Money Makers | Jonathan Davis

Notebook: what I tagged this week

21st March 2016

Every so often I highlight a number of articles, or pieces of data, that have caught my eye, being either sensible, profound or (just as valuable) challenging to consensus views.

Opportunities in investment trusts

Selling by a big insurance company has hit the share prices of a number of investment trusts, according to the sector’s #1 analyst, Charles Cade of Numis, potentially creating some bargain opportunities, such as Witan at a 7% discount): Pension fund sell-off hits investment trust shares
For more on this issue, see also this edition of Investment Trust Intelligence (you will need to self-certify as an investment professional to access the site): Witan Discount Opportunity

Are market valuations crazily high?

Fund manager Bruce Stout has an ultra-gloomy view of the world and the shortcomings of monetary policy, expressed in some detail in the latest Murray International annual report. (Disclosure: I have recently bought a few shares in Murray International, which have fallen to a discount after two years of poor performance. Despite a strong rebound this year, they are still yielding 5.5%).

Woodford Q&A

Neil Woodford’s held an online Q&A with his shareholders this week – part of his commitment to greater disclosure and better communication with shareholders. His most interesting comments, in my view, were those on oil companies (negative; the oil majors are obviously over-distributing at current prices), the poor short term performance of the Woodford Patient Capital investment trust (message: er, be patient…) and the likely (limited, in his view) impact of Donald Trump were he to become President (see quote of the week below): Neil Woodford Q&A

Buy-to-let a fading force?

Money Week editor Merryn Somerset Webb’s explains why in her view the sums behind buy-to-let as an investment are no longer attractive: Buy to let investing just became a very bad idea

Has the ECB shot its bolt?
“The question everyone wants answered”, according to M&G’s Stefan Isaacs, is whether the ECB has reached limits of monetary policy. His conclusion:

“The reality is that increased productivity and greater innovation is much needed to drive the Eurozone. Antiquated bankruptcy regimes need to be radically reformed, red tape needs to be removed and the banking system needs to own up to further loan losses that it has yet to provision for. These changes aren’t easily achieved, not least because they require the sort of short term pain that politicians rarely have long run incentives to deliver”.

Income investing may now be a trap

History suggests that investing for income at current levels is dangerous, says veteran Wall Street strategist Richard Bernstein. Dividend yields have been more attractive in 75% of the past 80 years, and too many investors are following the same trend – rarely a good idea: No one ever grew wealth being scared (pdf)

Look out for a rise in inflation

Don’t assume that the market is right about there being no rate rises this year, says Ambrose Evans-Pritchard in The Telegraph – some inflation warnings signs are becoming apparent. (I share some of these concerns – inflation when it comes always catches investors by surprise): US inflation rears its ugly head as global cycle nears danger zone

Skewed risks in equities

Jeffrey Grundlach, one of the highest profile bond fund managers in the United States, says the risk-reward ratio on risk assets (such as equities) is poor at the moment – in his view, no more than 2% upside and 20% downside. He doesn’t think there will be a US interest rate increase this year, although he also concedes there is no clear-cut indicator that suggest a recession is imminent. There are some interesting charts in the presentation this piece links to: Gundlach’s warning for risk assets

Gold has turned a corner

Find out why Charlie Morris, former asset allocation guru at HSBC, now working independently, thinks that the bear market in gold is over. His newsletter Atlas Pulse comes out monthly, and lays out what is happening in gold and crypto-currencies like bitcoin in a highly accessible way. His view: it is not yet a bull market in gold, but moving that way. Look out for his comprehensive table summarising the history of gold’s bull and bear markets: Atlas Pulse April 2016 (pdf)

Chart of the week

Nearly 20% of the world’s bonds, as measured by the JP Morgan Aggregate Bond Index, with an aggregate value of $7 trillion, are now offering negative yields – quite astonishing (and scary) numbers. The percentage has tripled in the last six months alone.

Quote of the week

“Donald Trump’s candidacy has clearly polarised opinion in the US. His popularity, in my view, is in part a product of the ongoing economic difficulties faced by many developed countries. Socio-economic groups that have not benefited from the recovery of the US economy since the financial crisis feel marginalised and are showing an increasing preference for ‘outsider’ politicians, like Bernie Sanders and Donald Trump. Trump’s more extreme political views on the campaign trail are likely to moderate significantly, if he were elected. In addition, the checks and balances in the US political system would clearly make some of his more extreme policy choices unlikely to prevail. My conclusion is, if he were elected, it would have a very limited impact on the US economy”.

Neil Woodford, founder of Woodford Investment Management

Attractive discounts in the investment trust arena

Here are the latest z-scores, as recorded by the broker Numis. A negative score indicates that the discount on an investment trust is wider than its historical average, and therefore a potentially attractive entry point, while a positive figure suggests the reverse. There may be reasons for these discount movements, which is why the lists are only described as “cheap” or “dear” in inverted commas. Always do further research before acting on these signals.

