As you may know from some other posts in the past, I am generally a buy and hold kind of investor who does not generally try to time the market. This is because timing the market is incredibly hard to do and I also prefer to allow time in the market and the power of dividends and compounding to work their magic. See a good piece from a useful website called 7 Circles for more on this.
However, with equity markets around the world flirting with all time highs as I write and with the US Federal reserve about to raise interest rates for a third time, I cannot help but start to feel a little nervous. This is compounded by the fact that US equity valuations in particular are looking somewhat stretched and towards the top of their range. Now while this in itself is not that helpful as a timing indicator, it does suggest however that returns from US equities may not be that great from this point. There was a good post discussing this in more detail which can be accessed by clicking the image below.
Thus given where Sterling has fallen to against the US Dollar I certainly would not be chasing US equities up here especially as the old saying goes - "don't fight the Fed." Nevertheless UK equities still look less stretched, but would not be immune to a shake out on Wall Street if the current rising rate cycle should lead to problems down the line.
Interestingly Neil Woodford put out a note pointing out the attraction of dividend yields in the UK Market and the benefits of taking a longer term view which reduces the risks of suffering losses, although he does have a new fund to sell - so he would say that wouldn't he? Nevertheless the article in the link above and an earlier piece a colleague of his did called - Are UK Equities Overvalued? - are both worth a look. In particular the second one suggests that the UK could offer 8% real returns based on its current valuation, but does caution that this could be undershot as it has been in recent decades. Interestingly Research Affiliates 10 Year Expected Returns analysis shown above also seems to confirm this and suggests you should probably invest anywhere except the US.
If you are taken by his arguments and evidence of the benefits of investing for the long term, then his new fund, the CF Woodford Income Focus Fund, will be available for investment from 20th March 2017, with the launch period closing at midday on 12th April 2017. Alternatively if you want to go your own way and do it yourself to save the fees, then don't forget the Compound Income Scores are available to help you identify good value, quality growing dividend stocks for further research.
Summary & Conclusion
Another old saying is that the market climbs a wall of worry and it may be that I'm worrying prematurely about rising US interest rates plus the fact that while valuations can be a good indicator of future returns they are not very good as a timing indicator.
Talking of which the timing indicators that I follow like the trailing 10 month moving averages, US Unemployment and PMI data plus general economic news are all still generally supportive. Thus despite the high valuations in the US, given the current economic background and the reasonable valuations in the UK, I'm inclined to extend my time in the market further and carry on compounding my dividends.
Of course if the US does catch a cold then the rest of the world will probably get influenza and likely lead to some downside when and if that happens. However this would then likely throw up more opportunities and an even better entry point in terms of timing and valuations.
...about an Investment Trust based on the Dicken's story which is popular at this time of year. So without further ado here is the first part teaser of the ghost of Christmas past as it were. So as it is the festive season and as they say a picture paints a thousand words - I'll leave you today with a picture of the past of this Trust. Hopefully see you back here later this week for the present and the future installments if this has whetted your appetite?
... I thought was an appropriate title for this piece as we saw the launch this week of a new film version of Dad's Army in which no doubt the latest incarnation of Corporal Jones will utter his famous catch phrase. So what's that got to do with investing I can hear you thinking. Well the don't panic phrase is a good one to try and remember when we are experiencing volatile markets such as those seen this January and since equity markets, with the benefit of hindsight, topped out last spring / summer.
Now some readers may be younger than me and indeed you may have only got interested in the stock market in recent years when it seemed like it only ever went up. While some will be older than me and have seen it all before no doubt. But it is worth remembering that equity markets only go up about 60% of the time and in a bear market which is defined as a 20% drop from a top, they can and do go down by 30% to 50% or more as we saw as recently as 2008/9. In extreme cases when certain markets are unwinding from bubble conditions they can and do usually fall by around 80% or more from the peak - think .com stocks back in the early 2000's for a recent example of that.
Having said all that investing in equities for the long term (10 to 20 years) has in the past delivered decent real (after inflation) returns in the region of 5 to 6% per annum which is always worth remembering, but whether you achieve these returns is largely dictated by the price or rating you pay at the outset. Swings in ratings both up and down help to drive secular bull and bear periods in markets which seem to have lasted on average around 17 to 18 years. It seems to me that having had a 17 year or so re-rating which peaked out in 2000 with the .com bubble, we have remained since then in a secular bear market as the FTSE has failed to make a decisive break into new high ground. This has not however precluded big swings a profitable period within that along the way, which is also in common with history. Any way if you want to read more about the theory of these long cycles I would recommend a book Stock Cycles by By Michael J. Alexander - as featured in my Resources list of recommended books and other useful things. Included on there is a link to Crestmont Research - which is really useful resource for swatting up on market ratings history and secular bull and bear markets.
