Investment Newsletter December 2015
Rallying Around Mike Deverell Partner & Investment Manager
It’s now midway through December and so far there’s been no sign of a Santa Rally! The FTSE 100 ended November at 6,352 and at close on 11 December it was at 5,952. As has often been the case in the past year or so, the poor performance in the FTSE has been driven largely by falling commodity prices which in turn has hit mining and oil stocks. Oil, in particular, has fallen around 10% in the past few days and Brent Crude fell below $40 a barrel for the first time since the financial crisis. The slumping price came after the recent OPEC (Organisation of Petroleum Exporting Countries) meeting ended without any agreement to cut production. Whilst too much supply is one reason for the low price, especially after the shale revolution in the US, in our view it is only part of the picture.
Demand for oil has also slumped. This is partly due to long-term factors such as the switch to alternative energy sources, but it might also be telling us something about the health of the global economy. The FTSE also reacted badly to the European Central Bank (ECB) not increasing quantitative easing as many had expected. Meanwhile, in America, markets think there’s an 80% probability that interest rates will go up this week. All of this is causing plenty of market volatility and is a reason for caution. In essence, it’s a convoluted and not particularly pretty macro picture right now, and much of what affects the FTSE are these global issues rather than UK or company specific issues. Given the market drop we have carried out another of our “volatility trades”, purchasing an index tracker for
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter December 2015
typically around 3% of portfolios. For most clients we purchased this at just below 6,000 and will look to sell if the market recovers around 5%. However, as we’ve noted several times of late, the FTSE 100 is not necessarily representative of what is going on in the UK market as a whole. For example, in 2015 to date (1 January to 11 December) the top 100 index is down 5.94% even including dividends. Meanwhile, the FTSE 250 index of medium-sized companies is up 7.59% and the FTSE Small Cap (excluding investment trust) index is up 9.29%. Companies in this part of the market tend to have more domestic and less global exposure.
Dividend Cover
Of course, the global issues affecting many FTSE 100 companies are having an effect on their profits which brings longer term concerns, one of which is the sustainability of dividends. A dividend is meant to be a distribution of profit share to investors. You would normally expect some of that profit to be held back to reinvest in the business rather than it all being paid out. To assess the sustainability of dividends we look at a metric called “dividend cover”. For example, if profits are £2 per share and dividends are £1 per share then dividend cover is two – profits are twice the dividend.
American and Glencore have already had to cut their dividends. However, this is not just confined to commodities. Tesco has already cut its dividend and four of the top 10 stocks in the FTSE have negative dividend cover. This includes GlaxoSmithKline and the worst offender Vodafone where the current dividend is more than twice profits. That is not sustainable in the long term and therefore, we would not be surprised to see more dividend cuts in the top 100 given the low levels of cover.
Right now, the dividend cover level on the FTSE 100 is about 1.1, so on average profits are only about 10% higher than the dividends paid out. This is low by historical standards. However, this is just an average figure. On some companies the cover is negative, meaning they are paying out more in dividends than they make in profits. Dividends are being paid from reserves, or from debt. BP and Royal Dutch Shell are two such companies, along with mining company Rio Tinto (using projected earnings for next year). Other miners such as Anglo Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter December 2015
Fund Selection
When we discuss investment performance with clients we (rightly) tend to focus on the top line – how the portfolio as a whole has done. We tend to discuss the asset allocation and how we think that fits in with the client’s plan, and how we are adapting it to current market conditions. We think this is the right approach given that asset allocation is the most important driver of returns. However, making up your portfolios are a collection of individual funds, and perhaps we don’t highlight these enough. Clients often ask us to look at funds that have performed very well and ask us why we don’t invest in them. The answer is usually because we already invest in other very good funds! For example, whilst the FTSE 100 is down 5.94% so far in 2015, as noted earlier, some of our UK funds have made substantial gains. The Miton UK Value Opportunities fund has gained 21.12% year to date, Marlborough Special Situations is up 17.78%, and Miton UK Multi Cap Income is up 17.77%. All these funds have a bias towards smaller companies but have all been much less volatile than the FTSE. In the coming weeks, we will look to feature some of our favoured funds and some of the stocks they hold in blogs on our website.
Overall, the weighted average equity fund in a balanced portfolio is up 5.73% in 2015 to date, even after taking into account FTSE tracker holdings and emerging market funds which have performed poorly. The FTSE 100 is now 13.34% below its April peak including dividends. However, a typical balanced portfolio after all fees is only around 2.4% below its April peak and is still up 2.71% in 2015. This shows the benefit of diversification both within equities but also into other asset classes. However, there’s a saying in the industry “you can’t eat relative performance”. It’s the absolute return that matters to investors, not the relative return. If the FTSE is down 13% and a UK equity fund is down 10% it has outperformed its benchmark, but the investor has still lost money. Despite that, when returns are hard to come by we tend to look at the relative performance more than usual. In 2015 to date we are pleased to report that every one of our individual sector portfolios is beating its benchmark. For example, our UK funds are beating their UK benchmarks, global equity funds are beating our global equity benchmark, our fixed interest funds are ahead of the corporate bond sector etc. The only exception (you won’t be surprised to hear) is our UK index tracker as actively managed funds have typically beaten the index this year. We always emphasise the importance of asset allocation because these decisions account for perhaps 90% of returns. However, we don’t ignore the 10% that can be gained by superior fund selection, and in more volatile markets this becomes especially important.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Market Views December 2015
General Economic Overview The problems in commodity producing countries and companies continue, exacerbated by the strong dollar. Outside of resources and the emerging markets that produce them, things still look okay with global growth remaining steady. The US and UK continue to be the strongest nations. With falling commodity prices and with China’s currency weakening, deflationary pressures remain. However, this may not keep the Bank of England from increasing rates next year. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets We keep our score the same as last month at -1. Whilst the FTSE has dropped substantially since last month many of our preferred sectors have not fallen as far, whilst sentiment has notably weakened. We continue to prefer Japan and smaller companies in the UK.
-1
Fixed Interest Our score has dropped from -1 last month to -3 this month. Whilst the yield on our portfolio is attractive the risks have increased. Notably, default rates in the US are creeping up particularly in the bonds of energy and resources companies.
-3
Commercial Property Commercial property returns are continuing to slow but they are still providing a steady, positive return. Property continues to provide attractive diversification to equities and bonds.
-2
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest and neutral property. We are slightly overweight equity and also have additional holdings in defined returns and alternative equity.
A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5% means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.
These represent Equilibrium’s collective views. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser. Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.