Image source: www.istockphoto.com

[printfriendly]

Notebook: banks, Buffett and more

4th March 2016

Central bankers are losing their followers

Since the financial crisis market forecasts have consistently been wrong, almost invariably in the same direction, underestimating growth and over-estimating bond yields. But now financial conditions are tightening? Why? Because, says Gerard Minack, former Morgan Stanley pundit turned independent commentator, investors are losing faith in monetary policy and the power of central bankers to keep on pumping up asset prices. You can read his comments in full on the Woodford Funds blog. He doesn’t think that is going to change – a hugely important development for risk assets if he is right. It could mark a turning point in the post-crisis cycle.

The euro is still “extraordinarily dangerous”

Mervyn King (as was, now Lord King of Lothbury), the former Governor of the Bank of England, makes a similar point in his new book The End of Alchemy, which has been serialized in The Telegraph this week. Monetary policy alone cannot save us from another financial crisis, he says. He also highlights how “extraordinarily dangerous” the euro project has become. “Put bluntly” he concludes

“monetary union has created a conflict between a centralised elite on the one hand and the forces of democracy on the other. In the euro area, the countries in the periphery have nothing at all to offset austerity. They are simply being asked to cut total spending without any form of demand to compensate. I think that is a serious problem. I never imagined that we would ever again in an industrialised country have a depression deeper than the United States experienced in the 1930s and that’s what’s happened in Greece. It is appalling and it has happened almost as a deliberate act of policy which makes it even worse”.

When will Buffett go ex-growth?

This week has also seen the publication of Warren Buffett’s annual letter to shareholders, a regular must read for all investors. This year’s letter is shorter than usual on general observations about the craft of investing, but interesting on the reasons for long term optimism about the US economy (a familiar theme) and climate change (whether a real danger or not, “not a concern for investors”). The insurance business whose cash flow (or “float”) is the engine that has powered Berkshire Hathaway’s exceptional returns over the past 40 years gets another big write up. For an interpretation of what this means for shares in Berkshire Hathaway, you may find this (quite dense) commentary by a long term Buffett follower helpful. More interesting perhaps is his earlier post Berkshire Hathaway: The Next Ten Years, which assesses the probability that at some point not too far away the company will decide to start returning capital to shareholders in large quantities, just as Microsoft started to do about 20 years ago.

Who to blame for secular stagnation

Is “secular stagnation” a risk for the US economy, as Larry Summers, former US Treasury secretary, has argued? The historian Edward Chancellor assesses this issue in his latest column for Breaking Views. These concerns are nothing new, he notes.

“Unsurprisingly, the notion of secular stagnation was first mooted in the aftermath of the Roaring Twenties. The boom, wrote Alvin Hansen in 1934, comes about when industry is “artificially stimulated by an overdose of easy credit [which]…is the basic cause of the depression.” Hansen lamented that Americans in the early 1930s had shown a “degree of public nervousness and impatience which has necessitated wholesale experiments with forced methods of recovery.” Similar traits resurfaced in the wake of the last financial crisis. Secular stagnation is the unintended consequence of easy money policies, both before and after 2008. It’s only while those remain in place that Buffett’s breezy optimism about America’s economic future looks misplaced”.

In the eye of the storm

Jacob Rothschild (Lord Rothschild) is also worried, he tells investors in RIT Capital in its latest annual report, published this week. Here are a couple of extracts: “We became increasingly concerned about global equity markets during the last quarter of 2015, reducing our exposure to equities as the economic outlook darkened and many companies reported disappointing earnings. Meanwhile central banks’ policy makers became more pessimistic in their economic forecasts for, despite unprecedented monetary stimulus, growth remained anaemic. Not surprisingly, market conditions have deteriorated further. So much so that the wind is certainly not behind us; indeed we may well be in the eye of a storm. Our view is that 2016 is likely to turn out to be more difficult than the second half of 2015. Our policy will be towards a greater emphasis on seeking absolute returns. We will remain highly selective when considering public and private investment opportunities. Reflecting this policy, our quoted equity exposure has been reduced to 43% of net asset value with private investments at 26%”. (Note: RIT is a core holding in the Money Makers investment trust portfolio).

An investment trust think-in

J.P.Morgan Cazenove are the largest market-maker in investment trust shares and the go-to broker for institutional investors. I was at their annual investment trust conference, hosted by Christopher Smith, their investment trust analyst, ten days ago. The panel sessions on asset allocation, peer to peer lending (positive), emerging markets (to me, unconvincing, though the longer term arguments seem strong) and property (focus on income from here) were particularly interesting. Look out shortly for an interview on Money Makers with Sebastian Lyon, CEO of Troy Asset Management, and investment adviser to the Personal Assets investment trust, who was one of the speakers in the asset allocation debate.

