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.

Have Your Investments Been Trumped?

Probably not or not yet! I have never received so many invitations to hastily arranged webinars by investment companies as I did on Wednesday morning after the US presidential election. In addition I was also bombarded by numerous commentaries and opinions by fund managers. So what are my thoughts on how a Trump presidency will impact the global economy and investments? I suspect you may have read and seen much yourselves so I am going to keep this brief.

As with the EU vote equity markets sold off sharply in the first hour of trading, gold soared and the Yen, a traditional safe haven asset rose against the dollar. However by the end of the day most of these trades had reversed. Markets had concluded that Trump would not be a disaster for the US and global economy, at least in the short term. Investors however play the long game.

It would be fair to say although investment company analysis is mixed, a number of Trump’s economic policies are thought to be a boon to the economy. Massively increased infrastructure spending in the US will create jobs and stimulate economic growth. Materials and construction companies will be obvious beneficiaries. Interestingly this is in tune with the increasing calls globally for fiscal stimulus, including government spending, to play a bigger role in boosting the economy than monetary policy. The latter including QE and interest rate cuts are the responsibility of central banks. Arguably monetary policy has run its course and is now firing blanks.

On the debit side US debt is likely to rocket even if economic growth is turbo-charged generating more tax. This is because US interest rates will rise meaning the cost of government borrowing becomes more expensive. However a Trump presidency will stymie global trade if policies lead to trade wars and tariffs. Time will tell as to how it all plays out. What we can say is that the domestic economy, i.e. consumer spending will continue to be the main driver of the US and hence the global economy.

I am cautious looking forward, irrespective of the Trump presidency. As night follows day stock market falls follow the rallies. It is why profit-taking and risk reduction is still a priority for my advice to clients. Beyond this it is about finding investments that offer real value and prospects for returns uncorrelated to equities. Identifying assets that outperform cash and deliver positive returns in most market conditions is also crucial.

This blog post is intended to be general market and investment commentary only and reflect my own thinking. 1001 other investment opinions are available. 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.

Price is what you pay, value is what you get

In my last investment blog in reference to equity markets booming and reaching new highs I stated that price and valuation are different. A stock market index peaks but it may not be expensive. Similarly a stock market or a company’s share price may collapse or remain at a depressed level for an extended period, but it does not necessarily mean it is cheap and it is a good time to buy. Such stocks may be “value traps.” The principal here is that these companies are cheap for a very good reason, the market has priced in significant problems with the business, earnings or the balance sheet and sees no catalyst for recovery. Bargain hunters investing on price alone are likely to lose money. They could be described as those who “know the price of everything but the value of nothing.” You meet such people in ordinary life.

Many years ago I was a member of a share club in Northiam, where I used to live. I recall someone suggesting we invest in Marconi PLC. The share price had peaked at £12.50 in 2000, but a year later had fallen to 29p. Had we invested at that price we would have fallen into a value trap because the share price continued to fall to about 8p. The company’s shares finally ceased trading on 16/5/03 and they closed at less than 1p per share. It was one of the most spectacular collapses in UK corporate history.

It was legendary investor Warren Buffet who observed, “Price is what you pay, value is what you get.” A principle of good investment is you need to consider both price and value. Many fund managers such as Neil Woodford of Woodford Investment Management and Nick Kirrage and Kevin Murphy at Schroders are referred to as value investors. They work on the premise that certain stocks are trading at below their fair value because the market has failed to recognise the true worth and turnaround potential of the companies. They buy on fundamentals, including good valuations not just price. Historically a value investment style as it is referred to has outperformed a growth investment style, where companies have more visible or stable earnings. In recent years however markets have favoured defensive growth stocks over the more cyclical value end of the market. Valuations are correspondingly higher however with defensive growth.

Space does not permit a full description of how the value of an index or stock is determined suffice it to say common measures are variants of the Price to Earnings Ratio or PE. This is the stock price (P) divided by earnings per share (E). The lower the PE the less valued the stock is and vice versa. Earnings can be historic i.e. 12 month trailing or they may be a forward projection, which invariably is subject to uncertainty. The single data point suggest a PE measure is crude and it is logically improved by use of the Cyclically Adjusted Price to Earnings Ratio or CAPE. This uses an average of the last 10 years’ earnings, adjusted for inflation, which irons out fluctuations in earnings over different economic cycles. However see below. Another commonly used valuation metric is Price to Book. Book value is the value of a company’s assets on the balance sheet.

