Space did not allow me in last month's column to explain why I had again added to the Growth portfolio's exposure to commercial property during May. I have also added to the portfolio's Japanese exposure during June. The former has had a good start to the year, the latter less so. But what unites them is the abundance of cynics who believe they are riding for a fall. I suggest investors defy the doomsters and stick with both.
Above the 'tree line'
I first started building exposure within portfolios to the commercial property sector at the very end of 2011. Sentiment was depressed and, consequently, discounts were wide and yields high - 15 per cent and 8.7 per cent, respectively for Standard Life Investments Property Income (SLI). How times have changed. The sector, and SLI in particular, has had a good run.
Last year, when doing a series of columns on out-of-favour sectors, I continued to make the case ('Commercial Property making a comeback', 13 September 2013). I suggested we were still in the 'foothills' of a very marked upswing in values. After a reasonable run, I now believe we are above the 'tree line', but that the best of the ascent is still before us.
The sector's run has certainly brought out the doomsters. The prospect of interest rate rises, the overhang of debt and the apparent absence of 'cheap' stocks all contribute to their gloom. This concern is, in itself, a good thing - one should particularly worry when everyone agrees. But it also helps to explain why, despite the run, there is still very good value to be found in the sector - especially outside the south east.
We tend to forget the extent of the fall since values last peaked. Property outside London and the regional mega shopping centres remain good value. On average, commercial property is around 30 per cent below where it was in mid-2007, with office space having fallen around 40 per cent. Meanwhile, good quality industrial property can still yield between 8 and 9 per cent, and perhaps more, in swathes of the country - more so, as you head north.
Therefore, despite the sector's run, on average commercial property still yields around 6 per cent, according to the Investment Property Databank (IPD). This compares well with yields of 3 per cent for gilts and not a lot more for good quality corporate bonds.
Meanwhile, the prospect of modest rental income growth as the economy recovers is particularly attractive to institutional investors when comparing yields with fixed interest securities. As the recovery takes hold, so should rental growth momentum.
Furthermore, the interest rate outlook remains favourable. For those of us who have long suspected that rates would remain low for longer than expected, the scenario has not changed - if anything, quite the opposite. Note how quickly the Bank of England's 7 per cent unemployment 'guidance' was ditched. Low interest rates are part of the 'financial repression' agenda referred to in previous columns - inflation is being engineered to help erode the debt.
A sector which still offers yields twice that of gilts, and the prospect of income growth as the recovery and inflation picks up, has plenty of potential to perform well. This is particularly the case given that lack of supply may be more of a factor this time round - there is much less of an overhang of vacant property - and that finance is becoming more readily available to investors both large and small.
There is perhaps one further factor in the sector's favour - it can help to diversify portfolios. In markets which are unerringly calm, perhaps overly influenced by government policies, one should always be looking for trouble. Diversification is one tool at our disposal. Commercial property fits the bill perfectly, while giving off a healthy and growing income. No wonder private banks are also buying the sector on behalf of their clients.
Therefore, during May, I increased the Growth portfolio's holdings in TR Property (TRY) and SLI. TRY's pan-European focus on property shares with a good weighting to smaller companies, together with SLI's recent dividend increase and growing penchant for good quality and decent-yielding industrial property, continues to bode well - aided by excellent track records and healthy revenue reserves to help sustain dividend growth going forward.
Adding to Japan
Having introduced Japan to portfolios upon the election of prime minister Shinzo Abe at the end of 2012, we enjoyed a good run in markets over 2013. However, so far, 2014 has been disappointing. I suggest this is a good opportunity to further top-up holdings as the cynics are once again holding sway - highlighting the high debt piles, an ageing population and the adverse consequences of a decades-long deflationary experience.
But key positives are being ignored. Shinzo Abe is popular and has a huge mandate. He is absolutely determined to hit his 2 per cent inflation target, raise the growth potential of the economy and encourage the country to embrace equities.
In addition to a massive dose of quantitative easing (QE), some of the measures which are being introduced include corporation tax being cut, the opening up of former monopolies to greater competition, better corporate governance, and pressure on companies to both raise wages and return large cash piles to shareholders. Initiatives to boost immigration to bolster the workforce are also in the mix.
Meanwhile, domestic savers are very underweight their equity market by historical standards. The preference for bonds and cash runs deep after decades of deflation. But the introduction of Isa-type vehicles for consumers and government initiatives to boost equity investment by the country's huge pension funds could be significant.
And the market is looking cheap by almost any measure - particularly price-to book. Even the price-earnings ratio compares very well historically with other developed markets. Furthermore, Japanese companies are looking lean and mean after years of cost-cutting and having to cope with an appreciating currency - something QE is helping to assuage.
This will be a slow burning fuse. But the combination of cheap valuations, improving liquidity and positive catalysts for change usually bodes well for investors.
Accordingly, during June, I added to the Growth portfolio's holding of JPMorgan Japanese (JFJ) while standing on 11 per cent discount. This was funded by the sale of JPMorgan Smaller Companies (JMI) after what has been a very strong run for the sector. Taking profits are seldom the stepping stones to ruin.
Otherwise, once again there were no changes to the Income portfolio during June.
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