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OPINION

Fighting the backdrop

Fighting the backdrop
July 5, 2017
Fighting the backdrop

True, the Trump presidency remains on course to be a disaster. A mixture of ego, unpredictability, economic illiteracy and indifference (to most things non-American) on the part of the president plus obsession and obsequiousness on the part of too many of his advisers could yet be toxic; especially as it is laced with contempt for the democratic processes. And the UK's political scene remains a tragi-comedy of the law of unintended consequences - pretty much as it has been since David Cameron carelessly promised a referendum on the UK's membership of the European Union back in 2010.

Yet the election of Emmanuel Macron to the presidency of France and of his barely-formed En Marche! party to dominance of the National Assembly offers hope that European voters have not given up on liberal democracy - so long as it comes in bright packaging. Even the cock-up that turned a comfortable parliamentary working majority that the Conservative party enjoyed into a joyless union with Ulster's Democratic Unionists offers hope that Brexit negotiations may become more constructive and that the eventual exit deal will reflect parliament's wishes. It still seems too much to hope that the idea of Brexit will be rejected as a nation's momentary madness; but you never know - these are strange times.

And I start this round-up of the first half of 2017 for the Bearbull Income Portfolio with a note on the political scene because, as I've said several times before, politics will intrude ever more forcefully onto investment as the 21st century develops; particularly if - as is feasible - what's labelled 'secular stagnation' is accepted as the new normal. The needs of a political system that depends on extensive welfare spending would permit nothing less.

Indeed, we can, perhaps, spot the effect of politics on UK equity market returns in the first half of the year. At least, in local currencies, the UK's gains pale besides those of other developed country markets. In the first six months, the FTSE All-Share index rose just 3.3 per cent, while the S&P 500 index of US stocks rose 9.0 per cent, the FTSE Euro 100 index gained 8.6 per cent and even the MSCI World index - in all its local currencies - put on 7.1 per cent. Much of the All-Share's dull performance reflects sterling's partial recovery from the beating it took in the second half of 2016 in response to the prospect of Brexit. This meant its performance in the latest half became stronger when translated into other major currencies. In US dollar terms, for instance, it rose 8.6 per cent.

We can also spot global factors influencing the Bearbull income portfolio. As Table 1 shows, many of the portfolio's first-half gains were driven by elements from the 'big picture'. Thus the best performer of the half, shares in foundries supplier Vesuvius (VSVS), surged as the group's performance exceeded expectations, helped by the slow, yet prolonged, recovery in global output. Ditto speciality chemicals supplier Elementis (ELM). Shares in Boeing (US:BA.) fulfil an aim to diversify the portfolio away from UK companies, but their price continues to surge as the group's commercial aircraft operations nudge towards higher-margin servicing programmes and the order book continues to creep upwards - a further indication of sustained global confidence. Meanwhile, shares in currency manager Record (REC) at last responded to concerns about volatility in exchange rates and the concomitant need for those with exposure to have hedging in place to lock in either anticipated revenues or forthcoming commitments.

While gains in the portfolio were spread around, the losses were concentrated as never before. I have dealt with Petrofac (PFC) at length (see Bearbull, 19 May and 2 June 2017), so there is no need to repeat the discussion. It is equally futile to say that, but for losses on Petrofac, the portfolio's returns would have been substantially higher. If we assume that, in statistical terms, the returns of the portfolio's holdings will be normally distributed around their average - give or take - then there must be outliers. That's just a fact of life.