Now this all very interesting (or sleep inducing, take your pick) but the key question is this. Is there a link between valuations and future returns? I do not purport to be an expert on the subject but I have seen evidence to suggest the answer is yes. The fund managers of the Schroder Recovery fund referred to above have shown there is a clear correlation between PE ratios and future returns. Schroders very kindly provided a document for me in March 2015 that illustrates their findings:

More recently I undertook some online training with Invesco Perpetual. It was a technical presentation on valuations. They showed a strong inverse correlation between the Price to Book Ratio and 10 years compound annual returns since 1974 (Data to 1/6/16). In other words the lower the Price to Book ratio the stronger future performance. Naturally there will be a scattering of returns for stocks with the same Price to Book ratio but the trend is clear.

Interestingly Invesco Perpetual showed that the trailing or historic PE was an accurate indicator of future returns, in fact more so than the CAPE, which was a surprise to me. They also described a “Composite Valuation Indicator (CVI) which was a combination of three accurate value measures, trailing PE, Price to Book and dividend yield. Invesco Perpetual argued that the CVI is the best guide to future returns with a 90% inverse correlation, the lower the CVI, the higher the returns over the next 10 years.

In conclusion value matters as it provides the essential context to assess the price of a market or individual stocks as well as future potential returns. High prices do not necessarily mean valuations are stretched as well. The rise in a share price or index may reflect strong underlying earnings growth. Finally high prices do not mean certain equity sectors or markets should be avoided. That said I haven’t considered in this blog is if global markets now are highly valued compared to their historic averages? That is something for another post.

Finally I need to say that an analysis of valuation is only part of what a fund manager does before deciding on asset allocation and stock selection. Just looking at valuations would be somewhat simplistic. Central bank monetary policy, government fiscal policy, balance sheet analysis, sector analysis and company management and market positioning are examples of the things they normally consider.

This blog post is intended to be general market and investment 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. Past performance is not necessarily a guide to the future.

Investment according to the Duke of York

It probably did not escape your attention that the FTSE 100 index set a new record high of 7,129 this week before falling back to close at 7,011 on Friday. The post Brexit vote bounce since 23rd June is attributable to the sharp drop in the pound against other major currencies notably the dollar and euro, boosting the value of UK companies’ global earnings. The rally raises a legitimate question whether now is a great time to invest cash when equities are priced so high. At first sight no would appear to be the answer. However in an e-mail on Wednesday to a client who is sitting on a fair chunk of pension cash I wrote the following edited comments.

The concern of investing cash right now is that global equities are buoyant and arguably valuations are expensive in some markets like the UK. There is a risk of a short term sell-off, which could be triggered by faster than expected US interest rate rises or by investors simply taking profits. However that should not be a reason not to invest in the cautious risk funds proposed …. These managed funds have defensive qualities and are run with capital preservation in mind. This is not to say they will be unaffected by a market sell-off, but the impact will be reduced compared to pure equity funds. In a similar way multi-asset and defensive funds will not have captured all of the equity market rally since the summer so there is less downside risk.

As for the more adventurous risk equity funds I proposed it is more complex. The ABC & XYZ US funds invest in my favoured equity market, due to a growing economy and a strengthening dollar (fuelled by expectation of rising interest rates). That said there is political uncertainty with the US presidential election next month and I am concerned about the potential for a regulatory created financial crisis with huge fines levied by the US justice department on the banks such as Deutsche.

On the plus side however the S&P 500 index, a more representative index of US companies than the Dow Jones Industrial Average is up just 1.1% since June 23rd and the German DAX is up 3.1%. In contrast the FTSE 100 index is up 11.5%. The point is the record highs breached by the latter are not necessarily reflected in other markets, meaning the Brexit bounce has been a UK phenomenon. All the equity funds I have recommended were global or US funds, none were dedicated UK investments.”

I would also add to my concerns, the risk of a collapse in over-valued government bonds and political risk with the US Russia relationship dangerously frosty.

With this in mind, for some strange reason this week the old nursery rhyme “The Grand Old Duke of York, ” popped into my head.

The Grand old Duke of York he had ten thousand men
He marched them up to the top of the hill
And he marched them down again.
When they were up, they were up
And when they were down, they were down
And when they were only halfway up
They were neither up nor down.

For those with a historical interest I found a brief article on the possible origins of the poem:
It seems as if the Duke of York was not a great military tactician – his disastrous actions led to his demise. However some out of the box thoughts come to mind about investment.

*Markets go up, markets go down and they stay still. It is a sure fire thing that when they are up they will go down and when they are down they will go up. Sometimes they will pause for breath and move sideways. Investors should consider banking profits when markets are up and not be scared to invest when they are down. If markets are moving sideways investors should ask what assets might benefit, if any.

*There is more than one hill. Along the valley there are several more hills. The Grand old Duke of New York has his men on one of these and the Grand old Duke of Brussels has his men on another. Just because our man Richard, Duke of York is at the top of his hill does not mean his US and European counterparts are as well. In other words don’t judge the global equity market by the FTSE 100 index.

