Value investor has sound strategy

GREG'S PORTFOLIO*

(*Held in individual savings accounts, self-invested personal pensions and general fund accounts)

LAST THREE TRADES:

Baillie Gifford Japan Trust (Buy)

Kames High Yield Bond Fund (Buy)

Vodafone (Sell)

SHARES OR FUNDS ON WATCHLIST:

Invesco Perpetual Corporate Bond Fund, Kames Investment Grade Bond Fund, BlackRock Frontiers Investment Trust, RPC Group, G4S, Greene King, Meggitt, Laird, Micro Focus, Paragon, British American Tobacco.

Chris Dillow, Investors Chronicle's economist, says:

You say you are moving towards value investing. This raises interesting issues.

First, it is the case that, on average and over the long run, value investing has tended to pay off around the world. But what is the source of this outperformance?

One possibility is indeed that low PE ratios - the metric which John Neff emphasised - signal that investors are irrationally overlooking a stock's merits. Insofar as this is the case, value investing gives you something for nothing, as you're profiting from others' mistakes.

But there’s another possibility. It's that value stocks tend to do badly in recessions; this is because, by definition, one year's earnings account for a bigger chunk of their value and so one bad year does more damage to value stocks than to growth stocks. To compensate for this cyclical risk, value stocks must deliver good returns in normal times.

I suspect both theories have some truth in them. Insofar as some value stocks are quite defensive, such as tobacco and some utilities, they have often been unreasonably underpriced in the past and hence a genuine bargain. However, value investors have often taken a beating in recession: Mr Neff's Windsor fund did badly in the recessions of the early 90s and (though he wasn't managing it by then) in 2008-09. This warns us that they do carry extra risk.

However, you might think that, as it is probable that the economy will pick up in the next few years - only probable, mind - then it's worth taking value risk.

This, though, raises two other issues. One is that you are already a value investor. Your big holdings in Marlborough Special Situations, Invesco Perpetual High Income and Cazenove UK Smaller Companies funds expose you to value and cyclical stocks. One problem some investors have when they combine funds and direct share holdings is that the two can be quite highly correlated, which can add to the risks of their portfolio.

The other issue is one of matching assets to liabilities. You say you want capital growth to pay off a mortgage. But such is stock market volatility that there is no guarantee that even a good equity portfolio will achieve this. Some rough numbers will show this. Let's say the expected return on this portfolio is 5 per cent a year in real terms, and that its annualised volatility is 15 per cent; this is less than the market's volatility, reflecting the fact that almost a third of your portfolio is in corporate bond funds. Then, on the reasonable assumption that returns from one year are uncorrelated with those the following, there is a one-in-six chance that you'll suffer a real loss over the next seven years.

Of course, one-in-six is a low chance. But how would you pay off the mortgage if it materialises? The obvious possibility would be to sell off some of your investment properties or part of your financial portfolio. If this seems unpleasant, then the alternative is to seek a better match for your mortgage liabilities. These would have to be bonds which mature when your mortgage does - though remember that while corporate bonds would do this on a higher return than gilts, they do so at the price of exposing you to some degree (perhaps tolerable) of credit risk.

Which raises a final issue - the role of your corporate bond funds. These serve the useful function of diversifying some type of equity risk, such as price falls caused by a rise in risk aversion. But they carry their own forms of risk. For higher-yielding bonds, there's credit risk. This is especially important for holders of value stocks because the same cyclical downturn that hurts some value stocks often increases credit risk to the detriment of higher-yielding bonds. For the lower yielders, however, there's simply the danger that over the longer term a cyclical recovery plus the ending of quantitative easing and perhaps an easing of the global savings glut would hit the prices of even high-quality bonds.

The latter losses might be tolerable, to the extent that they might well be offset by gains on shares. But these risks pose the question: might it not be better, especially for someone with your liabilities, to hold bonds directly rather than in funds?

Lee Robertson, chief executive officer at Investment Quorum, says:

You have been investing for a relatively short period of time and your investment objective for your Sipps, Isas and general investment accounts is to focus upon capital growth for a further five to seven years in order to pay off a mortgage on investment properties. Your stated tolerance towards investment risk is high and I like the focus you have upon a total return strategy through a mixture of direct equities and funds. You have spent a considerable amount of time on research and getting comfortable with your strategy which appears to be serving you well.

However, with the relatively short investment period consider your portfolio in terms of 'risk over return' and diversification to reduce overall risk.

While the markets have shown a considerable amount of resilience over the past 12 to 18 months against a backdrop of mixed global economic data, investors should be selecting their investments carefully from both strategic and tactical standpoints. Indeed, if you are investing into direct equities it is important that the company's balance sheet is strong and that the management is showing good leadership through global diversification or strong franchises leading to top- and bottom-line growth, accompanied by steady and rising dividends.

In a world that is showing signs of anaemic growth and low interest rates, possibly for a few more years to come, a total return strategy is very sensible. The power of compounding in this investment environment is a powerful tool that should provide real impetus, notwithstanding the short investment horizon.

A large proportion of the overall value of your investments is in one fund, Invesco Perpetual High Income, and while this is an excellent fund, managed by one of the most reputable fund managers, Neil Woodford, it is debatable whether such a large position can be justified in this investment environment of mergers and acquisitions, fund managers moving or even retiring.

I would like to see no more than 10 per cent invested in any one fund, or direct equity, based upon a diversified risk strategy. Furthermore, I would suggest real caution with regards to corporate bond exposure and would not be adding to this asset class as I believe that over the next few years we will see interest rates and inflation rising and therefore other asset classes such as global equities, convertibles, floating rate notes, property and commodities should deliver better returns versus the more conventional bond markets.

However, should you wish to continue to hold bonds consider switching out of your current corporate bond exposure and into the M&G UK Inflation Linked Corporate Bond fund (ISIN: GB00B44VX079) or the cost-effective iShares Barclays Capital Global Inflation Linked Bond exchange traded fund (SGIL).

You could contemplate maintaining your current strategic and high-yield bond funds for yield but we might suggest diversifying via others such as The Old Mutual Global Strategic Bond Fund and The Old Mutual Monthly Income Bond Fund, both of which are managed by very experienced fund managers, Stuart Cowley and Christine Johnson.

In terms of the UK equity exposure, I would reduce the largest positions in the Invesco Perpetual Income Fund, and the Marlborough Special Situations Fund in favour of funds such as the Linsdell Train UK Equity Fund, Cazenove UK Opportunities Fund, JOHCM UK Equity Income Fund and the Threadneedle UK Equity Income Fund. This would give you greater diversification and reduce the risk of having a large amount of your overall portfolios invested in a very small number of funds.

Likewise, I would suggest diversifying your global equity exposure and utilise funds such as Newton Global Higher Income Fund and M&G Global Dividend Fund, the BlackRock Continental European Income Fund, Newton Asian Income Fund, JPMorgan US Equity Income Fund, and the newly launched JPMorgan Emerging Markets Fund - all of which should give you a well-diversified and balanced element to your portfolio with the aim of capital growth.

Your two investment trusts, Baillie Gifford Japan Trust and Murray International Trust, are excellent choices but are on premiums of around 4 per cent and 10 per cent respectively, so you need to monitor them closely.

However, apart from the diversification issues, bond exposure and fund choices I have offered for consideration, this is a portfolio with a sound strategy.