Its Not Harry

Comment and opinion for retail investors in the UK

Education

Unpredictable consequences – trade restrictions

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Stock markets have fallen today as the US/China trade war escalates.  I already wrote a short piece about that subject ahead of the latest round of stone throwing, here.

We can’t say what the results will be for any given class of investments, but we do have a recent real example to analyse.  The EU banned all sorts of exports to Russia (an extreme sort of infinite tariff) to protest about Russian interference in Ukraine.  We can see some of the effects of that now after 3 years.  I will just look at an example.

In the UK, you might pay a couple of quid for a kilo of apples sourced from around the world (I checked with Sainsburys Online).   Here I pay about 40p for Grade 1 Polish apples of the same sorts of variety.  Now food prices in Lithuania are not typically 20% of what they are in the UK.  The reason apples are almost being given away is that Russia was a huge market for fruit from Central and Easter Europe.  That fruit is now coming into local markets and there is excess supply.

Lucky me – I like apples.  But what about Russia – the target of the sanctions?  I guess, with some media coverage supporting me, that prices for some foods went up in Russia because of the sanctions.  But that means Russian growers can increase sales at higher margins and possibly even plant more orchards.  Russia is a gigantic country with an enterprise culture (where it is not dissolved in vodka).  So the simple analysis of the consequences of interfering with the trade process is this:

  • Some products get redirected to different markets, creating surpluses and so prices fall.
  • Some suppliers have no profit margin and go bust, so capacity in the supplier market eventually reduces
  • Prices rise in the tariffed market, so that encourages increased local supply (witness the wine industry in South Africa during the anti Apartheid sanctions period).  The sanctioned/tariffed economy slowly becomes more independent (if it is a a well resourced large country), or the population fall into poverty (if it a weak undeveloped country)
  • Global trades shrinks.

This is an economic analysis and no political impacts are under consideration.  Elected politicians create risks for investors because their time horizons  are short in economic terms (to the next election) and they are not even interested in the long term consequences of what they do (in the main – there are honourable exceptions).

In the case of the USA and China playing tit for tat tariffs, we are looking at two huge economies with plenty of internal resources.  So, they can probably tolerate the consequences and reshape.  Maybe the US will modernise its manufacturing base, but Americans will pay more for their goods.  Those of us who are neither in China nor the US can expect cheaper goods coming our way – the EU (+Britain) is a great place to go selling the stuff the US does not want from China and vice -versa.  I predict, tongue in cheek,  more soya and pork from McDonalds and Huawei phones at half the price of Apple!

Diversification is like gardening

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Here is a rather technical looking graph (courtesy of CF Miton).  To simplify the orange line is meant to be predictor for economic growth in the US.  The blue line measures the relative value of cyclical stocks (those that do well when the economy is booming) with defensive stocks (which do better when people think a recession is possible).

It is no surprise with the luxury of hindsight that the curves are roughly the same shape – you would expect people to be buying shares that benefit from economic growth if they are reading surveys and analysis that says there will be economic growth and so momentum (more buyers than sellers) will push the price of cyclical stocks up.  Thus the relative value of cyclical stocks is higher in a growing economy.

The skill required of your chosen fund managers is to decide when to change the mix of shares ahead of a change in sentiment.  This mix of defensive and cyclical shares is very important and one that is often not picked up in the asset allocation models of advisers.  For example in an income portfolio, it is possible that the search for dividends will have resulted in a heavy bias to defensive stocks, like tobacco and pharmaceutical companies (people still buy fags and pills, possibly even more, in a recession).

If you think of diversification in the context of gardening (NotHarry is a keen gardener), you will realise that you need to have plants and trees that cope with different weather, grow at different rates, flower in different colours, have different shaped and coloured  leaves, will survive on poor and rich soil, acidic and alkali soils, are eatable and are not and so on.  An experienced gardener also knows how to combine things to get an overall pleasing effect, with some insurance policies!  Even after diversifying at the high level, say planting apple trees and blackcurrant bushes, the gardener will invest in more than one species to further reduce the chance of failure.   Gardeners would make great asset managers!

 

 

 

When to sell and hold cash

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This topic is one the exercises the minds of financial advisers and investors on a regular basis and is certainly worth discussing at the moment, with volatility returning to markets.   So it justifies a longish post and I am not restricting this to members, as everyone ought to appreciate these points.

Advisers don’t as a rule like clients to sell assets and hold cash because adviser fees are either a percentage of the assets they control, or based on trades.  This is one reason why NotHarry thinks that the best advisers charge fixed fees:  it takes away this inevitable bias against using cash as an asset class.  Some wealth managers and platforms do charge percentage fees on cash holdings as well (which is a rip off, designed really to protect their earnings when clients have money out of the market).

A famous quote from the legendary Fidelity Special Situations fund manager of some years back is:  ‘it is not timing the markets, but time in the markets’.  What he was stressing was that trying to sell at the top and buy at the bottom (timing) is never really going to work and it is better to stay invested and be patient.  It is pretty easy to prove that he is correct by trying to time markets yourself – trust me!  There is other evidence, used in a slightly misleading way at times, showing that not being in a given market for just a few days would mean much reduced returns over time, as recoveries are often extremely rapid after dramatic sell offs and people miss the best ‘up’ days.

