong. Aside from the comments above Europe has always been home to excellent global companies with strong overseas earnings, not dependent on sclerotic domestic economies. So there may be an opportunity here.

This blog post is my own assessment of Cornelian Asset Management’s 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.

Barometer of the Global Economy & Eeyore’s Favourite Food

Over Easter I read an excellent article written by Pictet Asset Management. This boutique investment house run a number of specialist funds such as the Pictet Water and Pictet Clean Energy but also manage a very good multi-asset portfolio that I have recommended to a number of clients. Pictet are strong advocates of the view that getting the asset allocation right is the key determinant of investment returns, something which I subscribe to. It was therefore interesting to read their April “Barometer” review of the global economy and investment markets.

The principal thrust of the article was that the global economy is demonstrating a synchronised broad based recovery with surging business and consumer confidence and this was evident in both developed and emerging markets. Pictet concluded this from a variety of facts including the global Purchasing Managers’ Index (PMI), a key measure of business confidence, which is the highest in six years. In addition Pictet observed that global consumption is expanding at a fast rate and global private investment is surging. This has reinforced Pictet’s bullish view on equities. This is the most upbeat assessment of the global economy I have come across for a long time and perhaps makes my last blog post look like it had been penned by Eeyore (famed as Pooh Bear’s morose friend) or by Private Frazer, infamous for his “we are all doomed” warning.

That said Pictet are more bearish on US equities and have adopted a maximum underweight position here. The reasons they give are reasonable. The failure of Trump’s administration to overhaul the healthcare system raises doubts about Trump’s ability to deliver on tax cuts and infrastructure spending. Other factors are US corporate earnings forecasts have been trending lower whilst US equities are expensive. Whilst this is generally true compared to other equity markets Pictet observed there are significant variations in sector valuations. Industrials in the US are expensive, financials are cheap and attractive, technology continues to have reasonable valuations and further upside potential. It is important to make say this as a comment that “US equities are expensive,” is simplistic. The reality is more nuanced. I am therefore more bullish on US equities than Pictet but I selectively prefer value or recovery stocks and smaller companies.

Finally on the US Pictet explained that some indicators show that in the US consumer and business confidence has been at all time high which is not supported by hard economic data. This suggest a potential for disappointment especially if inflation running at 3% p.a. reduces consumer spending. Rising inflation is then likely to trigger interest rate rises which will be a further headwind for the US economy.

In contrast Pictet are ultra positive about Japanese equities with strong external demand, an improving labour market, an upbeat outlook for corporate profits and ongoing monetary easing by the Bank of Japan, including the purchase of equities. One point made which was new to me, is that Japanese equities have a strong historical correlation with US bond yields. If the US Federal Reserve raises interest rates aggressively bond yields will rise, suggesting Japanese equities will do so as well. I would add a caveat here that correlations are rarely permanent and may flip.

Pictet are also upbeat on European equities, which were the best performing in the first quarter of 2017. This was from strong corporate results and merger deals. Emerging markets, including China were also highlighted in a positive light.

In the fixed interest or bond markets Pictet are more bearish on US high yield but favour US government bonds, called Treasuries. Firstly they see US Treasuries as insurance against political upheaval. The bellicose noises coming out of Washington and Pyongyang are concerning. I would also add a financial crisis is a potential risk. You may recall in the 2008 crash UK and US government bonds rose due to their safe haven status. Secondly Pictet explained that US debt offers much better value than European debt. Apparently benchmark 10 year US Treasuries yield about 2% more than the equivalent German Bunds, a spread not seen since the fall of the Berlin Wall. If investors flee to US Treasuries in a risk-off rally bond prices will rise, rewarding investors who buy US Treasuries now.

Finally on the UK, Pictet are neutral to underweight equities but they commented very little on the UK.

My conclusion is that Pictet’s analysis is a reasonable if perhaps a tad over optimistic assessment on the prospect for equities. To try and reconcile my own view with Pictet’s I would say there is downside risk of a sell-off in the short term but good upside potential from equities in the longer term. So perhaps we are singing from the same song sheet after all with the odd note’s difference.

“Now where did I leave my thistles?” Said Eeyore. “Over there,” Pooh pointed to a corner of the Hundred Acre Wood.

This blog post is my own assessment of Pictet Asset Management’s article. Nothing in this blog post should be construed as investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.