The case for investing in junk

What about high yield bonds (otherwise known as junk bonds)? Yield spreads over government bonds have widened dramatically in the last year, and not just because of the falling oil price, which threatens to lead to widespread defaults among lenders to oil and energy companies. Does the crash in junk bond prices create an attractive entry point for portfolios? I have only just caught up with this note from Ben Inker of GMO, the US fund management group founded by one of my favourite investors, the grumpy Yorkshireman Jeremy Grantham four decades ago. Inker’s conclusion:

“At current spreads, high yield seems to be no worse than fair value and probably better than that, even if we assume (as we do) that we are entering a fourth default cycle. In today’s environment, that makes it one of the best available risk assets for investors. But the nature of the high yield market suggests it is a good candidate for overshooting fair value to the downside whenever defaults begin to rise in earnest”

GMO are building a position but (characteristically) Inker adds:

“It would be lovely to claim we will be able to time the bottom for credit precisely. We will not, and unlike with equities, even if we did know the timing perfectly, getting material exposure to the asset class quickly would be extremely difficult. This leaves us with the hunch we are probably getting in a little early, the fear that we might not get all the exposure we would like before spreads move to less attractive levels, and the sure knowledge we won’t get the bragging rights of having called the turn. In other words, it seems to be an utterly classic value investing opportunity”

How to monitor your wealth manager’s performance

How well is your portfolio doing – or, more pertinently, how well is your adviser or wealth manager doing for you? The latest survey of wealth management performance by Asset Risk Consultants has just been released (go to www.suggestus.com for more detail). ARC lumps performance of the scores of wealth management firms whose performance they monitor into four main categories, depending on the degree of equity risk adopted. Here are the results for the steady growth bucket. As expected performance year to date has been muted – down in January, with some modest recovery in February. I will be providing regular updates on these figures as the months go by.

It is return on equity that counts, stupid

Another of my favourite fund managers, Terry Smith, was in good form at this annual shareholder meeting this week, naturally pleased (as am I) with the fund’s fifth consecutive year of outperformance and making a strong personal pitch for the merits of Brexit. It is worth revisiting his comments on the popular notion that so-called “bond proxies” – global companies that have stable earnings and strong business models – are overvalued. You can read them in the Fundsmith Equity Fund Annual letter (pdf). Note also his analysis of how the companies he owns in the fund would look if their results were reported as an ordinary listed company would do.

He also revealed this week the name of the two new companies in which Fundsmith has been building a position. These turn out to be IDEXX, a US veterinary diagnostics business, and the delightfully monikered J.M Smucker, another US consumer staples business. It makes peanut butter and jam, among other things. The company slogan is “With a name like Smucker’s, it has to be good”. In recent years its share price performance has been just that, but on conventional analysis the shares look expensive at 38 times earnings. It will be a good test of the Fundsmith thesis that quality always pays off in the end.

What if we get higher interest rates?

19th February 2016

On 19 February I took time out to talk to Professor Elroy Dimson of the Judge Business School at Cambridge University about the latest edition of the authoritative Global Investment Returns Yearbook which he and two other prominent academics, Paul Marsh and Mike Staunton, produce at this point in the calendar each year.

You can read my summary of this year’s findings, and/or download the full report yourself, here. To listen to my podcast conversation with Professor Dimson on what changes in interest rates changes mean for equities, bonds and other asset classes, simply follow the link below. This is the first of a regular series of podcasts you can access as a Money Makers subscriber.

What if interest rates go up?

16th February 2016

The annual review of global investment returns produced by Professors Dimson, Marsh and Staunton for Credit Suisse is a must-read chunky publication for professional investors, providing as it does a comprehensive series of long return asset class returns and topical analysis of their past and future potential performance.

This year’s theme is the way that asset class returns vary depending on whether we are in an environment of rising or falling interest rates. With the Federal Reserve, the US central bank, raising US interest rates for the first time in seven years in December, this obviously has important implications if – and it is a big if – the Fed’s action is the first step in a process of monetary policy normalisation.

As it happens, the sharp negative market reaction to the Fed’s first tiny step last month has led to speculation that the interest rate rise could be very short-lived. With other central banks around the world easing rather than tightening their monetary policy, it is unlikely to be followed any time soon elsewhere in the world, as some had started to expect. The UK has put its rate hike plans on hold while the central banks in both Europe (predictably) and Japan (more surprisingly) have loosened policy even further since the start of the year.

