Simplicity vs complexity

Life-long returns

This is the relevance of a recent JP Morgan Cazenove analysis as to which investment trust Marty McFly (of Back to the Future) should have bought in 1985 had he had a copy of the Financial Times from 2015. Capital Gearing was the winner out of the 20 he might have chosen, with an annualised return of 13.65 per cent; it seems that Pete Spiller of Capital Gearing is today the most bearish of those 20 managers.

The Association of Investment Companies (AIC) has looked at the average investment trust results on the same basis of 30 years, using a £100 initial investment, and these are shown in the Table.

Why are these results so much better than the market as a whole, or even index-tracking instruments? Far too many investors and Isas have been brainwashed by the finance industry into believing that costs do not matter. They do. A quarter percent here, and another tenth there may seem small but in the world of compounding returns – and that is what investment is all about – they kill returns.

Even with the positive returns of the Table, a difference of 1.79 percentage points between the return on £100 invested in the UK All Companies sector, and the same investment into Global amounts to £1,329,or more than half of what was actually made in the less profitable sector.

With other forms of investment, which are not as able or willing to control dealing losses and costs as well as investment trusts, these can cripple returns. And with markets significantly overvalued, and returns expected to be low or even negative, the next 30 years are not the time to risk that.

Why so much better?

Investment trust companies have significant advantages over other investment structures. Most important of all, they can benefit from the positive advantages of compounding. Negative returns are very destructive of compounding; the 2009 fall of 50 per cent in one year required investors to double their money the following year just to get back to an even keel.

And investment trusts are corporate entities, with boards of directors conscious that investment management is a low-margin business, requiring strict adherence to cost-effective housekeeping. Directors have clear objectives, since their shareholders wish to see their income increase but not at the cost of permanent loss of capital. Companies can put aside profits in good years, through revenue and capital reserves, to enable dividends to be paid when times are tough.

The investment manager thus has clear tactical objectives. The job is to find and buy profitable companies at a sensible price, to hold them while that business remains profitable and dividends increase, and so keep switching and dealing costs low. Within these guidelines, boards and managers can agree an investment strategy – global, smaller companies, technology or whatever – with the board supervising the manager’s execution of the policy.

Investment trusts were developed to allow private investors to take on investment risk that was beyond their intellectual or financial capability, originally in the Netherlands during the 18th century and, most successfully, in the UK a century later.

They are still doing that today, with new trusts investing in such areas as infrastructure, peer-to-peer lending, renewable energy suppliers, and frontier markets.

Thirty years – before and after

The history of the past 30 years is evenly divided. The first 15 years until the technology bust of 2000 saw investors convinced that technology was the future while, at the same time, governments, regulators, and central bankers lost control of the banking industry. Money flowed like water, as bankers enjoyed new found freedoms, and investors took stock markets to never-seen-before price/earnings averages of 44x.

The next 15 years vainly attempted to replicate those glorious easy-money times, leading to the 2008 financial crash. Then central bankers introduced quantitative easing, both to keep stock markets high and kick start the real economy. The first objective worked, the second failed. These were not good years for investment instruments that could not control or ameliorate the workings of compound interest.

The one fundamental of share pricing is corporate earnings – what they are, what is their trend, and how solidly based are they for the future? On this criterion the current outlook is not promising. Corporate earnings need economic growth and that seems difficult to find. Some politicians talk of the ‘new normal’ while others speak of ‘a little local difficulty’ that will soon be resolved and economic growth resumed. But no one can be sure why world growth is now on a much slower trajectory.

The main drivers of economic growth are currently suspended – consumer demand because of the great overhang of private debt – and government demand because most governments face equally unpalatable levels of debt. Since no sane CEO invests unless he can see a growing market for the goods and services his company provides, business investment is also subdued.

Deflation and change

Meanwhile, economists and politicians argue as to what can be done, or should be done, to prevent the world economy going into a deflationary spiral, and business people face a terrifying and confusing cascade of technological changes, many of which threaten the viability of their business model.

Will the average investment trust keep investors as safe and prosperous over the next 30 years as it has since 1985? Almost certainly ‘yes’ is the answer, provided investors do not indulge themselves too much with some of the newer style strategies, and do not buy investment trusts at a premium. These never last, whatever brokers say, and patience is always rewarded by the ability to buy a favoured investment trust at net asset value or even lower.

The deflationary world of the 19th century did no harm to economic growth, since it was also allied to a dazzling display of industrial and commercial ingenuity.

This may well be the case for this century, since technological change has actually accelerated since the 2000 technology bust. But the AIC Table highlights another worthwhile lesson. Good managers benefit from the freedom of the total market, hence the success of the ‘all companies’ linked trusts, and the lagging of the ‘smaller companies’ specialists.

So, for a safe pension in 30 years time, control your enthusiasm for what type of company will prosper in what may well be very uncertain times. Otherwise, as Einstein famously warned, “compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it”.