Aside from that I read a good piece on AAII.com recently which included some useful thoughts on a more rational approach to portfolio valuation. This basically talks about thinking like an owner as Warren Buffet talks about and having in mind a fair PE rating for the stocks you own. It suggests you then compare the rating that Mr Market is putting on your stocks and decide whether that is under or over valued and act accordingly rather than being influenced by noisy share price movements along the way. Seem quite sensible to me and well worth a read if you have been panicking about recent price moves on stocks in your portfolio.
Now for me the other longer term thing I focus on, as you know, is the income you can get from the dividends and compounding those. In a similar way to the article above, by focussing on these and what you think might be a fair or minimum yield you would expect on your stocks, you can also take a longer term perspective. Indeed it is also noticeable that in the past, although no guarantees for the future, that dividends have tended to hold up a lot better than prices during bear markets. This was evidence most recently in the 2008/9 bear market and subsequently when the UK stock market fell by around 50% but according to data from Capita (see page 6 of report) total dividend payments only fell by 14.3% between 2008 and 2010. They have since 2010 gone onto rise by 49% which represents an exceptional rate of growth of 8.3% per annum over the five years since then. I say exceptional as in the long run real dividends have tended to grow by more like 1 to 2% in real terms and indeed if you look at all the data in the Capita report on page 6 and include their forecast of a small fall in dividends for this year then the growth rate over the whole 9 years is likely to be closer to 3.5% per annum which in real terms will be closer to the long run average.
On the subject of dividends and their volatility versus the market prices there was an interesting look at the history of this in the US at A wealth of common sense - called The Incredible growing dividend. Now while this was US based data it did help to highlight why I like to focus on growing dividends and compounding them over time. Further to that there was an update last year to research from the value house Brandes Institute called: Income as the Source of Long Term Returns. This looked at the importance of dividends in the long term, the dividend yield gap versus bonds and also the stability of dividends in the longer term. Indeed they found that the volatility of the dividend streams themselves was a very small fraction (under one-twentieth) of the volatility of stock price movements.
From this report I particularly liked the lessons from the following extracts:
The message in Exhibit 7 is clear: higher dividend-paying stocks delivered higher total returns. While this was partly due to the dividend return, it is also notable that on a price-only basis, the top three quintiles of dividend-paying stocks had higher price and total returns than quintiles 4 and 5, as well as the non-dividend-paying stocks.
We have stressed the long-term nature of this research. However, many investors still have concerns over short-term price volatility. Did a focus on higher yielding stocks cause exposure to extreme stock price fluctuations? Again, the answer from our research is “No.” In Exhibit 8, we look at volatility of both stock prices and dividends within the quintile universe. Volatility of stock price returns was lowest for the highest dividend yield stocks, and increased steadily as dividend yields declined. So investors in the top quintiles received both higher returns (Exhibit 7) and lower volatility (Exhibit 8). My emphasis on the last bit there as that is as close to investing Nirvana as you can get I would say. I would also highlight that they also observed:
We have long held that paying excessive attention to short-term price movements is a behavioural error that can lead investors to make bad investment decisions. The data in this research suggests that investors might do much better to focus on their portfolio’s income stream as it develops over time. Exhibit 8 shows that the volatility of that dividend income stream was a very small fraction (under one-twentieth) of the volatility of stock price movements. To the extent that volatility causes investors to worry, switching attention from price volatility to dividend volatility might ease that worry substantially.
Summary & Conclusion
So definitely worth focussing on the income and thinking long term to avoid worrying about short term market volatility and making behavioural errors as a result I would say. Having said that though in the short term it is worth bearing in mind the Capita forecasts and the suggestions of others that dividends are more vulnerable now as levels of cover in the UK have been run down to low levels, so I suspect the outlook for dividend growth from the market overall may not be as good going forward in the short term, but do try and think long term and don't panic.
This is especially obvious in the UK given the concentration in income from the top 5 stocks which represent 33% of the income while the top 15 represent over 50%. As the top 5 all have question marks over the sustainability of their dividends, this is worth bearing in mind if you are investing in tracker funds.
That's why I prefer to invest and seek out companies able to grow their dividends in a diversified fashion so my income is not dependant to a large extent on a handful of companies and should therefore give me a growing income stream to live off of and compound over the long term as hopefully I might have another 20 to 30 years on this planet if I'm lucky. Or as the Brandes Institute put it:
We believe this research illustrates that the industry acceptance of five years as a long-term investment horizon underestimates the potential of reinvesting and compounding income. By reinvesting the income contribution of investment returns, investors can leverage the power of compound interest. Investors should not let recent market experience distort their perspective, and particularly should avoid preconceptions that income is less important than capital gains in its contribution to total equity returns. Income has served as a significant component of returns, and the combination of reinvested income and capital appreciation historically has presented the best option for long-term investors to realize optimal returns.
Cheers have a great weekend, whatever you are up to. Finally to bring the post to a close and to bring it back full circle to the title - as it is the weekend and it has been a while since I inflicted any music on you - here's a song from a new band The Brothers Osbourne called - Stay a little longer which seems appropriate in the context of this post.