Nevertheless it is well worth studying the analysis that the three academics, originally all from London Business School, report on in their latest annual review. Subscribers to Money Makers can study the findings in detail for themselves by following this link to a pdf version of the yearbook (generously provided by Prof Dimson, who is a longstanding contact of mine). Here I concentrate on a few key points.

Higher interest rates impact all asset classes

The broad assumption that most investors make is that rising interest rates are positive for equities and negative for bonds, and the historical analysis in the yearbook amply bears this out. Thus for example in the United States equities have provided a 9.3% annualised real rate of return during easing cycles, but only 2.3% during hiking phases. The results are broadly similar for the UK (8.2% and 1.7% respectively). For bonds easing periods have produced 3.3% pre annum higher real rates of return than hiking periods in the US (although, somewhat strangely, in the UK there is next to no difference on this one measure).

The chart below summarises some other key differences, with easing periods marked in blue, hiking periods in turquoise and the overall averages in green. The yearbook data on which this analysis is based goes back to the start of the twentieth century, although it is noteworthy that the effects have been similar even if you exclude the period before 1950, when monetary conditions and policies were very different. Reliable data for other countries does not go as far back as it does for the US and the UK, but the impact of interest rates is generally even more marked in other parts of the world, the professors find.

Looking more widely at some other popular asset classes, some are clearly more sensitive to interest rates than others, as the chart below illustrates. What it shows are the differences in annualised rates of returns on 11 different asset classes over two-year periods when rates are clearly rising and similar periods when they are falling. In all cases periods of falling rates produce higher returns than those when rates are rising. As you would expect gold and silver are among the most sensitive to changes in the cost of money, while farmland and other types of property are more immune.

The impact on investment styles

The academics also take a look at the effect that different phases in the interest rate cycle have on industries and investment styles. So for example they find that there is clear evidence of a “systematic relationship between the performance [of different industries] in tightening and easy cycles”. Utilities, telecoms, energy, capital equipment and healthcare companies produce good returns when rates are rising, but worse – and typically negative – ones when the reverse is the case. Retail, financial, consumer durable and listed property stocks on the other hand are affected in a diametrically different way, generally doing poorly when rates are rising and well when they are not.

Just as important for practical purposes is the evidence the professors uncover on the behaviour of investment styles. Analysing their database, Dimson, Marsh and Staunton find that the returns to a value or income style of investing do better when interest rates are falling, though still remain positive when interest rates are rising. The behaviour of small and large cap companies reverses altogether however, with the well-established phenomenon of the “small cap premium” (the tendency of smaller companies to deliver higher returns even after adjusting for risk) disappearing altogether during periods of rising interest rates.

These are all important things to bear in mind when thinking ahead with your investment strategy. The point about small cap is particularly important, given how strongly smaller companies have performed, in both relative and absolute terms, since the turn of the century. If we are in for a period of higher interest rates, the small cap dominance is likely to reverse, making it sensible to lock in some of the gains that you will have had from smaller company funds and rotating into large cap ones.

Are we at a turning point now?

The one thing that historical analysis cannot tell us, sadly, is whether sustained periods of changing future interest rates are coming or not. At the time that investors first see a cut or hike in rates, it remains unclear whether the trend will persist (as indeed is the case now). For what it is worth, the academics find that the average hiking cycle lasts just under two years and includes four rate rises, while the average easing cycle lasts just over two years with more than four rate cuts. There have been seven occasions however when a hiking cycle by the Federal Reserve consisted of just one increase in interest rates.

Will the Federal Reserve suffer the same fate this time round? There are many in the markets who think so, although my view is that we need to look beyond the initial period of turbulence before rushing to judgement. The key point for me is that studying historical analysis, as with so much of investing, enables you to use past experience to make sure you are prepared for whatever comes next. If we are about to enter a hiking cycle (which will in any event come to pass eventually, even if it does not start today), you should by then be better prepared to know what to do.

You can listen to my podcast interview with Elroy Dimson elsewhere on the Money Makers site.

Main image © http://istockphoto.com

[printfriendly]

Savers are right in the firing line

28th January 2016

The quarterly investment reviews from Jonathan Ruffer, the founder of the wealth management firm Ruffer, are always required reading, the language being as colourful as the content. The latest review, which focuses on the threat to savers from government policy, both in the UK and around the world, is no exception. He starts by noting the Chancellor’s recent moves to compromise the income of savers, with the assault on buy-to-let, higher taxes on dividend income for the wealthy and ultra-low interest rates.

Here is an extract.

The result is grim news for the saver – a sharp reduction in income, and what is left has been hit with higher tax charges. We await the last boot to fall (this attack is from Cerberus: three heads, three boots). Many investment strategies have sought out higher yield assets – and we are seeing the income from them collapse.