Why the latter observation is misleading is that it is based on the idea that someone is buying and selling tactically, so sells close to the top of the market (clever) but is not quick enough to buy back in at the bottom (psychology makes it hard for most people to buy a falling market).  When the market suddenly turns after everyone has lost faith in it, and the cash gets put back in far too late, the timing advantage is lost.   This is an entirely valid observation of reality, but it is misleading to use it as a generalisation, because there can be other good reasons for selling out and holding cash that are not driven by a motivation to be a tactical speculator.

Take another scenario.  It is 1999 and you don’t believe in dotcom companies.  You have made money on the general boom in Western market stocks (a ‘bull’market) but decide valuations are just mad so you sell out and go to cash.  If you held your cash for 3 full years, you could buy a whole bunch of assets much cheaper in 2002.  So this ‘intelligent’ timing worked well.  It would have worked even better if some of your money was left in Asia Pacific markets that had bombed in 1996 (a currency crisis) and which did very well indeed as Western markets struggled.  My advice at the time was exactly that.

So the issue is not so simple.  How can you make decisions?  There are some reliable rules or processes.

  • The first is what is called valuation.  There are a number of ways of deciding if stocks are expensive or not (in the Useful Links you can connect to Robert Schiller’s work if you really want to understand this subject).  This varies across global markets, naturally.  If stocks everywhere are expensive compared to the long term average, it might be sensible to sell.
  • The second is time horizon.  All major market corrections are part of a cycle and valuations of the market as a whole will recover.  So if you are saving for a pension many years in the future you can pretty much ignore the cycle and let your fund managers take what advantage they can of it (at times when cycles turn, inflection points, good managers earn their fees, doing better than passive trackers).  If you own just a few stocks of your own selection, you may need to reflect on what is changing and how to reposition – good luck, as I have never thought I was clever enough to do that.  If you need your money soon, say to build a house, pay your pension income or similar, then the time horizon is very short and you need to take money off the table and have it available in cash, or you will maybe end up selling at exactly the wrong time.
  • The third is diversity.  You can in fact leave money in the markets (of various types) and also hold cash at all times.  A “Boris” solution of having your cake and eating it.  There is a cost to holding cash when markets go up – you miss out on the high returns. I consider that opportunity cost to be an insurance premium – the cash is there to spend when markets fall, so you don’t have to sell assets at the wrong price and can wait for the cycle to move on.  The loss of upside return is the premium.

At the moment, on valuation grounds, most markets are expensive and some (bonds or fixed income stocks) very expensive.  So if you have a need for cash and not much already on hand, selling some of your investments might be prudent.  Bear in mid that you can often buy other assets that diversify stock market risk, but that is not at all easy at the moment.  NotHarry knows of a few options and will write a members’ blog on the subject.  I will also write longer piece on diversification in the near future!

 

Facecbook and ESG

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The scandal around the use of data in the US elections and the BREXIT vote has increased awareness of what might be called “the age of data” (nod to the books by Yoval Noah Harari).  The concern is not that what data handers/processors do is commercially weak – in fact it appears to be ingenious.  You get loads of data from people by subtle manipulation of human nature at no cost and can use it to change the world to suit your objectives.  Almost the theme of a James Bond film, with much younger sweet faced villains!

The issue is one of ethics and social morality. Capitalism and politics don’t really do either of those very well, but they do like to try, more or less.   The current way the investment world assesses businesses on these counts is called ESG – Ethics, Social and Governance.  There are rankings for companies on these tests and some research suggests that companies with a good ESG score are actually better long term investments, as well as it feeling “nicer” to own them.

Facebook’s ESG score has slipped, no doubt, as for now has its share price.  But there is no doubt at all that data handling is a core global business (that the US and UK are doing especially well at, with Russia and China quite likely up there too)  and indeed owning data is an economic and political factor of significance in these times.  In the same way that banking is never going to be especially loveable as an activity, “big data” handlers are likely to be correctly seen as overly powerful elements in the developed world.  But we had better get used to living with that.

Research or a promotion?

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“3 top rated trusts trading on a double digit discount” is the lead headline on the Morningstar email page that was emailed to me (as a retail investor) yesterday.  The follow on teaser text suggests that this could be because UK funds are “oversold” and therefore cheap.

However, reading the actual content, which is confined to a rather shallow commentary on 3 Smaller Companies investment trusts, one reads that the double digit discounts are less than the 10 year averages, which themselves are drawn from a relatively benign long term “bull’ market.  So no extra value there!

Playing the discount to premium game (and of course vice versa!) is an aspect of owning investment trusts, but one that adds extra risk.

Morningstar is  a good business with highly qualified academics in its research units so it is a pity that it seems to be turning into a touting vehicle for the fund managers that pay to get listed with it – a sort of quid pro, I guess.

In my opinion, if  a research organisation lives on the fees it gets from the people it researches, you can’t expect it to give you independent advice.  In this case, you obviously can’t rely on it to apply logic either!