Its Not Harry

Comment and opinion for retail investors in the UK

Education

‘Buy land – they’re not making it any more!’

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A piece of advice from the ever amusing and perceptive Mark Twain, I believe.

I have recently been looking at model portfolios offered by different investment advisers and funds investing in commercial properties like shopping centres, warehouses and office blocks are pretty much standard components of cautious or defensive models.

When I was in my early 20s and became a pension fund trustee, the pension fund advisers said we needed to buy some property to diversify from our portfolio of fixed income bonds and international equites. I read the proposal and noted that the income yield was about 4.5%. As other fixed income assets were paying about twice that, I could not see the advantages.

What was politely explained to me was that inflation in the early 1980’s was so high that the return on deposits and government bonds was in real terms negative. Because property values went up with inflation, so did the rent over time (unless you had no tenant, of course) and that was the merit of the asset. It was a hedge against inflation.

That is the main theoretical advantage of owning a portfolio of commercial properties. Commercial property has the advantage over private residential property in that the owner has much stronger rights over the tenant and rarely has to meet the cost of repairs, insurance and so on. Leases are also quite long, typically 9 years at least and sometimes much longer. Tenants may be ultra reliable, like banks or government departments.

All asset classes should be bought in the context of the value on offer at the time of purchase.

So financial advisers put property funds in portfolios to get the steady income yield, the inflation proofing over time and there is also a limited degree of diversification.

But, that does not mean they are ‘safe as houses’. Commercial properties do not sell quickly, so such funds have to hold a lot of cash to meet withdrawal requests when people get nervous, or they have to impose restrictions on withdrawals. Holding cash when cash interest rates are low is a drag on performance.

Valuations are also not so frequent, maybe quarterly. And valuation is a matter of opinion if the property is not actually for sale. Comparisons with similar properties are made, so if the market gets into trouble there is contagion.

If valuations go up over a long period and economic factors mean that rents don’t, then yields are said to become ‘compressed’. That is usually a warning that valuations need to come down, because the asset class is becoming less attractive. I have seen that happen several times in my working life – there is a definite cycle.

Tax is an issue too as property fund income is taxable at source unless it is set up as a PAIF (a special type of fund structure) and that is not possible with conventional collective funds, only ISAS, SIPPS and other tax exempt structures. So non-taxpayers will lose 20% of their yield in some cases. After tax and expenses, some well known retail property funds are currently yielding not much over 2%.

With town centre retailers having a hard time, Brexit threatening distribution chains and foreigners not wanting to invest in Britain, the sector faces some tough headwinds. I would be avoiding it for the time being, but will always consider it as a portfolio component when the time is right.

Most investors in Southern England already own plenty of land (in value terms) and live on it!

Slack, bang, wallop?

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Another astonishing new share flotation in the US. A business messaging application called Slack (hardly a great novelty – I can recall various versions of such going back 20 years) has floated and immediately moved to a valuation, based on share price of 25 billion dollars.

This is a business that turns over 400 million dollars and managed to lose more money than its previous year’s turnover. As the BBC explainer on this says, losing money when you start a business is normal (easier when it is someone else’s money, I might add). The BBC refers to the few successes that became worth billions, but in recent examples the valuation is starting at billions, in effect completely discounting any chance to make money like that in the future. The sure fire winners are the founders, who have struck lucky.

The valuation is clearly totally detached from reality and the only other people who will make money are those who resell their initial allocation of shares to those who haven’t got them and want to speculate, at a nice profit. These people only invested to make this resell profit, like ticket touts. They don’t care in the slightest if the underlying business is any good any more than a ticket tout has any interest in the singing merits of Taylor Swift.

At its worst, the stock market makes gambling look logical

This sort of activity has not much direct relevance for investors in retail funds, but when it becomes the norm, one must worry. Why? Because if 25 billion dollars goes into a worthless business and is later lost, the investors in question will sell other assets to balance their books and those sort of sales have a significant negative effect on the market.

And that is not all – a crash in a certain segment of the market can be the start of a domino effect, because the market mood changes and FOMO (fear of missing out) is substituted by a rush for the emergency exits.

If you have big profits in tech funds, now might be the time to think about securing them!

How much can you like a company?

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I don’t generally comment on investment trusts (ITs) as they are listed shares with different risk characteristics to open ended funds (OEICs), but they are a form of collective investment and some argue they are a cheaper way to access a fund manager’s skills. That assumption is not based on a general reality, but on some selective observations of certain trusts.

I looked at the Lindsell Train IT recently because it came to my notice while I was researching the Japan OEIC covered in my monthly subscriber newsletter. It is a great example of people taking a really big bet and quite likely not knowing what they are doing!

The shares in the trust are at an astonishing 100% premium to the asset valuation! That means people are paying twice as much to buy a block of assets via this trust than they would pay if they just went and bought the same assets directly. They can only be doing that because one key asset is the Lindsell Train business, whose shares you just can’t acquire in the ordinary market.

I had to check and re-check that – it was so remarkable. The fund is 100% geared, so has borrowed against the security of the investments such that if it was wound up in severe difficulty, the shareholders would get nothing (or a very small payout). The banks would probably be able to take all the assets.