The big oil companies are still undecided about their dividend policies, but just before Christmas, the mining giant BHP, indicated that the dividend was being passed – what signal does this give Rio Tinto, whose outlook is similarly clouded? How about the drugs businesses, Glaxo and the like, as their blockbusting drugs go off–patent?

In the fixed interest market, the high yield sector has at last come to its senses, and is now pricing in the certainty of defaults. It is interesting to go back to the days before the cult of the equity, when nearly everyone thought only in terms of yield, and wanted the contractual comfort of a fixed interest investment, not the blue–sky possibility of a capital gain in the equity of a new business – the latter tended to be owned by the founding families.

Seen through the eyes of most of the last two hundred years, what is unfolding is something extreme; not the sort of thing that Conservative governments do when they fancy themselves radical. It is a conscious decision to compromise returns on savings – an attack, although obscured by the concomitant rise in capital values, which is the first step in the recalibration (downwards) of the savings of the country’s citizens. Let us be unsurprised when the more conventional enemy of savings – inflation – is deployed.

It is important, Ruffer goes on, to understand why a Conservative government is “pursuing a policy so little different in its effect to that of Lenin and the many socialist extremists who have followed on”. His argument is that higher inflation is the only acceptable way to head off the powerful forces of deflation. “While the Pitekkys and Lenins want to the rich to suffer, the government apply these measures for medicinal purposes – the necessary steps to rebalance the wealth from creditors to debtors, without the caesura of default”.

He ends with a bold prediction that 2016 will be the year when this policy finally breaks into the open – meaning, I think, that as the measures to confront deflation prove ever less effective, the underlying inflationary objective will become both more public and more visible to all. That in turn will, by implication, be pretty bad news for the prices of risk assets. If he is right, it bodes ill for equities in general, and small cap in particular, while in the fixed interest market “the high yield market has at last come to its senses, and is now pricing in the certainty of defaults”.

Given these views, and its absolute return objectives, it is not surprising that Ruffer’s investment strategy has been defensive for some time now –and taking a purist view of performance, too early to have been so. Ruffer portfolios are designed to offer protection against both inflation and deflation, with a hefty dose of index-linked and an above average holding in Japanese equities.

Shares in its quoted investment trust, the Ruffer Investment Company, which typically trade at a significant premium, have fallen over the course of the past 12 months – a disappointing outcome. Thanks to its success in navigating the global financial crisis in 2008, however the ten-year returns remain both positive and ahead even of the average trust in the global sector, as well as the cautious model of financial advisers (line C in the chart). If you buy Ruffer’s thesis, you won’t want to sell them now. As a holder of the shares (alongside a number of more risk-on funds), I certainly take that view.

Source: FE Trustnet

Main image © http://istockphoto.com

[printfriendly]

Fund manager sentiment is changing

26th January 2016

Here is a short extract from the latest market commentary by John Chatfeild Roberts, who runs the successful multi-manager team at Jupiter Asset Management.

The start of the New Year is of course a traditional time to take stock of the situation and make resolutions for the coming year. Unfortunately what many investors resolved to do when they got back to their desks in January was “sell, sell, sell”. The early weeks of 2016 have been a difficult time in global stock markets, with the UK market down 5.8%, the US down 6.6% and Europe down 7.4%. [1]

So what changed? Well, in reality very little except perception. Evidence of this can be seen by the market rise triggered by comments from Mario Draghi, president of the European Central Bank, that he may possibly reconsider current monetary policy and provide further stimulus to the eurozone economy. If such comments can trigger sudden price moves it tells you that markets are acting more on feelings than facts.

Is that right? There is another way of making the same point. This chart is from Bank of America Merrill Lynch’s regular survey of global fund manager expectations, which has been running for many years and remains a useful, if sometimes contrarian, indicator of how market sentiment is moving. The chart plots the percentage of fund managers who think we are the early, middle or late stages of the economic cycle (the final option being recession).

As you can see there has been a significant change in mood over the course of the last year, with the number of those saying we are in the late stages of the cycle poised to overtake those who think that we are still in mid-cycle. I think this goes some way to explaining why professional investors have been so nervous going into the New Year, sparking a wave of selling in the face of several well-documented but as yet not fully materialised risks – China’s slowdown, bankruptcies in the oil and gas sector and fallout from the Federal Reserve’s interest rate rise.

It is worth noting however the three most recent times when the two lines crossed over. Two were in 2011 and 2012, when the ongoing crisis over Greece threatened the collapse of the Eurozone and a new debt meltdown seemed a very real possibility. Expectations promptly reversed themselves as the risk of crisis receded. The third crossover happened in 2005 when although the number of late cycle adherents continued to rise, the bull market still had 18 months or so to run. Which way will the trend go from here?

