December 2017 Investment Review

What’s happened over the last three months?

The FTSE 100 climbed 248.93 points in total from it’s September close of 7438.84 points. With a very late Santa Rally, it finished December at an all time high of 7687.77 points.  As late as the 20th December the market still stood at a maximum of around 7550 points, a level it first reached in May of this year. The final 150 points came in a week. So the market has had a full seven months to catch it’s breath.

How have we done over the last quarter?

All clients are in the process of receiving their personal quarterly valuations. But here is how the four main model portfolios that we operate have performed over the last 12 months. Continue reading “December 2017 Investment Review”

Zero Sum Game

Childish Joke

Bet nobody has tried this one on you for a long time. Unless you have grandchildren.

What’s the heaviest? A tonne of lead or a ton of feathers?

The answer is they both weigh the same. I can see your sides splitting with that one.

However it was a trick question. I mixed my tonnes (Metric) and tons (Imperial).
Imperial ton = 2240 lb = 1016 kg metric tonne = 1000 kg = 2205 lb

The correct answer is therefore the ton of feathers. But frankly who cares? Well Brussels does actually. If either a ton or a tonne fell on you, you would be squished. The difference is the metric tonne would result in much more paperwork. It’s too early for me to comment on Europe but after reading Roger Bootle’s excellent book, I’m with Boris. Anyway enough of Europe.

Win or Lose

Let’s talk about the price of oil instead. Shell and BP are perhaps the obvious losers from a drop in the price of a barrel. Quite rightly the shares have fallen 48% and 40% from their peaks of September 2014. Ouch. They are a couple of the larger shares that make up the FTSE 100 index, so not surprisingly from it’s peak last April it too fell 19%. But neither Shell nor BP can set the price of oil. They cannot make the price rise to make more profit. Supply versus demand does that job and pulling the strings are nations not companies. Saudi Arabia, UAE, Iran, USA, Venezuela, Libya, Russia, Norway etc.

So here we are. Too much supply, we are awash with the stuff. Hence a barrel of oil is cheap. It’s been calculated (I don’t know who does this) that when oil falls by $10 a barrel, the revenue lost is a mighty $1 billion per day! It’s fallen by almost $100 over an 18 month period. I can’t calculate the losses the number is just too big. So let’s look at the oil producing nations as the ton of lead. One huge great lump of immediate and ongoing loss. A ton of losses.

Lost or moved?

So where does a $1 million trillion billion gazillion go when it gets lost. Well interestingly it isn’t lost it’s just been moved. We are the billions of feathers that make up the ton of feathers. I can’t prove there are a billion feathers in a ton. Just stick with me here. Think Blue Tit not Ostrich. If the oil nations can’t sell for $100 a barrel then we are not buying it at $100 a barrel. The money isn’t lost is been redistributed to us. Not in one big lump but in lots and lots of tiny feathers. Visible in petrol receipts, future utility bills, reduced delivery costs to supermarkets bringing the cost of food down, air fares, cruise tickets etc. etc. etc. It’s a zero sum game. OPEC win and we all lose. OPEC lose and we all win. It’s just taking some time for us all to realise we are the winners.

OK then. Why have other shares fallen too?

Well it’s supply and demand at work again. Imagine the Sheiks and Oligarchs with their wheelbarrows full of Petrodollars. The money has been coming in for decades. It’s been buying London property, Football clubs & bling of all shapes and sizes from diamond encrusted underwear to gold plated Rolls Royces. Some of the more sensible purchases though have been Global Shares, Government Gilts, Corporate Bonds & Foreign Currency. With the books no longer balancing at $30 a barrel, the wheelbarrows are being used to bring the cash back home. Whatever can be sold quickly and easily.

Normal service will be resumed

On the left side of the scales I give you a ton of lead. On the right side of the scales slowly building is a ton of feathers. Balance will be achieved when individually we all spend our oil savings, generating business profits from Greggs to Harrods. More company turnover means more profit. The profit leads to higher dividends which means share prices will rise once again.

The smart money is on the oil imbalance coming to an end towards the Autumn. Unless a deal is done behind the scenes where all the oil producing nations agree to cut back production now. That looks unlikely. Saudi Arabia agreeing anything with Iran?

Buy Oil

At some point we will be investing in an oil fund, looking to ride the doubling in price from $30 to $60 a barrel. Just not yet. We can’t buy oil. Where would we store it?

The egg, the bread roll & the hotdog

Investment Diversification
Investment Diversification

Investment Diversification has often been cited as “the only free lunch in investment”. We must diversify and spread our investments. Increased safety is achieved by not having all of your eggs in one basket. Simple stuff. The statement however leads us to two questions.

Question 1: How many baskets do I need to be safe?