Worse than that, a sharp fall in markets would likely trigger covenants in the bank lending agreements that would require loan repayments, making the trust a forced seller of shares in a falling market. Did the word Woodford pop up in your mind?

The dividend yield is well below that of the main shareholdings, at 1%. So no-one is buying this fund for income.

Errr..how does that make sense?

Notably, almost half the trust is invested in the unlisted Lindsell Train company. That would be impossible with an OEIC and is one of the reasons I stress that investment trusts are NOT to be seen as having the same risk profile as OEICS.

In short investors, one might say, admittedly as a simplification, have invested in a trust the assets of which have been fully mortgaged to buy shares in the manager’s company! That strikes me as demonstrating huge enthusiasm for the Lindsell train business – in effect giving it an interest free loan in the hope that its shares will rocket in value.

Maybe they will – but do the bulk of small investors (a lot of share trades are in amounts of just a few thousands) actually understand the proposition? I hope so.

Mystic Meg

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Introduction

I suppose with Potter being my surname, one might think I had some magic in my genes – if you live in a fantasy world! I am grateful to J K Rowling for giving my surname to someone who isn’t a pompous buffoon of a retiree bank manager or an officious school caretaker (previous media Potters acted by wonderful British stalwarts). However, any foresight I can offer comes from experience and a decent understanding of human behaviour, not from Harry!

I certainly believe that if one has long experience of an area of human behaviour (and investments markets are classic models of that), then one can at least predict some probable outcomes.

Several years ago when Mr Neil Woodford left Invesco Perpetual to set up his own business, I declined to recommend his funds, even though I had supported him for literally decades in his previous role and my clients had been well rewarded. Shortly after he set up his own firm I was senior member of an investment committee at the firm I had merged my own business into and we discussed the Woodford offering.

A colleague was keen to use the funds – he had been getting a strong ‘sell’ from the sales ‘rep’ at the firm who was a long term acquaintance of his. Yes, fund managers have sales staff who use sales techniques on advisers, just like drug companies do with GPs. In both cases, there is legislation to prevent obvious corruption, but the fact that fund managers and drug companies pay fat salaries and bonuses to sales staff makes me think they must get results!

The committee, being a committee, compromised and agreed to put a small weighting of the Woodford funds in the firm’s model portfolios. My reservations were minuted, as I recall.

The future is not always a mystery

This week (June 2019) the main fund at Woodford Asset Management has been suspended for at least a short period and it may take a while before investors can make withdrawals. This is likely to upset a lot of people, especially investors at Hargreaves Lansdown, who kept the fund on their recommended list long after every one with any degree of skill detected possible problems. One can only speculate about why they did that and I have some pretty good ideas, but it is not for me to publish guesses, even if they are educated ones!

What were the problems I predicted years ago and how did I come to (correctly) anticipate them?

In essence the worry I had was that I knew Mr Woodford was a very strong minded character who did not tolerate contrary viewpoints. I had, like many advisers, been severely put down by him in meetings for asking questions that challenged his point of view.

I also knew that he liked being a major investor in smaller companies and in effect being involved like an executive director. This I knew from seeing an obscure documentary about his role years back in a company called British Biotech, which revealed that he was able to call the shots and act in ways that were in my opinion (as someone who originally qualified in UK company administration) bordering on the illegal.

So, I suggested that out on his own, he might act in a less constrained way. There would be no big risk management department at his new firm and no annoying compliance officer that he had no choice but to respect. Of course there would be appropriate processes, but a founding chief executive wields a lot of power (compare Metro Bank, Arcadia and others).

He was also attracting very large investment sums and for a man with an obvious level of confidence in his own ability, he might be inclined to follow some more ‘interesting’ investment opportunities – in effect play at a being a venture capitalist.

So my view was that Neil Woodford as the owner and outright controller of his own firm was a much more unpredictable character than he was as an important and well remunerated employee.

The question I asked myself and others was this: if a fund manager is highly respected, known to be very rich and exceptionally well paid, even something of a celebrity in his field, why would he take all the risks of running his own business?

There is only one answer – to have independence of action.

And what actions could he not take at Invesco Perpetual? Some became clear very quickly – a more transparent approach with better customer communication which everyone thought was admirable. However, this very transparency began to reveal some stock ownership that was at best out of the ordinary and in some cases hard to agree with. Once it became clear that his funds were holding large blocks of shares in unquoted companies – enough to breach regulatory limits, then serious alarm bells started to ring.

There is more that can be said about why the crisis has now been reached and if anyone is interested, I can offer more explanations on the telephone.

Right some of the time…

The lesson here is that fund managers of strong character are to be sought out and will make good money for investors in many cases, but we should never believe that someone who gets great results in one environment will in another. A strong character needs regulating at times!

I have previously written that I avoided the funds at Fundsmith for reasons to do with the manager’s over bearing personality. In that case, it looks like I made an overly cautious call – but if you own the Woodford Equity Income fund, you might be thinking ‘better safe than sorry’.