Experience suggests that it is futile to expect professional investors to predict a new recession until the last minute (and the chart confirms this). But the recent shift in sentiment is consistent with the idea that the later stages of a bull market are often the hardest to navigate, as valuations become expensive by historical standards, but the markets are still going up, often with heightened volatility. Although we certainly cannot rule out further market weakness, we could be entering just such a period today.

[printfriendly]

Should one take Soros to heart?

23rd January 2016

I thought the best comment on last week’s World Economic Forum came from the historian Niall Ferguson, who aptly summarised why so many powerful and power-needy folk feel the need to wend their way to the Davos get together every year. In addition to opportunities to network and do deals, he argued, Davos offers a third motivation for those who are there: “to establish, by comparing notes all day and all night, an elite consensus – a set of views that for the rest of the year will ensure that one doesn’t say anything too ludicrous.”

For prominent public figures, most of who know that year-ahead predictions have little real value, this is clearly a useful function. Alas, the “prevailing consensus” at Davos is, as Prof Ferguson notes, often wildly misplaced. Things rarely turn out the way that the so-called elite expect. Their corridor chats reinforce their faith in the rightness of their views, but rarely convince anyone else. I can remember the year that emerging markets were all the rage, just as emerging markets were about to enter their recent four-year history of weakness.

But should investors also take note of the warnings that high profile speakers from the investment world also tend to deliver at these events? Warren Buffett aside, there is no bigger name in the investment business than George Soros – and it was he who made as gloomy a prognosis at Davos about the outlook for investors as I have heard this year (and there is no shortage of competition for that dubious honour).

Soros in effect predicted that China was set to inflict a rerun of the 2008 financial crisis on the world, thanks largely to an out of control explosion in debt which threatens to bring the economy grinding to a halt, while adding to the deflationary forces already affecting the rest of the world. Here is an extract from the Bloomberg report.

“It’s one of the sources of deflation,” Soros said [about China]. “You’ve got basically three major root causes. One is China, the other is oil and raw material prices, and the third is competitive devaluation,” he added. “You have all three.”

Deflation is a hot topic at Davos. Billionaire hedge fund manager Ray Dalio mentioned it in an interview on Wednesday: “I think the Chinese situation with the currency is very important – very important. If there is significant currency weakness for the Yuan that will mean more imported deflation and it will make things more difficult.”

Soros said that it has been 80 years since the world last faced a deflationary environment, and the world doesn’t know how to handle it: “None of us lived in that environment. Last time we had that was [in the] 1930s. While I was around then, I was not engaged in the markets. We just don’t know how to handle it. It’s a different environment. Now we have to face it.”

You can listen to his Bloomberg TV interview here. As Prof Ferguson says, it all sounds horribly plausible – but how seriously should we be taking it as a guide to the investment outlook? Mr Soros is one of the most successful investors of the last 30 years, having generated an annualised return of 30% per annum over a period of many years, so it would be stupid not to take note of his comments. Remember however that by his own admission the outsize returns he made were in good part attributable to his use of gearing and a tolerance for risk that most investors would be unwilling or unable to replicate even if they had the necessary skills and temperament.

Like Prof Ferguson, I can think of two other reasons for being cautious about taking his predictions too closely to heart, at least at this stage. One is that, after 30 years of following his sayings, I have never found Mr Soros’ public pronouncements that useful as guide to future market direction. Global macro traders, of whom he was once a prime example, change positions very quickly and frequently – by the time you get to read about what their thinking is, they may well have already done a 180 degree turn.

More important however is that Mr Soros, who is now in his 80s, is no longer actively manging money professionally. His primary role these days is as a political and social activist, one who is determined to use the power and influence which his success gives him to achieve political change at the highest level, particularly in Europe. One of his primary objectives is to try and save Eastern Europe from Russian interference and aggression, another to persuade Mrs Merkel to ease up on the hounding of the Eurozone periphery over debt.

That is not to say that the major risks he sees – such as a “hard landing” for China being “practically inevitable” – aren’t for real. They may well come home to bite in due course. A lot depends on how the Chinese authorities handle the debt and currency issue. They can handle it, Soros says, but the cost will be felt in the rest of the world. Will central banks then try to print more money to escape from the fallout? We don’t know.

The other question for investors is how soon any of this happens. The more risk averse you are, the more seriously it will pay to take these warnings as the market cycle plays its way through. My view is that the only way to play these tricky periods is to set yourself some hypotheses about how the markets might behave and follow the technical behaviour of the markets very closely, looking for confirmation or otherwise of those assumptions – which is pretty much how Soros himself went about his trading activities in his glory days. Short term that means it is important for the leading market indices to hold around the lows they set last August.

[printfriendly]

The worst start to a year anyone can remember

21st January 2016

The brutal sell-off in equity markets around the world has continued well into its third week, making this easily the worst start to a year that anyone, including any number of dusty-haired statisticians, can remember.