Not as many as you might think is the short answer. Around 20 baskets will suffice. Many investment funds or managed portfolios hold an enormous amount of individual investments. My theory is that the big named companies want to justify their amazing investment proposition by making it look very complex and impressive. A multi-page investment statement issued twice annually looks rather grand compared with just a couple of hands full of funds. But what diversification benefit remains after you hold 20 baskets? Here’s the maths.

  • With all of your eggs in 1 dropped basket, you lose everything.
  • With 2 baskets, you could drop one and still keep 50% of your eggs.

and so on…

You can see what is happening, each time we add a basket we are not reducing our risk by as much as the previous time we added a basket. If we could carry 20 baskets, we still keep 95% of our eggs if we dropped one basket. If we could carry 40 baskets, we would keep 97.5% of our eggs if we dropped one basket. If you ask me, I’m more likely to drop a basket if I’m trying to carry too many in the first place. So it’s the law of diminishing returns in play here. Around twenty is plenty. Holding too many isn’t diversification, it’s probably diworsification.

Question 2: What should I put in my baskets?

This is where I get to talk about correlation. Positive Correlation, Negative Correlation & Non-Correlatation. Let’s stick with eggs to begin with.

As well as having many baskets holding our eggs, we must not hold just eggs alone. Let me explain. Put an egg in a pan of boiling water for 10 minutes and we get a hard boiled egg. Yum! Put a duck egg in the same pan; same outcome, just another hard boiled egg. So all eggs are positively correlated. We get the same outcome when we boil them. Put a bread roll in a pan of boiling water though, and we simply destroy the bread roll. Yuk! It won’t go harder it will do the opposite, it will go softer. Therefore the bread roll is negatively correlated to the egg when dunked in boiling water. One is yum , the other is yuk.

In investment terms if yum is up and yuk is down, then a 50/50 split of eggs and bread rolls gets us nowhere. We end both 50% higher and 50% lower = no change. We want to group together things that just don’t react together, either in lock-step upwards nor in absolutely the opposite direction. Useful diversification only comes about when all the constituents of the investment portfolio each do their own thing independently of each other.

So you’ve met the egg and the bread roll, say hello to the commando of the boiling pan world. Enter the hot dog sausage. Out of the tin he is cold, out of the boiling water he is hot. Either way the heat hasn’t changed him. “Dunk me again! I can take it”. He’s become neither harder like an egg or softer like a bread roll. So this is it. This is true non-correlation to boiling water. The egg will change, the bread roll will change, the hot dog won’t.

Is this useful or am I just mad?

In investment terms the pan of boiling water is any political or economic event that is set to change the outlook for investments. China’s growing up problems, OPEC’s collapse, the US threatening to increase interest rates for 10 years, Grexit, Brexit, ISIS, debt crisis, drought, mass migration……

All global shares are correlated to some extent. Whatever boils the water it causes one of two outcomes. Yum or Yuk. So you can’t achieve diversification just by owning shares, even if some are in the UK, some are in the US and some are in Japan. They still may all fall together. Forget diversification by Geography. Shares know no political boundaries anymore now that companies are global. A fall in Chinese domestic spending will directly impact on the future profits of many a US company.

Our current diversification hero

To keep on the food theme, I have cast the hero of the day as the humble Gregg’s Steak Bake. (Sorry to you veggies). Absolutely useless in a pan of boiling water by the way, please don’t try that at home.

Small shares don’t react to many global events like large shares do. Small company profits are usually created locally not globally. You don’t get more local than Gregg’s the bakers or Domino’s pizza or Dignity Funeral Services. For 12 months now everyone has had a bit more jangle left in their pocket, caused by the savings obtained at the fuel pump.

Consider a typical scene.

  • Monday lunchtime 12:30pm, 1000 white van men buy a steak bake.
  • Monday evening news 6:00pm. “Stockmarket’s around the world fall in unison as billions are wiped off China’s stock market in investor panic.”
  • Tuesday lunchtime 12:30pm, 1000 white van men buy another steak bake.
  • Meanwhile Gregg’s share price changes not one jot to the global events
The FTSE 100

As you know this year has been a stinker for the FTSE 100. It started the year at 6547 points but currently lies at just around 6150 points. Still almost 6% down on the year. But why? UK businesses seem to be doing very well; pubs, restaurants and shops are all busy. Well two reasons for the FTSE fall. The bigger boys in the index who make up the majority of it are international firms and the smaller ones don’t count as much as the larger ones. The bigger the company – the bigger the slice of the FTSE 100. Overall 80% of the earnings of the FTSE 100 now are generated overseas. The FTSE 100 is not a barometer of how the UK is doing, more of how the world overall is doing. The largest climbers within the FTSE 100 this year were Taylor Wimpey and Barratts, both making their profits mainly in the UK.

In a previous blog, Big isn’t best, I discussed my tactical strategy of introducing smaller shares into our portfolios last April and I’m pleased to say that relative to the FTSE 100 the changes have saved our bacon. I’m hoping our January Investment Review will reveal the fruits of our labour.