Can be demonstrated by listening to Lord Lee. He is the famous FT columnist who was apparently one of the first to become an ISA Millionaire in 2003. You can listen to him give an update in this FT Money Show Podcast in which he reveals that his portfolio is now apparently worth £4.5m.
Interestingly £1m to £4.5m over 12 years from 2003 represents a reasonable but achievable 13.4% per annum by my reckoning, so maybe this can be an encouragement to everyone to make the most of their ISA allowances and let compounding work its magic.
Apparently there was also an article based on this in this weekends FT, although I didn't see that and can't find it on line so if any reader has a link or knows where to find it perhaps they could be so kind as to add it in the comments, cheers and don't forget to Compound that income.
Well the reason I couldn't find the article is because it was in today's FT not last weekends.
Having read it, it seems he did put a bit more capital in after 2003 which would make the compound return a little lower than the one I calculated above. It also included details of his current holdings and an extract from his book, How to make a million slowly, of his 12 Golden Rules.
So it is quite an interesting article and you should be able to read it on line here, although you may have to sign up as a user to access a limited number of stories for free each month, if you are not already a subscriber.
...the sage of Omaha as he is known and as you probably know - Warren Buffet. This comes from his annual letter to shareholders in his company, Berkshire Hathaway, the latest of which was published this weekend. There is quite a lot in it and I attach a copy at the end of this post if you want to read it in more detail. However, one section which I thought provided the sound advice dealt with returns from investing in equities and peoples perceptions of risk. It was so good I think it is worth highlighting verbatim.
Extract from Berkshire Hathaway Shareholder letter 2014:
Our investment results have been helped by a terrific tailwind. During the 1964-2014 period, the S&P 500
rose from 84 to 2,059, which, with reinvested dividends, generated the overall return of 11,196% shown on page 2.
Concurrently, the purchasing power of the dollar declined a staggering 87%. That decrease means that it now takes
$1 to buy what could be bought for 13¢ in 1965 (as measured by the Consumer Price Index).
There is an important message for investors in that disparate performance between stocks and dollars.
Think back to our 2011 annual report, in which we defined investing as “the transfer to others of purchasing power
now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal
gains – in the future.”
The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far
safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for
example – whose values have been tied to American currency. That was also true in the preceding half-century, a
period including the Great Depression and two world wars. Investors should heed this history. To one degree or
another it is almost certain to be repeated during the next century.
Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however,
currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock
portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That
lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for
risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from
synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.
It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and
purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors – say,
investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell
securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds
should keep appropriate sums in Treasuries or insured bank deposits.
For the great majority of investors, however, who can – and should – invest with a multi-decade horizon,
quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing
power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less
risky than dollar-based securities.
If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may,
ironically, end up doing some very risky things. Recall, if you will, the pundits who six years ago bemoaned falling
stock prices and advised investing in “safe” Treasury bills or bank certificates of deposit. People who heeded this
sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement. (The
S&P 500 was then below 700; now it is about 2,100.) If not for their fear of meaningless price volatility, these
investors could have assured themselves of a good income for life by simply buying a very low-cost index fund
whose dividends would trend upward over the years and whose principal would grow as well (with many ups and
downs, to be sure).
Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active
trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees
to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of
equities would otherwise enjoy. Indeed, borrowed money has no place in the investor’s tool kit: Anything can
happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can
tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.
The commission of the investment sins listed above is not limited to “the little guy.” Huge institutional
investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits
tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn,
recommend high-fee managers. And that is a fool’s game.
There are a few investment managers, of course, who are very good – though in the short run, it’s difficult
to determine whether a great record is due to luck or talent. Most advisors, however, are far better at generating high
fees than they are at generating high returns. In truth, their core competence is salesmanship. Rather than listen to
their siren songs, investors – large and small – should instead read Jack Bogle’s The Little Book of Common Sense
Decades ago, Ben Graham pinpointed the blame for investment failure, using a quote from Shakespeare:
“The fault, dear Brutus, is not in our stars, but in ourselves.”
Summary & Conclusion
So some great advice there about the longer term benefits of owning a diversified share portfolio to protect your income and capital from the ravages of inflation over time. However to do this you need to be prepared to accept and embrace some extra volatility in your capital. He also talks about a portfolio acquired over time and owned in a manner which incurs only token fees and commissions. This should be the essence of a DIY portfolio and is certainly one I subscribe to along with utilizing tax free wrappers wherever possible to maximize your after tax returns.
I am fortunate in having the time, knowledge and inclination to devote to this and thereby save myself fees and commissions that I might otherwise pay to professionals to manage my money. For others who are perhaps time poor or don't have the inclination to devote the necessary time to running their own portfolio then Warren Buffet's advice is equally clear that you should probably use index funds to get your exposure so as to keep you costs and time commitment to a minimum. Setting up regular payments so you can automate the savings process before you spend the money would also seem to be a good way to stick with the programme through thick and thin.
Also if you are early in your investing journey then you should be hoping for more falls and bear markets so you can get the chance to accumulate more investments at cheaper valuations.