In general, I am a big fan of cheap index tracking funds. They are much cheaper to own than the funds that try to beat the market which often fail to do so. If you are looking to grow the buying power of your money from a portfolio of shares – by earning a return more than the rate of inflation – then just buying the whole index for a very low cost is often an uncomplicated and relatively stress free way of doing providing you have the time and temperament to cope with the inevitable ups and downs that comes with stock market investing.
The one key caveat that comes with this is that the index that you are trying to track is any good. When it comes to the FTSE 100 index and the shares within it, I am not so sure that it is.
The FTSE 100 has grown the buying power of your money over the last decade as stock markets in general have rebounded from the financial crisis. It has also had a reasonable start to the year and is up by around 11 per cent year to date, but its long-term returns are far from stellar compared with alternative homes for your money.
In price terms, at a level of 7303 at the time of writing the index has just over doubled since the bottom of the last bear market in March 2009 but is only just under 9 per cent above its previous peak in October 2007.
Contrast this with the S&P 500 which has more than trebled in value since the March 2009 bottom and has increased more than 80 per cent since its October 2007 peak excluding dividends received.
Yet for UK investors, the FTSE 100 has fared even worse than owning UK government bonds as yields have continued to fall.
Over the past five years, the Vanguard FTSE 100 ETF (VUKE) has given a total return of 26.1 per cent compared with the Vanguard UK Government Bond ETF (VGOV) which has returned 28.8 per cent.
The bull case for the FTSE 100 over government bonds is that its dividend yield of over 4 per cent is much more attractive than the yield on UK government bonds where the 10 year treasury gilt has a yield to maturity of just 1.1 per cent at the time of writing.
A 1.1 per cent yield is deeply unattractive and is less than the rate of inflation, but as we have seen in countries such as Germany and Japan, yields can fall to zero and then go negative. Paying money to hold an investment doesn’t make sense to most people but unless interest rates increase significantly, investors will be protected from the big losses that are inflicted on equity investors from time to time. If the UK economy weakens and the Bank of England creates more money to buy government bonds then who’s to say that UK 10-year gilt yields cannot end up at zero or lower as well.
It seems somewhat bizarre to think that a portfolio of UK bonds offering such meagre income to investors could be a better home for your money than a basket of one hundred shares with an average trailing dividend yield of 4 per cent. However, if you look at the makeup of the FTSE 100 you can be forgiven for asking, what’s to like about it?
Top 20 Constituents of FTSE 100 by market capitalisation
Market cap £m
PE roll 1
Royal Dutch Shell
British American Tobacco
Reckitt Benckiser Group
Lloyds Banking Group
The current market capitalisation of the FTSE 100 is just over £2.1 trillion. Just under half of it is made up of the ten largest companies. Just over two thirds of its market capitalisation is made up of the top twenty largest companies. If you invest in a FTSE 100 tracker fund then your fortunes are largely tied to the success or otherwise of these companies.
I don’t know about you but a portfolio of these 20 shares doesn’t really appeal to me. I look at them and struggle to see how most of them are going to grow much bigger than they are already. Many face competitive, technological and regulatory challenges that make this difficult. As I wrote last week, the safety of dividend payments from many companies in the FTSE 100 cannot be taken for granted either. Vodafone has slashed its dividend and Glaxo hasn’t increased its dividend for some years now.
The argument that UK shares in general are a buy because they are cheap and offer a high dividend yield is a weak one in my opinion and has been for some time. They are cheap for a good reason. The UK market is dominated by big lumbering companies that will struggle to grow their profits and dividends in a meaningful way and are priced accordingly.
That’s not to say that there aren’t any good companies that have the potential to grow in the FTSE 100. I give some examples below but you have to pay very high valuations for many of them.
High quality FTSE 100 constituents
Market Cap £m
PE roll 1
London Stock Exchange
InterContinental Hotels Group
Auto Trader Group
I would struggle to put together a twenty stock portfolio from the index, but I’d rather own the few good businesses in it rather than the index in its entirety. Tracking the FTSE 250 index has been much more rewarding, but for me, the UK market is one for selective stock pickers. If you don’t want to do that then an S&P 500 index tracker is a better option than most.
Will Amazon’s tie up with Deliveroo blow a hole in Just Eat’s UK profits?
Technology companies which make it easier for consumers to do things such as ordering taxis and takeaway food are all the rage and are valued very highly by the stock market. The bull case is that the companies involved in this line of business have state of the art technology that helps companies and consumers save time and money which is difficult to copy. This will eventually allow them to grab a big slice of a big and growing market and make lots of money for their shareholders.
Well, that’s the theory any way. The reality for companies such as recently listed Uber and UK based Deliveroo is that the losses are currently stacking up and profits are just a pipe dream at the moment.