Personally I have to admit to rather liking these hairy periods in markets, as they invariably create buying opportunities for those who are willing to look and have no pressing reason to sell. This is particularly true if you favour investment trusts, as I do, since you can often find discounts widening to attractive levels in times of turbulence. A good example came 18 months ago when shares in the Lindsell Train investment trust, a company that I had been looking to buy into for years, suddenly fell to a discount after years of trading at a substantial premium (which they do again today). Since I managed to get in on that happy day, the shares have comfortably outperformed everything else in the general global sector.

Are there any such tempting opportunities today? It seems that the answer is “not so many”. Partly that reflects the fact that valuations generally have been driven to high levels by years of QE and cheap money. Another reason is that more investment trusts than before now employ discount control mechanisms, which limits the scope for egregious bargains. Even so, the average discount (the dashed line in the chart below) has come in a long way as the bull market has progressed since 2009 and is now close to its highest level for a long time, a sign of the bull market’s maturity. Nevertheless, after such a dismal performance by the major indices since the start of January, it is disappointing not to find more glaringly obvious steals out there.

Source: J.P.Morgan Cazenove

Scanning through the latest prices, some names do still stand out. Murray International, for example, managed by the canny and soft-spoken Dundonian, Bruce Stout, has been trading at a premium for so long that it has been able to issue a mountain of new shares, doubling the issued share capital over five years. It now trades at a discount for the first time in ages, thanks in part to its hefty exposure to emerging markets and the manager’s uncompromising commitment to being paid for what he owns, in the shape of securely covered dividends from globally competitive businesses. Murray International (MYI) now yields more than 6.0% and is on a discount of a trifle over 4%, a level not seen in years. It may go wider still, of course, until the emerging market story improves, but looks a good bet for the SIPP or any other long term portfolio.

For those of a more nervous disposition, looking to batten down the hatches against tougher economic times ahead, it may also be worth taking a look at Capital Gearing Trust (CGT), a specialist trust that has rarely featured on any broker’s buy list, being both very closely held and almost invariably trading at a premium. These days you can however pick up some shares at around net asset value for the first time. This is not primarily because of the performance of the trust, which has been outstanding over almost its entire three-decade history, but is the result of a conscious decision by the board last summer to introduce a discount control mechanism for the first time since a then junior Cazenove partner, Peter Spiller, took up the running of the trust more than 30 years ago.

The objective of the policy, unusually, is not to so much to narrow the discount as to eliminate the premium and broaden liquidity in the stock, which has always been very narrow. Mr Spiller continues to run the fund, despite stepping down from the board last year, but at some point will no doubt be looking to realise some of his substantial investment in the trust, as will others of those who have backed him from the beginning. The shares have also not been this cheap since 2008 and being stuffed full of defensive assets (40% of the portfolio is in index-linked and cash, reflecting Mr Spiller’s gloomy global outlook and distaste for current market valuations) offer powerful portfolio ballast for anyone with an adventurous asset allocation which they are now regretting. (In the interests of disclosure, both CGT and MYI are core components of the Money Makers model investment trust portfolio, as well as among my personal holdings).

Are really on the cusp of a new bear market, to compare in scale to those of 2000-03 and 2007-09? History is clear that we would need a recession to bring that about and the evidence that one is coming is not yet compelling, although it is easy enough to make the case, as many of the investment banks have been doing. The second down-leg in oil prices is certainly a potential concern as oil below $30 a barrel brings the health of the banks that financed the shale boom firmly into the spotlight for the first time. Bad bear markets are invariably accompanied, and in some cases triggered, by problems in the debt markets. The technical behaviour of the equity markets also worries me. Short term it is clearly oversold (see the RSI below). But from a wider perspective not only has market breadth (that is the proportion of stocks that are falling as a percentage of the number that are rising) fallen quite sharply, but there have been successive “lower lows” since the market peaked at the start of last year. That is consistent with the post-2009 bull market starting to “roll over” into something worse. These are warning signs that need monitoring.

The important message for investors in times of disruption in the markets however is not to forget thinking about what they could be buying, not just what they might be tempted into selling. The worse the headlines, the better the opportunities are likely to be, and if you are too busy panicking about the sea of red on the screens, you are bound to miss the best ones, ensuring maximum future regret. As James Henderson, a fund manager whose experience goes back as far as the 1990-91 recession (which was a very nasty one), notes in our latest Q&A, unless you are feeling uncomfortable about buying something in these kind of conditions, the chances are that you aren’t making a good decision. Bargains should always feel uncomfortable at the time you are making them, just as selling good stocks before they peak should be painful too. It is what being a value investor is all about and why those who practise a value discipline so often look pinched and drawn as they go about their business.