To Risk or Not Risk, That is the Question

March has been and gone and I’ve not found time, or truth be told the inspiration to pen a single investment blog. At a time when I have been very busy with investment reviews and end of tax year planning, stock markets have fortunately been tranquil.

With equity markets hitting new highs my investment reviews have all followed the same theme, profit-taking and risk reduction. Profits from pure equity funds have been selectively switched to cautious risk and multi-asset funds in anticipation of a stock market sell-off this year. I hasten to add this is my view. I have no crystal ball; it is just a feeling or intuition. The trigger for a crash may be a political event, a financial or banking crisis or merely the “wall of worry” syndrome with nervous investors fearing ever rising share prices and heading for the door in a collective stampede.

Given this view it is simply not good enough to sit back and admire portfolio performance. This is because profits accruing in a portfolio are paper profits until they are crystallised and experience tells me they can disappear as fast as you can say, “The London Stock Exchange.” Tranquil markets have provided a rare window of opportunity to protect profits and therefore in my view is one not to be missed.

In summary in the short term I am cautious about equities, but in the medium to long term I am bullish, especially with the global economic recovery gathering pace. This creates a conundrum for me and highlights the risk of risk reduction. Firstly a crash may be sharp and rapid followed by a quick V shaped recovery. The fall-out from the June EU referendum was an example. In cases like this risk reduction is arguably an unnecessary and potentially expensive exercise especially if investors end up buying back into stocks at higher prices than they sold out of. In other words it would have been better doing nothing, staying invested and saving money on the advice costs as well. However few economists and fund managers correctly anticipate the timing of crashes let alone the trajectory of the subsequent recovery. A quick V shaped bounce is observable with hindsight but is not usually predictable in advance.

Even if the recovery is slow it is reasonable to argue that if I firmly believe the long term direction of equities is up why bother with risk reduction at all? Surely a buy and hold investment strategy should be adopted. Advocates cite the mantra, “it is time in the market not timing the market that counts,” and I have seen examples of this with mature portfolios. About two years ago I noted a £3,000 investment a client made in a European equity fund in November 1996 was valued at more than £21,500 less than 20 years later. The investment had been held through thick and thin – the technology bubble bursting in the early noughties, the financial crash in 2008, several Euro crises and various recessions.

The problem with a buy and hold strategy is that not everyone is a long term investor and many of my clients rely on investment income in retirement. Similarly with a number of my clients approaching retirement risk reduction has been essential. In contrast younger investors with secure employment tend to invest for long term capital growth and sharp dips in portfolio values and general volatility are less damaging.

Moreover a cautious approach that takes risk off the table is commonly adopted by fund managers. It is based on the idea that protecting capital on the downside is as important as capturing the gains when markets are rising. In other words risk reduction is a key element of long term investment performance. Defensive strategies are also likely to help fund managers, investors and their IFAs avoid the temptation to take too much risk to recover losses after a crash.

In conclusion risk reduction has its risks and costs especially if markets do not crash. However invariably the decision to risk or not risk will be determined by individual circumstances, timescales and attitude to risk. Long term or adventurous risk investors may say “do I look bothered?” when markets crash whilst cautious risk clients may not sleep well at the first sign of trouble. The importance of peace of mind is on a par with profits.

This blog post is my own investment thinking and commentary only. 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.

The First to Present His Case

There is a proverb I like which states:

“The first to present his case seems right, till another comes forward and questions him.” *

The context of this proverb suggest it relates to court judgements but equally it is relevant to investment opinions as fund managers advocate polar opposite views on the investment case for differing assets and markets. For example many have called the end of a 35 year rally in bonds. Others disagree. It depends which hypothesis on the state of the global economy you subscribe to and the outlook for inflation and interest rates.

At all times but especially now after a strong rally in equities, opposing opinions on the direction of the global economy and stock markets need weighing up carefully. If you are investing cash now you run the risk of taking a big hit if there is an equity market sell-off. I have no evidence that a crash is coming but I would be surprised if there is not a sharp correction by the end of August. It could come from political events but I principally fear the wall of worry syndrome and the propensity for investors to act with a herd instinct in a crisis. I hope I am proved wrong.

