Investment spotlight: Back to basics

Reality bites

So investors need to be aware that 2014 was one of the worst years on record for investment management. Not many more than 10 per cent of professional fund managers [whether retail or institutional] beat their benchmarks. There is no reason to believe that they will do better this year, because economically the world has changed since 2008, and that magic word ‘growth’ is now absent.

The credit boom that blew up in 2008 had persisted from at least 1980 and, by the time it came to an end, was some two or three times greater than that of the 1929 disaster. A simple parallel encapsulates the problem. In 1985 the average UK house cost just about £33,000; now it is worth £186,000 or more, but salaries and take-home pay have not risen by anything like the same fivefold extent.

Solving the over-indebtedness of the 1930s took 15 years and the Second World War. It also needed the activities of the two Roosevelt presidents (the legacy of Theodore and policies of Franklin D) to ensure that those who would spend money – the working and middle classes – had it to spend and so fuelled those post-war years of economic growth. This is no longer the case; even in America, the rich have collared all the technological growth of the past generation and few Americans now believe in the American dream – that their children will be better off than they themselves.

Avoiding the worst with QE

Politicians did learn something from the 1930s, probably due to the work of Irving Fisher, who had examined what happened after the credit downturns of 1837, 1873 and 1929. Quantitative easing (QE ) has avoided the potentially chaotic and deflationary impact that 2008 might have caused to asset prices, but has simply delayed the equally important deleveraging of private and government debt.

For the moment, governments hope that cheap money will restore economic growth, and that QE plus inflation will magic away the over-indebtedness. US recovery seems set fair, although how much of this is due to the fracking revolution is unclear, and the likely effects of the oil price war between OPEC and the US even more so. As for the rest of the Atlantic world, aging populations, falling productivity and high and embedded youth unemployment all suggest that economic growth is off the agenda for at least decade if not longer.

Investing in a changed world

It is very hard for individuals to change their minds, and almost impossible for large institutions. But this is what private investors must do if they are to protect and grow whatever savings they might have. Fortunately, they now have help as Gervais Williams, a successful fund manager, has just published a book called “The Future is Small”.

As an insider Williams has seen how the major investment professionals have absorbed the lessons of the credit boom to industrialise their activities, and brainwash their clients into believing that investment success is about transactions. Rather than concentrating on products and market share, cash generation and increased value of tangible assets, analysts began to predict not values but prices.

And from predicting prices, it was easy to suggest which shares to buy that, later, could be sold at higher prices, so creating capital gains for the investor. Since these generally had lower tax bills than dividend income, investors were charmed. While credit was expanding, and markets going up, this appeared to be a surefire strategy. But it did have problems, as Terry Smith explained to his Fundsmith investors.

Explaining why he never bought Tesco, the markets’ darling at the time, he showed that, while the earnings per share trend was impressive, he was more concerned with another figure. Cash generation within the company was going down, even while the dividend was going up, showing that Tesco was investing at less than its cost of capital. Believing market image rather than balance sheet figures cost Warren Buffett millions.

Splitting portfolios between large- and small-cap shares had been a classic way to achieve diversification within a national market. But as markets became increasingly international, a cheaper way to obtain diversification was to target different national markets, and especially the identification of ‘emerging markets’.

Moreover by concentrating on only those shares with high liquidity – to enable quick market execution –and of a certain minimum capitalisation size, these same benefits were obtained at a lower cost in terms of analyst time.

The purpose of investment

Capital gains have never been the purpose of investors, only of speculators, and there have always been fewer successes at this than market rumours supposed, or dealing platform advertisements suggest. Investors buy shares [or bonds] to purchase an annual income and, if the company does well and increases its dividends, then the value of that security is likely to rise in price to reflect that higher yield.

Intuitively we all think that small companies have better prospects than large companies; they are less bureaucratic, closer to the market, and with greater opportunity to grow. These may well be significant advantages in a slow- or no-growth world. Interestingly Williams shows that common beliefs about investment are wrong, not only over many decades but also over many markets.

The small company effect seems not to be an anomaly but a permanent part of the investment environment, producing returns several times greater than any other market return.

And far from liquidity being essential to success, it seems the opposite is true: illiquid shares have a premium value, especially if they reflect small companies of value or income type.

But ‘small’ is an elusive word, as Mr Williams demonstrates, and investors need to be sure what they are buying. Diverse Income Trust was classified by the Association of Investment Companies (AIC) as the best new investment trust, and is certainly one possible way of investing in this market.

Another is Caledonia Investment Trust, the family trust of the Cayzer shipping business with its four pools of quoted, private, income and growth company investments [See Numis.com]. The two trusts combined should enable private investors to look back over 2015 with some satisfaction.