 

The performance bridge

The first half of 2017
Portfolio value at 31.12.16£295,720
Plus gains on: 
Vesuvius6,006
Zytronic5,500
Boeing5,055
Record3,680
Elementis2,975
Air Partner2,367
NatWest prefs1,972
Minus losses on: 
Petrofac-10,714
Other price movements (net)65
Portfolio value at 30.6.17312,626

 

My job - and the task of any portfolio manager - is to make the decisions that will shift the average return towards the positive end of the distribution continuum. Do that and the negative outliers won't have a brutal effect. In that regard, Petrofac was an outlier that got away in the first half. But not so much that it turned a good overall performance bad. The income portfolio's first-half gain - 5.7 per cent - comfortably outpaced that of the All-Share index (3.3 per cent). In addition, the income portfolio received dividends that generated a 4.4 per cent annualised yield on its average value for the half year (see Table 2). Thus the portfolio's total return was 10.1 per cent compared with 6.9 per cent for the All-Share.

 

Income portfolio distributions

Year ended Payout (£)ChangePortfolio yield (%)Cumulative payout (£)
20151st half6,236-2%4.4138,346
 2nd half7,4321%5.1145,778
 Total13,668-1%4.7 
20161st half6,7989%4.8152,576
 2nd half7,8926%5.4160,468
 Total14,6907%5.1 
20171st half7,0083%4.4167,476

 

In the larger scheme of things, I would be perfectly happy if the portfolio put in that performance for the full year. It would be its best total return since 2013 - when the gain was 25.4 per cent - even though it would be below the average return that the portfolio has generated in the 17 years - 2000 to 2016 - for which there are full-year comparative figures.

The point I am driving towards is that equity returns may well average down in the coming years and - more than that - the income portfolio's excess returns will come under pressure. They are likely to be too good to be sustainable. Realism rather than false modesty pushes me towards this conclusion. To see why, let's run through the data. In its 17 years, the income portfolio's average gain is 7.1 per cent while its average dividend yield is 4.4 per cent (remember, it distributes all of its income). In comparison, over the same period the All-Share has managed an average gain of 2.3 per cent and an average yield of 3.2 per cent. In other words, the average total return from the income portfolio - 11.4 per cent - is twice the All-Share's total return.

The income portfolio’s yield premium should continue. After all, I won't buy a stock unless it offers a dividend yield of at least 1.2 times that of the All-Share. When a holding does particularly well then its yield is driven down; for instance, the yield on Vesuvius is down to 3.4 per cent and on Zytronic (ZYT) it is 3.2 per cent. But those are balanced by holdings whose yield started well above the threshold and remains on the high side.

Far tougher to maintain will be the average annual gain of three times that of the All-Share - 7.1 per cent against 2.3 per cent. How much of the excess return is due to skill and how much to good luck I simply could not say. In truth, we never know these things. I try to buy shares in companies that I understand; that seem to be good quality businesses whose stock market value is below their theoretical value. There are some exceptions to this rule. Some stocks can be relied upon for their income so business performance matters less or - in the case of NatWest prefs (NWBD) - not much at all. Others looks as if they can help smooth the portfolio's returns, for example, Pan African Resources (PAF). Some come with recovery potential - Zytronic or Record. Still others have share prices so bombed out that they seem worth the risk despite their limitations; for example, Dairy Crest (DCG).

But, from whatever source they are derived, average gains of three times what the market offers are pushing against the limits of what seems realistic. So I'd expect that scale of outperformance to be pegged back.

Nor will it help that the real returns produced by the income portfolio - ie, after deducting the effect of inflation - and even by the All-Share index look close to unsustainable. Over the 17-year period under review, UK inflation, as measured by changes in the Retail Price Index, averaged 2.8 per cent a year. That's a bit more than the All-Share's average annual gain, which helps explain why the performance of the All-Share has been so muted since the income portfolio was launched in September 1998.

It also means that all of the real return offered by the All-Share has come from its dividends. But if future growth of dividends is restrained by secular stagnation, or some such effect, then even that source of real return may come under threat. Sure, the yield on the All-Share could rise, but that would only be at the cost of still lower capital returns as share prices fall to accommodate the duller future.

Granted, I will still be trying my hardest to escape their grip, but it's sensible to be aware of the forces that are likely to depress returns in the coming years.