When markets peak investors naturally seek to buy into undervalued sectors, invest into safe haven assets or those that are non-correlated to equities. The difficulty is identifying these and there is a danger in misreading the signals on markets that appear to be fully valued. Take US equities which have enjoyed one of their longest bull-runs in history. Two years ago I remember asset allocators were recommending rotating out of US equities to reinvest in the UK and Europe, based on valuations. The case for doing so was sound at first sight, US stocks were fully valued, prices were high and the bull market was long running, but others argued differently, challenging the consensus view. In a blog post from 2/9/14 I wrote:

“My last blog post focused on the US stock market and equity valuations. You will recall that opinion is strongly divided between the bulls and the bears. The latter have argued there is a disconnect between the high stock valuations and the lack of underlying earnings growth from US companies.

JP Morgan suggested the record high profitability for US companies is set to continue, domestic economic activity will drive revenue growth and the potential for taking on debt onto balance sheets will help counter headwinds such as higher labour costs and wage demands. They conclude although above average equity valuations will reduce expectations of future returns, the current analysis adds up to a constructive and benign environment for equity investment in the US. Time will tell.

Well the last two to three years proved JP Morgan was right. My instinct at the time was the US economy was innovative and strong and that equities would continue to rally and I therefore continued to recommend US funds to clients. I am glad I did. Today I am more selective about the US, favouring small companies and high yield bonds, but that is another story.

Index linked bonds are another divisive asset class, especially in the context of inflation and interest rate expectations. Inflation linked assets are the Marmite of the investment world. I happen to like them but time and space does not permit me to explain more. Instead the proverb cited I want to conclude on the case for global emerging market equities. There has been a wide, though not complete consensus from fund managers and asset allocators advocating emerging markets given the clear signs of an improving global economy, fears over the Chinese economy abating, rising commodity prices and attractive valuations compared to developed market equities. I pretty well bought into the story without too much questioning until along came counsel for the prosecution Terry Smith, a maverick fund manager who runs the iconic Fundsmith Equity fund. He is an one of the very best bottom up stock picking investors. In practice he ignores the speculation about the global economy, political events, currency movements and other macro-events on the basis that firstly they are very difficult to predict and secondly even if you can call them correctly what do you do about them? Instead his focus is purely on what he can control, picking strong companies and holding onto them.

In a recent article in the Financial Times Smith he included a graph of cumulative net inflows of investment into global emerging markets ETFs compared to non-ETF funds since 2000. To remind you ETFs are Exchange Traded Funds and these are tradeable securities that track a stock market index. They are examples of low cost passive investments that include all stocks (or a representative sample) held in a stock market index. The weighting of stocks is based on whatever criterion is used to compile the index, typically the market capitalisation of the companies. This means that as more money is invested via index funds or ETFs, it is automatically invested via the fund into the companies in the relevant index based solely upon their market value. Since 2000 just over $150 bn cumulatively went into emerging market ETFs. In contrast the flows into actively managed emerging market funds fell by $50 bn. The graph looks like a capital Y turned 90 degrees clockwise which Smith calls the “Jaws of Death.”

The implication of this is clear as Smith puts it himself:

If money pours into markets via ETFs it will cause the shares of the largest companies in the index to perform well irrespective of their quality or value — or lack of it.

In fact Smith states the largest companies in the emerging market index are not good quality based on a number of observations.

Another consequence of Smith’s view is that active fund managers picking stocks based on their underlying quality are likely to underperform passive ETFs and index tracking funds as long as inflows into passive investments continues. I conclude:

1. Caution is required when investing in global emerging market equities. Smith’s comments certainly have made me think I need to rein in my enthusiasm.

2. Relative outperformance of passive emerging market funds over actives should be treated with caution. Whilst it can be argued it is a no brainer to avoid actively managed funds when passives outperform and are cheaper, when there is a sell-off, ETFs are likely to suffer more with a reversal of the inflow benefit. For example if the share prices of the largest companies take the biggest hit because they are poor quality, it will feed through to poor index and ETF performance. I suppose the maxim advocated by Warren Buffet comes to mind:

“It is only when the tide goes out that you see who is swimming naked!”

3. It is best to avoid passives when allocating money to global emerging markets.

4. Actively managed smaller company funds should avoid the worst excesses of a collapse in emerging market equities as their weightings in ETFs will be small. You will know that I have an instinctive bias to smaller companies anyway.

*New International Version of Bible – Proverbs 18:17.

This blog post is my own investment thinking and commentary only. Nothing in this article should be construed as investment advice. Investment in US equities, US high yield bonds and index linked bonds may be unsuitable for you. You should seek individual advice based on your own financial circumstances before making investment decisions. Past performance is not necessarily a guide to the future.

