Investment spotlight: Back to the future

It has also driven bond yields to historically unknown low levels, and even has some central bankers questioning their role as political ‘fixers’ for governments.

Cash not economics

Today’s markets are a good illustration of the paradox that market activity is determined by cash flow rather than economic or political realities. The 20th century had sufficient crises to destroy all but the strongest and most resilient of investors, and the same is true today.

Values do not reflect the demographic decline of the developed world, nor spreading deflation, the descent of parts of the Middle East into the mediaeval barbarism of ISIL, nor the return of war to Europe itself and the breakup of, if not the EU itself, then probably the eurozone.

How should prudent investors prepare themselves for this uncertain future? All securities markets are overvalued, and earnings growth has stuttered over the past few years. Demand for goods is falling, even for consumer staples.

While deflation is currently a threat, the inflationary dangers stored up by quantitative easing (QE) have not disappeared. One day, but no one knows when or why, that reality will lead to a panic, and a sharp fall in prices.

Investing in dangerous zones

There is much to be learned from the attitude of the single capacity stockbrokers, destroyed by the Big Bang of the 1980s, after a century of successfully protecting the capital of Britain’s upper middle classes. These advisers understood that, while possible to identify value in stock markets, it was simply impossible to predict prices.

So they concentrated on investing for income and found that the growing income of an equity portfolio produced the capital gains needed by their clients, helping to offset the depredations both of inflation and tax. They knew instinctively what professors Dimson and Marsh of London Business School later proved by research – over any reasonable period, 90 per cent or so of capital growth comes from reinvested dividends.

So until the 1980s the typical private investor portfolio was a 30 per cent mix of fixed interest securities (often not gilts but preference shares or corporate debentures) and 70 per cent blue chip equities. Fixed interest yields were generally some 50 per cent more than equity yields, and the combination of the two gave an income return of 2-3 per cent more than current inflation. A portfolio would consist of some 15 to 20 different securities, as was considered the optimum level of diversification.

But equally the analysts were concerned about the capital risk involved in the equity holdings, and especially

-Valuation risk – were the shares too expensive?;

- Financing risk – was the company over-geared with debt?; and

- Franchise risk – how solid was the business model?

It was this combination of yield, diversification and prudence that kept investors safe through a very dangerous century.

The loss of skills

Those skills might still exist in some professional houses, but are no longer available to retail investors. It was not only the Big Bang that destroyed them but the inability of long-established and complacent stockbroking firms to appreciate the social changes that transformed Britain and led to Lady Thatcher. For the new rich, the simplicity of unit trusts – and insurance salesmen – offered access to a world of ‘instant wealth’.

The charging structure of unit trusts [and indeed pension funds] is bad for the investor but excellent for the adviser and manager, and was hidden from the view of the buyers by the supercharged and debt-propelled performance of equities from the 1970s onwards.

Those private stockbrokers carried personal liability for their actions, and so had to be concerned not with total assets under management, but preservation of client accounts.

The new style of investment management has no such built-in regulation, and its overriding concern is size not quality.

Managers, at any level, cannot afford to think of what is right for their clients, but only what will not endanger the volumes that they manage. And since 2000, this preference for size rather than quality in volatile markets has resulted in poor compounded returns. This is especially true of those ‘actively managed’ trusts that are in fact ‘closet trackers’ and the double and treble charging multi-asset funds.

The rediscovery of investment trusts

The advent of the RDR has turned the attention of some IFAs to investment trusts, and some of these retain the portfolio-making skills of the private stockbroker.

And the older foundations, going back to the 19th century, remain relatively cheap options for investment management. An investment trust portfolio is complete in itself, both concentrated but also positioned for whatever market outcome both board and manager anticipate, or fear.

A fundamental difference between unit and investment trusts is that the latter are properly constituted companies quoted on the stock exchange. As such they have a board of directors that ought to set investment strategy, and a manager that executes it.

Common sense dictates that an investment trust board of middle ranking executives from a large financial conglomerate such as JP Morgan are less likely to be independent than those serving on the boards of independent trusts like Caledonia or Personal Assets, but the split of responsibilities exists legally – and trusts are increasingly being held to account by shareholders.

Information for all

And investment trusts can use revenue and capital reserves to smooth their dividend payouts. The AIC (Association of Investment Companies) website has details of some 16 trusts that have increased their dividends for at least the past 20 years, while a further list of those that have done this for the past 10 years will soon be issued. Indeed the AIC, together with Numis Securities ,are essential and free sites for all private investors concerned with understanding investment matters.

But it is less information that matters than attitude. If anything, today’s investors have too much information. Although much of it is meaningless, some is valuable – such as which boards show competence in identifying

an investment strategy and then overseeing its execution. This can only come from following progress through the annual accounts of the company. What is needed today is practical – not clever – management.

So overall, investors should forget most of the academic nonsense that drives professional managers and their products – such as efficient market hypothesis, Sharpe ratio, beta and smart beta – and concentrate on common sense. And the best source for that is Rudyard Kipling’s poem ‘The Gods of the Copy Book Headings’.

You should look it up.