Finally I must briefly mention valuations. Space does not permit more. It is important to say that prices and valuations are not the same. Just because a stock or index hits a high it does not necessarily mean it is expensive. Strong earnings may support the price and even provide momentum for further increases. Equity analysts and fund manager undertake fundamental research on companies and markets and part of this measures valuations, using PE ratios, Cyclically Adjusted PE ratios, price to book etc. The holy grail of investing is to find good stocks that are undervalued or fair valued with the potential to grow earnings and dividends. More on this in a later blog.

This blog post is intended to be general market and investment commentary only. Nothing in this article should be construed as investment advice. US equity funds or cautious risk investments may not be suitable for you. You should seek individual advice based on your own financial circumstances before making investment decisions.


Last time I wrote about profit-taking. Today I want to tackle a related subject, by a roundabout route – football! I hear the collective sigh from my readers but please read on. Anyone interested in football knows there is much debate about systems i.e. how teams set up; 4-4-1-1; 4-2-3-1; 4-4-2 etc. and about player positions – strikers, defensive midfield players and left backs. Great teams in the past used two strikers. These are the goal scorers who did all the damage – Greaves and Gilzean, Shearer and Sutton, Dalglish and Rush. They are rarely used these days but today there is one outfit who use two strikers; they play for a team called the Profit-Gobblers, a Premiership outfit and they make a great partnership.

Last time I described one of these. I’ll call him Market Crash. He wears 29 on his shirt. He loves gobbling up profits and capital. He is very fast and sneaks up on you whilst you least expect it. His best seasons included 1929 (the Wall Street crash) and 2008 (the global banking crisis). However he is capable of nicking money off investors slowly and without you noticing. He is also brilliant at diving at awkward moments in the game. However he can be contained and given a red card. As I explained in my last post, in my role as first team coach of Investors United a tactic I use is to bank profits whilst possible. However nasty Market Crash is he can’t gobble up profits (or capital) from cash (it gives him indigestion) and he just gets mere morsels from cautious risk funds. Another tactic is to employ a defensive midfielder called Buy and Hold. He is the Eric Dier of the team. He sits in front of the defence and strangely does not engage in profit-taking and he ignores Market Crash for 10-20 years. Why? He has faith in Investors United’s main striker called Mr Equity. Buy and Hold is rewarded because at the end of the game Mr Equity has normally scored more goals than Market Crash and Investors United beat Profit-Gobblers.

The second malcontent in the partnership at Profit-Gobblers is Tax Man. He lulls teams such as Investors United into a false sense of security as he doesn’t take much money off investors immediately. He gets a few kicks in, from siphoning off dividends or nabbing a bit of capital gains tax. However don’t be fooled. Over many years profits have grown to produce a lot of money, carefully guarded by profit-taking or Buy and Hold. Just when all the players of Investors United think the game is won in the last minute of added time Tax Man pounces. You see in this world, games last much longer than 90 minutes. They go on and on and on and eventually something tragic happens, players from Investors United suddenly die. And here is the despicable thing. As they are lying on the floor Tax Man comes along and takes 40% off them – not only profits but capital as well, money that could well have gone to children and grandchildren.

The moral of the story should be clear. Investors rightfully spend a lot of time protecting their investments against stock market falls but seem to discount the equally damaging effect of inheritance tax on their wealth. For some reason planning to mitigate tax on death is given a lower priority despite its real threat. It is like bolting the door but leaving the windows open at night. Both are needed to keep the burglars out. However with good planning there are a variety of ways to mitigate against inheritance tax. For this reason it has been said: “Inheritance tax is a voluntary tax paid by people who love the tax man more than their family.”

There are some understandable barriers that dissuade investors from inheritance tax planning – death is a future and final event. The tax paid won’t affect me unlike a stock market crash. The complexity of some arrangements, notably those using trusts is also a put-off. Waiting seven years for the inheritance tax exemption seems a long time and irreversible gifts are a problem if people think they may need access to capital for long-term care. However there are planning options which offer tax relief after just two years and/or which provide access to capital.

To conclude if Market Crash doesn’t get you Tax Man will. Fortunately both can be countered. Don’t expect much help though from referee Hammond, he is a big fan of Tax Man whilst linesman Carney may only provide a bit of protection from Market Crash.

The content of this blog post covers investment planning and tax mitigation strategies that I use and should not be construed as advice to you. You should seek individual advice before making investment and tax planning decisions.

No footballers died during the making of this article.

Profit-Taking Season

During August I have been busy with investment portfolio reviews. A key element of these has focused on profit-taking. It is always very pleasing to present an investment report to a client that shows a portfolio and individual funds in the black. However gains are only paper profits until they are banked or crystallised. They can disappear much faster than the time they took to accrue. In the same way paper losses are only real losses until they are crystallised.

