We are seeing some companies return cash to shareholders in the form of capital returns. At the moment, however, cash is remaining very much on the balance sheet and this affects valuations.
Dividends are different; earnings drive them, and the companies that are most attractive strike the balance between payouts and using capital to invest in opportunities to grow those earnings.
The lack of confidence that companies are exhibiting, despite shoots of a recovery in the UK, presents investors with a conundrum. In recent years, monetary policies have served to stave off a global depression, but latterly, they have supported and stretched asset prices. From now on, some tougher decisions have to be made by politicians and central bankers alike, to move on to the next stage of the global economic recovery.
These political solutions may be harder to resolve and that does not make investing easy. The danger is that one becomes complacent in a world of cheap money. In order to avoid this, investors need to ask the following: are companies making sensible investment decisions; are their balance sheets appropriate? Given the right environment, one may even support greater leverage, if there is confidence in those decisions; however, more importantly, one must look at price. The future remains very uncertain, despite the ebullience of markets. We want to pay a price that is an insurance against the future, not dependent on it.
At this juncture, there have been strong movements ahead in the markets, as benign monetary conditions combine with positive economic data to push equities forward. This ideal scenario was fractured towards the end of May as some harsh realities returned to the forefront of investors’ minds. Greater concerns were raised with regard to the slowing rate of growth in China and the impact of any deceleration on the global economy. Public protests increased in peripheral Europe, as there was greater clamour against the policies of austerity. In America, the term ‘tapering’ gained traction in the economic lexicon, amid discussions regarding when to start decelerating the rate of asset purchases by the Federal Reserve.
While a value and risk-oriented style can act as a brake when markets move ahead strongly, investors must not be complacent. There are stresses in any market, and the argument is well rehearsed. I believe investors should have core holdings across the mid- and large-cap spectrum that exhibit strong “economic moats”, to coin Warren Buffett’s phrase, and therefore provide comfort through earnings that are visible and sustainable. Businesses such as Cineworld, GlaxoSmithKline, William Hill, and Lockheed Martin, generally speaking, have continued to create value for shareholders in the past six months. Tobacco also remains an important sector and while shares in companies like British American Tobacco, for example, are not as cheap as they once were, their cash flow is secure; over the longer term, the company should continue to buy back its own shares. By doing so, the share of future earnings (and therefore dividends) should increase.
As prices begin to reflect this quality, however, investors would do well to trim their holdings. Needless to say cash levels will increase as investment opportunities in rising markets are harder to come by. Value is regularly accompanied by some form of blemish – there is a reason why an asset is cheap – so there is a trade-off between price and business risk. Stock picking becomes ever more important, and it is this tension that should frame investment decisions. An example of this dynamic is Rio Tinto, where the share price is discounting very low returns into perpetuity. Its management is promoting a more disciplined approach to investment (although in the short term, there are capital expenditure requirements) and herein lies the opportunity. This is a cheap stock and should be considered an exercise in lower price risk compensating for higher business risk.
Share prices of companies such as Diageo, Dechra Pharmaceuticals, British American Tobacco and Unilever have been weak; however, yet again, this is price risk coming to the fore. Indeed, it is not necessarily a bad thing for some of the froth to come out of share prices. Keller Group, a pilings and foundations business, is a case in point. Shares in this company have almost quadrupled from their lows (they may even go higher). Had you held this stock, it would have rewarded you well, but a sell discipline is essential in any form of investing and once the profits are made, it is time to ‘fish’ in different waters.
From an economic and market perspective, further bouts of volatility are likely. Excitement is coming from concerted doses of quantitative easing, and there is the contradictory spectacle of equities selling-off on good economic data, lest the easy money drug is withdrawn. Furthermore, investors should bear in mind that the necessary steps have yet to be taken that would begin to deal with the many structural problems that will beset economies – long-term liabilities in the US such as Medicare, Medicaid, and social security obligations; mending the eurozone, if that is possible, and the shift towards private consumption in China.
Once more, there are risks and uncertainties in any world view; the trick is to try and balance those out in a portfolio that offers the potential for income growth and capital preservation.
Carl Stick is a fund manager of Rathbone Income Fund
Key points
■ Some companies are returning cash to shareholders in the form of capital returns.
■ Political solutions may be harder to resolve and that makes investing difficult.
■ Stock picking becomes ever more important and it is this tension that should frame investment decisions.