In Henderson’s case he has been slowly and patiently starting to build new positions in Glencore, Rio-Tinto and Anglo American, the most hated and battle-scarred stocks in the upper reaches of the UK market. He is looking through the current meltdown to their future dividend-paying capacity (only Rio of the three has not announced a cut in its dividend so far). When the miners do eventually bounce, it is sure to be a sharp move. Rio-Tinto in particular is a great company that won’t be going out of business whatever happens, even if it does eventually cut its pay-out. The commodities bust is probably approaching its final capitulation phase. Buying Glencore is another matter as far as I am concerned, sitting as it does on what another veteran fund manager of my acquaintance likes to call his OMDB list – stocks that can be bought only “Over My Dead Body”. Without the career risk of straying too far from the benchmarks on which professional fund managers’ livelihod depends, private investors can afford to be choosy in this way.

Jonathan Davis

An important insight from hedge fund land

20th January 2016

If you think that market commentators in general are sounding somewhat cautious, you should try reading the farewell thoughts of Martin Taylor, a hedge fund manager who announced a little while ago that he is shutting down his hugely successful hedge fund Nevsky Capital because, in his words, he can no longer see a way to make money in today’s overblown market conditions. After generating an impressive compound return of 18.4% per annum from his fund since the year 2000, he has announced he has had enough and is retiring to spend more time with his accumulated riches.

A rather dramatic way to announce that you are bearish, you are thinking? Yes, but it is not that uncommon in the hedge fund world, where investors are notoriously quick to punish any fund which fails to deliver impressive short term results. As it happens Mr Taylor is one of the few hedge fund managers who has unquestionably earned his corn over the last 20 years, although much of the reward in early years came at a time when he was still investing primarily in more obscure Eastern Europe markets, where inefficiencies abound and the potential risks and rewards to active investors are both commensurately higher.

For the last two years his fund has made no money at all, although he did take time out, surprisingly perhaps, to pledge a lot of money to the Labour party ahead of the last general election. But don’t hold that against him. He has plenty of interesting to things to say about the way that financial markets behave has changed since the global financial crisis. Among others he mentions: the impact of high frequency trading, the reduced liquidity in many market sectors (following tighter bank regulation) and ever less reliable statistics (from governments) and earnings numbers (from companies). He too is worried about the deflationary threat that a combination of technological change, China’s slowing economy, the maturing business cycle in the United States and currency spats are creating.

He notes for example that if the participation rate of the US employment market had not declined as fast as it has in the last few years, the unemployment rate would still be 8.7%, instead of its current ultra-low (by historical standards) 5.0%. The Fed would not be thinking about interest rate rises if the participation rate was still the same as it was in 2008. Companies meanwhile have squeezed so much out of their costs since 2008 and with revenues falling and wages starting to pick up, their record profit margins look vulnerable – being held up only by increasing usage of debt.

His conclusion is not as simple as saying that equity markets have to fall, but is a somewhat more nuanced warning that the potential outcomes have become awkwardly (or rather dangerously) binary. China and the US hold the key to what comes next. In his words:

Intriguingly though, these problems do not preclude material upside to markets from here. The balance of risks suggests markets will go down, but the current record high global savings rate, in combination with QE from the ECB and BoJ, means developed markets could yet experience the kind of late cycle liquidity bubble – again centred on tech that temporarily ‘blew the roof off’ normal valuation criteria in 1999-2000. Likewise the very stresses that China is under could result in the government there eventually choosing to eradicate the main representation of their problems – too much debt – via QE funded purchase and cancellation of NPLs from the banking sector. Were this to happen emerging market equities, which are massively under owned, would soar overnight as the quality, duration and cost of capital associated with Chinese growth would be transformed for the better.

The problem with this potential dispersion of returns – majority logic saying that there will be a grinding downside, but with a not insignificant minority risk of sudden upside driven by global liquidity or Chinese policy – is that they are inherently contradictory with regard the investment conclusions they produce. Being bearish and going net short given the risk of unforeseeable sharp upside is not a sensible option, whilst being long given the growing risk of a bear market, is equally not palatable. Taking a middle path of no net exposure but a large gross is also not obvious given the rising event risks surrounding large individual stock positions described earlier in this newsletter. There is, quite simply, no answer that squares this particular circle.

Although you may have little interest in hedge funds, Mr Taylor’s farewell letter is well worth reading in full:

Nevsky Newsletter 151231

His point that the market outlook is becoming more binary in a world where reckless monetary experiments have become almost routine is worth bearing in mind as this year’s events unfold. I suspect it may become a recurring theme – but one that you are unlikely to hear much about from your friendly wealth manager or adviser, should you have one. Too unsettling.

Main image source: istockphoto.com

Martin Taylor photograph source: citywire