Investment Themes for 2017

At the start of the year fund managers, economists and other investment professionals as usual have put forward their views on the state of global economy and the direction of equity and bond markets. So what will be the key themes for investors in 2017? There is a wide consensus that this year could be a pivotal year for markets. The principal reason is the expected return of inflation and rising interest rates, especially in the US. Inflation is expected to arise from several sources, some global and others local. At the macro level the rising price of oil is a key factor as is the general improvement in the world’s economy. Last year emerging markets joined the party and rallied after around five years of underperformance. The economies of many emerging market countries are linked to the price of commodities, which rallied sharply in 2016. Another factor was the easing of concerns about China’s economy, a key trading partner of emerging market countries especially in Asia.

If the baton for stimulus passes from monetary policy to fiscal policy it will also be inflationary. Since the financial crisis of 2008, “easy money” has been the main tool used to stimulate the economy. It was the domain of central banks who cut interest rates and introduced QE programmes. There are now widespread calls for governments to do more, to cut taxes and boost spending. This is fiscal policy. Whatever you may think of Donald Trump, this is the direction he is taking the US economy, with promises of significant infrastructure spending. Markets have liked his message…so far. Inflation and interest rates rises however are expected outcomes which could then put the brakes on the consumer economy in the US. Interest rate rises could also be damaging for asset prices. In 1994 there was a sharp sell-off of bonds and equities when US interest rates rose faster than expected.

In the UK the Brexit vote and the ongoing uncertainty about the process of leaving the EU has been inflationary with the pound falling and the cost of imports rising. Wage growth is also up after a period of stagnation and this will inevitably feed through to higher retail prices for goods and services.

If this analysis is correct what will be the consequences for UK investors? The 35 year rally in bonds (fixed interest), especially government issues and investment grade corporates may finally come to end with significant interest rates rises. However there have been previous occasions in the last five years where the end of the bond rally was called incorrectly. In my view the rally will only end if interest rates begin to normalise, i.e. return back to their longer term averages. The issue here is will they ever normalise? Economies are so addicted to ultra-low interest rates they may be incapable of doing so. Even if 2017 is a bad year for bonds I still see value in some sectors, notably high yield corporate bonds, especially in the US. In addition inflation linked bonds are expected to do well especially those with low “duration,” i.e. low sensitivity to interest rates. Examples here include short-dated issues, floating rate notes and high yield corporates.

At the start of an interest rate cycle equities normally do well and they remain my favoured asset class. I am perennially upbeat about smaller companies whilst European equities appear to be on asset allocators’ radars, on the back of improving economic fundamentals. In addition the clear link between valuations and future returns (see paragraphs 4 & 5 and associated link) suggests European equities are more attractive than US equities.

Although I think 2017 should be good for equites not everyone thinks so. Albert Edwards from Societe Generale who is described as a “permabear,” the ultimate investment pessimist, is concerned about recession and the potential for financial turmoil as bad as 2008. It would be disrespectful to ignore a prophet of doom. A concern I have is the wall of worry syndrome, which I have described previously. The idea is simple. Imagine you are a rock climber scaling a huge vertical rock face. The higher you go the scarier it gets, especially if you look down. For investors seeing record stock market highs fear of a crash may trigger one. Investors and markets are highly subjective and panic sell at times, However as UK star fund manager Neil Woodford says fundamentals always establish themselves in the end. Nonetheless if there is no equity sell-off in 2017 I will be very surprised.

The conclusion for me is that whilst equities are favoured in the long term, caution is required in the short term. To this end I anticipate the theme of my investment reviews for my clients in 2017 will continue to be about portfolio risk reduction and selected switching profits to cautious multi-asset funds for capital protection purposes. My advice as usual will be in the context of individual circumstances, financial objectives, risk profiles and timescales. What is appropriate for Jack may not be for Jill.

Finally I return like a stuck record to the benefits of monthly investment into equity funds, an under used strategy for most investors, other than for pension savings. Risk is reduced with multiple investment dates and investors may benefit from volatility of value, the so called “pound cost averaging.”

This blog post is my own investment thinking and commentary only. Nothing in this article should be construed as investment advice. Investment in equities European equities, smaller companies and high yield bonds and value investment strategies may be unsuitable for you. You should seek individual advice based on your own financial circumstances before making investment decisions. Past performance is not necessarily a guide to the future.

Investing and Investment Planning – Art, Science, Gambling or Gardening?

