We live in interesting times. As I mentioned in last month's column, this economic downturn has broken with previous ones in that it has been characterised by high debt rather than lack of demand. And as central bankers become increasingly frustrated in their attempts to stimulate economic growth, policies once considered radical are now becoming the norm. How much longer before governments themselves roll up their sleeves? The financial system is being tested and markets are wary - and volatile.
In recent columns I have reminded investors of the importance of certain tried and tested strategies - of ports in a storm - during such times. These have included both ensuring diversification ('Reducing risk over time', 5 February 2016) and seeking value ('Seeking value via Private Equity', 8 April 2016), whilst always remaining invested.
A further related but distinct strategy employed by both my Investors Chronicle and website portfolios, and which is helpful in these uncertain times, is to overweight bonds and equity yield. It is no coincidence that the portfolios yield more than their benchmark allocations would suggest. However, investors need to be aware of the risks within elements of each asset class.
Bond bubble?
Investors regularly raise with me my contrarian view of bonds. As regular readers know, I have long believed interest rates would remain low for longer than the market expected. Given the unusual nature of this downturn, economic growth and therefore interest rates were always going to remain low - especially as the deadweight of debt usually has a deflationary 'dark side'.
But this has not stopped overly optimistic economic growth forecasts from becoming the norm. The International Monetary Fund (IMF) is a good example. In September 2011, it was forecasting near 5 per cent global growth by 2016. Its forecast for growth by 2017 has continually had to be scaled back as time has passed - in October 2012, it forecast 4.5 per cent; in October 2013, the figure was 4.0 per cent; its latest forecast in January 2016 now puts the figure at 3.5 per cent. How much longer before the forecast is shaved again?
For those portfolios where bonds are appropriate, I am therefore overweight relative to respective benchmarks and continue to add to positions on bad days. The bond exposure in the Growth and Income portfolios is around 13 per cent and 34 per cent respectively, with the website's well diversified Winter portfolio holding around 50 per cent in bonds - which helps it achieve a 6.2 per cent yield.
As ever, one needs to be selective. Given the state of government finances and the fact gilt yields presently leave little margin for error, I continue to focus on good quality corporate bonds across the yield spectrum. I consider the higher-yielding end of the spectrum to be relatively attractive, as it will better react to any return of inflation further out and whilst company default rates remain relatively low.
I also continue to underweight bank corporate bonds because of concerns about the health of their balance sheets and because of the implications for them should policy-makers continue to struggle to generate economic growth. The latest new norm increasingly pursued elsewhere - negative interest rates - conveys a negative message that something may be wrong to an ageing population already turning away from borrowing, and it penalises the more sensible banks by hitting their profit margins.
Dividend diversification
The portfolios are also overweight decent-yielding equities. These can be more resilient in uncertain times, in part because yield can act as a cushion and because they tend to have a 'value' focus with a fair bit of 'bad news' already baked into prices. This strategy also reflects the fact that dividends account for the vast majority of market returns over time. The figures are compelling - my favourite being those produced by legendary investor Jeremy Siegel.
He calculated in 2005 that, over the previous 130 years, 97 per cent of the total return from stocks came from re-invested dividends. $1,000 invested in 1871 would have been worth $243,386 by 2003. Had dividends been reinvested, the figure rises to $7,947,930! The message is clear: do not spend your dividends unless you have to. Reinvesting dividends is the best way of growing wealth over time, particularly in a low growth environment - and to access these dividends, investors need to stay invested.
But here again, one has to be selective. Historically, income-hungry investors have tended to focus on the largest UK companies. This is in part because they are deemed safe and because the FTSE 100 accounts for around 85 per cent of all dividends generated by the FTSE All-Share. Yet recent high-profile dividend cuts have highlighted the danger of this approach. Portfolios need to diversify their dividend sourcing by looking abroad and to smaller companies.
Asia looks particularly attractive when it comes to both growth and income. According to Liontrust Asset Managers, there are over 160 companies in the Far East (excluding Japan) that offer both earnings growth of around 10 per cent and a dividend yield in excess of 4 per cent. This compares to around 30 companies in the UK, 60 on the continent and two in Japan. America comes in at around 170. The region offers huge potential to good fund managers.
The portfolios are also overweight decent-yielding UK smaller companies. This is in part because larger company payout ratios are at high levels, and this affects their ability to sustain and grow dividends going forward - as recent FTSE 100 cuts have indicated.
By contrast, smaller companies enjoy healthier balance sheets. This should help them to build on their impressive track record when it comes to dividend growth. Over the past three decades since the FTSE 250 index came into being, the index has produced annual dividend growth of around 7 per cent compared with less than 5 per cent for the FTSE 100. Meanwhile, smaller companies in general look attractively priced relative to earnings growth.
Some suggest it is difficult to construct a high-yielding but good quality equity portfolio. The recent introduction of my website's new Dividend portfolio, with its 5.5 per cent initial yield, shows this remains very possible via investment trusts with progressive dividend policies and good track records. Given the portfolio consists mostly of equities, it also has greater potential for both capital and income growth compared to the other yield-focused portfolios which, for reasons of diversification, contain more bonds and other lesser-correlated assets.
There were no changes to the portfolios during April.