Profit-taking can take various forms. The most obvious is to sell the profits to cash. This may be required if clients have a major item of expenditure that needs funding or if they wish to top up their cash savings. The alternative is to retain the cash within the investment for example an ISA deposit facility or a money market or cash fund.* This gives the option of fast tactical investment back into equities in the event of a significant market sell-off.

When I advise profit-taking I normally recommend retention of the original capital unless the market or sector the fund invests in is overvalued or there is a risk of a sell-off. For example a client invested £5,000 in August 2013 into a Japan smaller companies fund and it was valued at just over £7,850 nearly three years later. We sold £3,000 to ISA cash but retained nearly £5,000 in the fund because in my view there is further potential for strong capital growth from Japanese smaller companies.

Profit-taking is generally about risk reduction, especially with switches to cash. A less defensive alternative is to invest in cautious risk investments of which there are a variety of options including managed multi-asset, targeted absolute return, or short dated bond funds. One benefit of these is they have the potential to beat the returns on cash and usually inflation as well especially over the medium to long term. Cash is great for the short term but holding too much for too long is a drag on portfolio returns and its real value will invariably be eroded by inflation; so cautious investments offer something extra.

A final option for profit-taking is to invest in assets or markets where the client has no exposure to or is under-represented in the portfolio, especially where valuations are attractive. It permits rotation out of highly valued markets where further upside potential is limited or is liable to a sell-off if large numbers of investors take profits and exit, to markets or sectors with better prospects. Here risk reduction is created through adding diversity and holding funds with less downside risk and more attractive valuations.

To finish I want to cover the tax position on realising gains from investments held outside ISAs or pensions. As you may know everyone has a capital gains tax (CGT) allowance. In 2016/17 this is £11,100. This is a very useful allowance for absorbing realised gains without incurring a tax liability.

Now as it is exam results season this blog comes with a test. Don’t think you can get away with just being a passive reader!

Using the example above but rounding up the figures – Patrick invests £5,000 into a Japanese smaller companies fund outside an ISA and exactly three years later it is worth £8,000. He draw out £3,000 representing the accrued profits. Ignoring any buying or selling costs:

1. What is the gain realised for CGT purposes?

2. What is the relevance of the three year period?

You’ve got one minute to think about it. When done please scroll down the page.

Brain activity, calculations, CGT, taxman, gobbledegook
Brain activity, calculations, CGT, taxman, gobbledegook
Brain activity, calculations, CGT, taxman, gobbledegook
Brain activity, calculations, CGT, taxman, gobbledegook
Brain activity, calculations, CGT, taxman, gobbledegook
Brain activity, calculations, CGT, taxman, gobbledegook
Brain activity, calculations, CGT, taxman, gobbledegook
Brain activity, calculations, CGT, taxman, gobbledegook
Brain activity, calculations, CGT, taxman, gobbledegook
Brain activity, calculations, CGT, taxman, gobbledegook
Brain activity, calculations, CGT, taxman, gobbledegook
Brain activity, calculations, CGT, taxman, gobbledegook
Brain activity, calculations, CGT, taxman, gobbledegook
Brain activity, calculations, CGT, taxman, gobbledegook

OK here are the answers. If you said £3,000 to question one I’m sorry it is not the correct answer. If you said £1,125 award yourself a prize. This is because the withdrawal of £3,000 is deemed part original investment and part profits. As a proportion the £3,000 encashment from an investment worth £8,000 is 3/8ths. So on the same fractional basis the amount of original capital withdrawn is 3/8ths of £5,000 i.e. £1,875. This means the profits are £3,000 – £1,875 = £1,125.
This is the figure that counts against the £11,100 CGT allowance. The key point here is that more money can be encashed without realising CGT than might appear at first sight. Subsequent withdrawals are more complex but by now you have probably enough of the maths, are bored stiff or are miffed you were asked to take a test!

As for question two, the period over which profits arose is irrelevant to the calculations. It does not matter whether the gains were accrued over one year or three years. In the past, the investment timeframe did matter as an allowable reduction in the chargeable gain was available for inflation over the period. This so-called Indexation Allowance was scrapped for private investors some years ago although it is still available for companies paying corporation tax including life assurance companies running investment life funds.

*A cash or money market fund is a collective investment like a unit trust rather than a deposit account. It invests in cash deposits and near cash instruments such as floating rate notes and short term bonds such as Treasury bills or commercial paper (please google if you want further information on these). Money market funds are highly secure and liquid but because they have a management charge or may potentially be affected by defaults they may yield very small negative returns occasionally.

The content of this blog post covers investment strategies in general that I use and should not be construed as advice to you. This article is not a recommendation to invest in Japanese smaller companies as these may not be suitable for you. You should seek individual advice before making investment decisions.