For my final investment blog post of 2016 I want to change tack from the usual technical analysis and market commentary and address the more philosophical aspects of investing. The key question is this. Is investment planning and advice on investments an art or science? Should I be going to the Tate Modern for inspiration or the Science Museum and the Institute of Mathematics?

I think fund managers who actively manage their portfolios, primarily but not exclusively see their work as a science. They and their team will engage in comprehensive qualitative and quantitative analysis of the companies they invest in, seeking to understand their business models, markets, balance sheets, cash flows and valuations. Most companies are filtered out at an early stage in the analysis. It is all very process driven. However fund managers also typically meet the management of hundreds of companies each year. I suspect that this is where art becomes part of the stock selection process as they gauge key executives’ competence and thinking. With the personal contact they get a feel for the business and the people in charge who are driving it forward, or potentially into the ground.

My investment processes work in a similar way. When choosing investments for a client I first need to identify which assets and markets to invest in – equities or bonds; developed or emerging markets; larger or smaller companies? I then need to recommend specific funds to clients. Naturally I undertake qualitative and quantitative analysis of investments but decisions are not made purely with the head. Some come from the heart with a strong feel for markets and sectors that I like. Some picks are long term favourites, for example US equities and smaller companies, others assets and sectors are temporarily in my good books and may be recommended for tactical investment. Currently I like value and recovery investment strategies.

Ask me why I favour smaller companies, for example, and I can point to more than just feelings. Historically they have outperformed larger companies in the long term and the lack of analyst research results in mispriced companies whose values have not been recognised by the market. It is about market inefficiency and my confidence that good stock picking fund managers can unearth mispriced gems. The feelings are rooted in facts and convictions.

The same goes for selecting funds. Whilst again there is objective analysis I also buy people. Listening to fund managers speak at seminars and webinars and present their case for the market they invest in and their portfolios is very important to me. Every now and again my interest is especially piqued and I am attracted to a fund manager and his or her investment thinking. Quite a few years ago I listened to Jeremy Gleeson, manager of the Axa Framlington Global Technology fund and I thought, “Hey I really like this guy. He understands technology.” Over periods of time his fund has under performed his actively managed peers over one, three and five years he has beaten the sector average fund (Source: FE Trustnet 10/12/16) and he has served my clients well.

Passive fund managers as you know do not make stock selection decisions obviating a need to meet with company managers. Their methods are entirely process driven, employing index tracking techniques to replicate the market. Due to management charges, trackers and exchange traded funds (ETFs) invariably under perform the index they are tracking. You won’t see these fund managers at the Tate Gallery; they’ll be seeking inspiration from algorithms and mathematics.

The underlying premise of the philosophy of index tracking investment is that few active fund managers outperform the index and when they do they are inconsistent. Why invest in an active fund and pay 0.85% p.a. in fund charges when an index tracker may cost just 0.15% p.a. and deliver better returns? It is a fair point and there is evidence of index tracking delivering superior returns in steadily rising markets and with US equities, the market for which is highly efficient in pricing stocks. However I don’t subscribe to this view as a universal principle across all markets and market conditions. Index tracking is a poor strategy in volatile markets that move sideways. A clear example is the FTSE 100 index which is virtually unchanged from its December 31st 1999 value. Another example can be found with smaller company investment.

The passive v active debate is complex and space and time does not permit further discussion here. However those who strongly advocate index tracking strategies hold an implicit belief, that is, active fund managers are not very good at their job and those that outperform are lucky. Now I don’t believe they would express this view in quite such dismissive terms but I think they hold it. If they are correct, there is not much skill involved in their investment management and active fund managers are effectively highly paid gamblers. They are no better than giving a chimp a pin and a copy of the Financial Times and getting it to pick stocks for your portfolio. I use hyperbole to make my point.

I am an advocate of active fund management and my clients’ portfolios are dominated by investments that are run by managers with strong asset allocation and stock picking convictions. However in rare circumstances I see value in adding passive strategies. In general terms though I just don’t get the point of a strategy that requires investment in basket case companies just because they are in index!

In conclusion is investment an art or science? I think it is both. Is investment a gamble? To some extent it is. Fund managers and IFAs like myself make asset allocation decisions that go wrong. A few years ago after commodities hit what I thought was rock bottom prices I advised some clients invest in commodity funds. Prices however continued to fall. With hindsight I called the rally in commodities too early. Without certainty of certainty, investment decisions must surely have an element of being a gamble. In this respect I think art and science results in investment decisions that may be just best guesses, albeit educated ones.