Diversification when done properly is the only free lunch in Investment. Steak Bake anyone?

Big isn’t best

Last week the FTSE 100 fell by 1.29%. It was kind of business as usual and not surprising when the week before it rose by 1.04%. Swings and roundabouts you might say. But when you lift the hood of the index and take a look inside there are some horrors!

Just take a look at the table above. The index overall lost 1.29% but the biggest faller amongst the FTSE 100 shares lost an eye watering 26.7% of it’s value. Meanwhile a couple of winners put in a sterling effort and climbed by 6.1% each. So between the highest climber and the lowest faller there was a variation of 32.8%.

Expert fund manager A thinks that the only way for the banks, miners, house builders and engineering firms is up. His clients took a beating this week.

Expert fund manager B dislikes the banks, miners, house builders and engineering firms and so avoids them. Instead he invests in Pharmaceuticals, Hotels, Leisure and Telecoms. Winner winner chicken dinner!

The trouble is that it’s just a lottery. No-one knows who will be the winners and losers each week. When things go right for an active manager he milks it, when things go wrong he has “deep conviction in his long term strategy”.

It’s the reason why we usually invest in just the whole index. We shouldn’t get any nasty surprises.

Which index should we invest in?

I have said many times that the FTSE 100 isn’t my first choice of index even though it is the most common and easiest to see the price of. In fact you just can’t avoid it’s daily progress on the TV, Radio and Newspapers. You could believe the FTSE 100 index is the only show in town.

We are always invested in around 6 or 7 indices at a time. We will return to the FTSE 100 in the future I’m sure, when the price of steel, oil and copper all start to pick up and the banks stop being fined for scandal after scandal. Since April of this year my main UK index weapon of choice has been the UK Small Capital Index, shown below in the chart as the white line. It’s progress has been plotted against the FTSE 100 index, shown as the green line. The difference between the two is 10% over the last six months.

IMG_3465

Investing in an index is known as passive investing by the experts who advocate active investing. There is substantial evidence that shows that over the long term, simply investing in an index usually beats in excess of 90% of active managers. Ask Warren Buffet. We are invested for the long term aren’t we?

Same side of the boat

Simple stuff really; but if you want to sell a share, then you need someone else to buy it. If you held Northern Rock shares you will know this. There were thousands who wanted to sell, but not one person wanted to buy. The result was there were many small shareholders left holding the baby. A total loss.

Previously I have blogged about The Relentless Search for Income, if you missed it you can read it here

I also explained in March why I had halved our holding in a long time favourite fund, the Vanguard UK Equity Income Index Tracker. Here is the link if you have some time to re-read it. Just six weeks after that blog I then sold the rest of that fund.

Where are you going with this?

Well in the recent budget it was announced that there was to be a long-awaited over-haul of income tax payable on dividends. It was announced that investors could now earn up to £5000 per year tax-free in dividends. £5000 per year tax-free on top of our £10800 per year personal allowance free of income tax. How good does that look to the average investor who has loads of money sat outside the tax-free shelter of a pension or an isa?

Well I don’t think there was any need to further incentivise investors to choose high dividend producing shares. They cannot earn income in a bank and the returns on Government Gilts are frankly ridiculous for the potential downside risks that lay ahead. Individuals have been loading up with “safe” high dividend paying shares for years. More will follow due to the favourable income tax treatment. Where is it going to lead?

It’s a crowded trade about to get more crowded

UK Equity Income funds have become a very crowded, one-sided trade. I prefer to describe it as everyone is on the same side of the boat. If we are not careful we know what happens next.

Remember, to sell a share you need a buyer? When this many shareholders start to look for the exit together, buyers could look scarce. Just don’t expect to sell at a high price. The few of us who don’t own the shares will be looking for bargains.

The income tax they have saved could look tiny compared with the capital loss they could incur.

When we finally sold all of our UK Equity Income Fund, we replaced much of our UK holdings with a fund that tracks smaller UK shares. Many have been overlooked as they don’t pay dividends. It’s early days, but this is what has happened so far.

small v large1

P.S.
I try to write these blogs well ahead of my deadline. The sharp eyed amongst you will have seen the chart above finished a fortnight ago. What happened next? Since the trades on 28th April, so just two months ago, here’s the up to date position

SOLD- Vanguard UK Equity Income Index Fund -3.6%
BOUGHT- iShares MSCI UK Small Cap +1.2%

I hope the investment boat slowly rights itself with investors naturally stepping away from the side. But I fear that the “tax free” draw will drag even more investors into the big dividend paying shares.

I used “Orca” as the boat in the photo above to illustrate my point of a sinking ship. I could have used “Poseidon” instead, but since I’m off on a cruise in a week…..