At least Just Eat does make a reasonable amount of money - over £100m of trading profits and nearly £200m of operating cash flow in 2018 - and has big profit margins in its main UK market.
Source: Just Eat
The company has achieved this by building up a significant scale in the UK with over 12 million active customers who made nearly 123 million orders last year. When this scale is leveraged over a large fixed cost base (staff and an IT platform), once profits start being made they grow very quickly with each additional £1 of revenue. Just EAT is hoping that it can replicate its UK success in its 12 other markets.
There is no doubt that its shares are priced for a rosy future and trade on a punchy 48 times rolling forecast earnings at a share price of 633p. This is despite the fact that the share price has fallen very heavily since last year.
The company is under pressure to convince its investors that it can make a success of its delivery operations and faces severe pressure from the likes of Uber and Deliveroo. Its chief executive stepped down in January and an activist shareholder is so concerned that the company lacks sufficient leadership that it is pushing for it to merge with rivals in Europe.
The fact that iFood, the company’s investment in Latin America is expected to lose between £80m and £100m this year (on an EBITDA basis) is also weighing on the shares. Throw in a lacklustre trading update last month and sentiment towards the shares is pretty low right now.
Last week came the announcement that Amazon had backed Deliveroo’s latest round of fundraising gave the shares another kicking. Deliveroo is going to use the $575m it has raised to beef up its technology and its app and also roll out its idea of delivery only kitchens across the UK.
These kitchens allow takeaway food companies to quickly and cheaply set up a presence in an area without all the costs and overheads of having bricks and mortar premises. In doing so, Deliveroo is trying to build bonds with companies that is difficult for them to break away from but this will take some time to build up to a meaningful scale.
But what does this mean for Just Eat’s prospects in the UK?
The mere mention of the involvement of Amazon is enough to strike fear into most businesses it has set its sights on but such a conclusion in this case looks premature for now in my opinion.
It is clear that delivery capability is the key battleground in the online takeaway food business. It is part of Just Eat’s strategy and it is investing a lot of money in this area. By improving the delivery capability it can offer restaurants quicker delivery times which hopefully leads to more orders which them improve the utilisation of delivery drivers and riders and drives down the cost per order. This then allows Just Eat to have stickier customers and keep hold of more of the restaurant's business.
The trouble is, no-one is making any money out of delivering food to customers. It is often the case that the fee paid from the restaurant can be less than the amount paid to the person delivering the food. Amazon set up a food delivery business in the UK in 2016 and closed it down two years’ later. Deliveroo is loss making and so is Uber Eats.
Just Eat makes all its profits from its marketplace business where its gets a percentage fee of the order value when people order food through its website. It also gets some service revenues when restaurants sign up for the system.
This business is very sticky with over 100,000 restaurants signed up to it and 26 million consumers using it across the world. It is an example of a network effect in that the more people use it, the more valuable it becomes.It is deeply entrenched with its users. In some ways, it is very similar to a business like Rightmove or Auto Trader. It is profitable and very defendable against competition.
It is difficult to see how Deliveroo or Uber is going to take enough business from Just Eat to destroy its profits.Just Eat has by far the biggest selection of restaurants and has the business is many small towns sewn up which means the economics don’t stack up for new entrants. It is many times bigger than Deliveroo and Uber.
I see the Amazon/Deliveroo development as a very minor concern. The key issue with Just Eat is whether there is enough growth out there is its chosen markets to justify the current valuation of the business. A lot of good news is still priced in.
Time to end the abuse of adjusted profits
Back in November last year I wrote an article called “The Problem with Profits”. It highlighted the numerous abuses committed by companies when they were presenting their underlying or adjusted profits to investors.
I have no problem with companies trying to show investors what the underlying profits of a business are if certain one-off costs are ignored. The problem I do have is management having their bonuses based on a number they can easily manipulate.
Reading through many company results releases in recent weeks shows that the levels of abuse continue to be as high as ever. Amortisation of intangible assets such as software are real costs backed by cash outflows. Opening costs of bars or shops are real costs. They are cash outflows and represent a transfer of value away from the owners of a business. They may not happen every year for the bar or the shop concerned but are they really exceptional or one off when a company has a strategy based on opening more bars or shops for many years to come?
The real bugbear is the stripping out of payments to employees in the form of shares - share based payments. The arguments seemed to be that because they are a non-cash expense that they can be ignored.
They may be non-cash but if they are not an expense then what are they? In the eyes of existing shareholders they represent a future dilution of your stake in the company. They are taking away a slice of your share of the profits and net assets. To say that these are not real costs and don’t matter couldn’t be further from the truth.
I always deduct them as an expense when working out a company’s real profits. I think others should do so as well.