Finally and briefly an investment manager or investment adviser is not only an artist, a scientist and a gambler but he or she needs to be a gardener too. Investment portfolios are dynamic. A well-constructed, balanced and suitable portfolio may be entirely appropriate at outset but it is not static. It is like a garden. A neat, well-tended garden doesn’t stay like that for very long. Plants become unwieldy, weeds appear, grass edges become scruffy and left untended the garden reverts back to an unkempt wild state. It is the same with investment portfolios, adventurous risk funds get too big and under performing funds may need to be weeded out. Reviews are required to rebalance portfolios and reduce risk. In the last six months I have done a lot of gardening.

This blog post is my own investment thinking and commentary only. Nothing in this article should be construed as investment advice. Investment in US equities, smaller companies and value investment strategies may be unsuitable for you. You should seek individual advice based on your own financial circumstances before making investment decisions. Past performance is not necessarily a guide to the future.

Value in US & UK Stock Markets

In recent blogs I have suggested price and value are not the same thing. An index or stock price may reach a high but that does not necessarily make it expensive. Similarly a collapse in the price of an index or stock does not necessarily create good value nor is a signal to buy. Remember the concept of “value traps?”

What I want to do in this article is give consideration to current valuations in US and UK equity markets. As noted in my blog post of 29/10/16: there are a variety of technical measures of value of a market or stock for example, price to earnings ratio (PE ratio), cyclically adjusted PE (CAPE),* price to book or a composite value indicator.

In a recent webinar on US equities, Invesco Perpetual presented data on CAPE from Shiller. At 31/10/16 with a CAPE of 27 the US market is not cheap in historical terms, being well above average since 1920. However in 2000 prior to the technology bubble bursting, the CAPE reached almost 45 and prior to the Wall Street crash in 1929, the CAPE peaked at 33.

It would be reasonable to conclude after a long rally in US equities since 2009, valuations are not cheap and money should be allocated elsewhere. A couple of years ago investors came to this conclusion and there was a marked rotation out of US equities to the UK and Europe, which were assessed as offering better value. Personally I was not convinced that the US had run its course and it remained one of my favoured equity markets. This week the three main US stock market indices, the Dow Jones Industrial Average, the S&P 500 and the Nasdaq hit new highs. Investors may sell out too early, driven by the “wall of worry,” syndrome, the higher you go the scarier it gets. However if prices are supported by strong earnings and earnings growth, rising prices and market peaks do not mean stocks are expensive.

Moreover Invesco Perpetual pointed out that in the US there is a wide disparity in valuations between defensive growth stocks and value stocks. Whilst consumer services, retailers and household companies are at or above bubble territory; autos, energy, banks and insurance are trading at very low valuations. The same point was highlighted by Schroders in the bar chart linked from the 29/10/16 blog post. What this means is that a whole market cannot be dismissed as expensive based purely on an index valuation. Some sectors will be but others are not. This is why I favour active fund management over passive index tracking. Expensive sectors and stocks can be avoided whilst index trackers by definition must buy the whole market, good or bad, cheap or expensive.

What about the UK? In a recent blog post by Schroders they stated the FTSE 100 is much better valued than the FTSE 250 index of mid-cap stocks. The valuation disparity is due to stronger profits growth in medium sized companies. While the FTSE 100’s CAPE was 30 in 2000, it is 15* today whilst the respective figures for the FTSE 250 are 30 and 26. In other words, while the FTSE 250 is almost as expensive as it was at the height of the technology bubble, the FTSE 100 is at half its valuation.

With the FTSE 100 index being close to its long term average I conclude it is not especially expensive and I currently favour UK large and mega-caps these over mid-caps. The same caveat about disparity of valuations between sectors and indeed within them also applies, so care is needed when the market as a whole.

*CAPE is often referred to as the Shiller PE after Robert Shiller, the economist who created it the valuation measure. The date of the FTSE’s CAPE of 15 was not stated in the blog but other data I have seen state it to have been 14.07% at 31/10/16 (

This blog post is intended to be general market and investment commentary only. Nothing in this article should be construed as investment advice. Investment in UK or US equities may be unsuitable for you. You should seek individual advice based on your own financial circumstances before making investment decisions. Past performance is not necessarily a guide to the future.