While never complacent, it is pleasing to report that 2019 was another good year. The Growth portfolio produced a total return of 27.5 per cent compared with 18.2 per cent for its benchmark – the MSCI WMA Growth index. Meanwhile, the Income portfolio gained 20.5 per cent compared with 15.1 per cent for the MSCI WMA Income index. These figures reinforce the long-term record of outperformance since the portfolios’ inception in 2009 – the performance table below has more details.
At the year-end, the portfolios were yielding 2.9 per cent and 4.0 per cent respectively, in part because of their overweight holdings in bonds and other assets. Changes this month to both portfolios have helped increase income levels, and yields are now 3.1 per cent and 4.2 per cent, respectively.
The portfolios’ overweight positions in the UK, technology and smaller companies both home and abroad all contributed to the outperformance. In particular, the portfolios benefited from both asset values rising and discounts narrowing when the UK market climbed the wall of worry as the general election came and went and ushered in greater certainty regarding Brexit. The underweighting of the US did not detract too much as this was compensated for by holdings elsewhere.
In looking forward it is important for investors to stick with established principles when managing portfolios and to focus on the long term when assessing markets and companies. In particular, at this time of year, the temptation to allow short-term forecasts to influence asset allocation should be resisted.
Sticking with established principles
Tried-and-tested disciplines have certainly guided the portfolios’ progress over the past decade. When deciding strategy, little attention is paid to short-term market ‘noise’. The most important determinant is the ability of companies to create wealth and add value, and the conditions that sustain such an environment. The focus remains on the longer term when assessing sentiment and fundamentals, and volatility is therefore seen as an opportunity.
The portfolios tend to remain invested and seek to add value over time – wiser investors are left to try to time the markets. Such an approach also allows the full harvesting of dividends, which become an increasingly important contributor to total returns over time – the portfolios’ higher yield, relative to benchmark, acknowledging the significant contribution made by reinvested income to overall returns.
As time passes and the investment journey progresses, the portfolios also recognise the importance of rebalancing and diversification as a means of helping to protect past gains – both essential but undervalued disciplines. This involves increasing exposure to assets less correlated to equities, including bonds, infrastructure, renewable energy, commercial property and cash. Such an approach can also help to increase income levels.
Furthermore, and most importantly, investment is best kept simple to succeed. Complexity usually adds cost, risks confusion and hinders performance. The portfolios therefore avoid structured products, hedge funds and derivatives etc and instead focus on what we know and on my fundamental belief in the power of well-chosen equities to produce superior returns over cash and bonds over the long term.
Indeed, adherence to such disciplines guides the progress of all nine real investment trust portfolios run in real time on the website www.johnbaronportfolios.co.uk – including the two regularly covered in this monthly column. It helps them achieve a broad range of risk-adjusted strategies (five of the portfolios reflecting an investment journey), a growing level of income with yields of up to 5.3 per cent, and good performance relative to respective benchmarks.
…and avoiding forecasting folly
In paying little heed to market ‘noise’, the portfolios are not influenced by short-term economic or market forecasts. We are now in the midst of the ‘Silly Season’ when forecasters are expected to predict the short-term direction of markets and companies by way of expected values, despite little evidence that such endeavours add value or are remotely useful. The renowned economist JK Galbraith once said: “Pundits forecast not because they know, but because they are asked.”
The evidence suggests an especially poor track record of economic forecasting. This has been known for some time. JK Galbraith went further: “The only function of economic forecasting is to make astrology look respectable.” The International Monetary Fund (IMF), the European Commission, the Bank of England and the US Federal Reserve all missed the global financial crisis of 2008-09 despite various signals flashing red.
Despite the evident financial turbulence, as late as April 2008 the European Commission predicted eurozone growth would be 2 per cent in 2008 and 1.8 per cent in 2009. Again, this proved well wide of the mark. The figures actually turned out to be 0.4 per cent and -4.5 per cent. In statistical terms, such differences are significant. Many analysts and economic organisations also missed the oil price collapse in 2014.
Perhaps the most high profile illustration of the malaise within the economic forecasting profession surfaced during the European Union (EU) referendum period. ‘Project Fear’ involved the Bank of England, the IMF, the Treasury and various economic, media and trade bodies all forecasting prior to the referendum economic woe if the UK simply voted to leave the EU. A ‘DIY recession’ by Christmas was suggested. The CBI, for example, in a major report in March 2016, forecast an extra 950,000 unemployed within a few years.
The reality has turned out to be very different. The UK has seen good economic growth relative to other countries, record manufacturing output, strong inward investment (attracting more inward investment than Germany and France combined) and record low unemployment – nearly half that of the EU average. These ‘Project Fear’ forecasters chose to ignore the fact that investment and jobs is largely determined by ‘comparative advantage’ – an economic concept covered in previous columns.
The extent of inaccuracy has encouraged many to believe that, as a social science, economics can be too far readily skewed to serve the interests of politics and business at the expense of accuracy. What has perhaps encouraged this perception is that economics is subject to ever more complex mathematical models, which can create the false impression of accuracy or precision.
It is little wonder economics has found the terrain difficult post-2008. At least the Bank of England had the grace to apologise for its errors. Early in 2017 the Bank’s chief economist, Andy Haldane, admitted forecasting failures (particularly in relation to the financial crash of 2008 and the catastrophic consequences if the UK voted for Brexit) meant the economics profession was “to some degree in crisis”. This has been confirmed in previous studies.
In 2001, IMF economist Prakash Loungani studied the accuracy of economic forecasts throughout the 1990s in both the public and private sectors, and concluded that “the record of failure to predict recessions is virtually unblemished”. In 2014 he and Hites Ahir repeated the study and found that even during the autumn of 2008, well after the fall of Northern Rock and Bear Stearns, the consensus economic forecast suggested no country would fall into recession in 2009. Yet 49 of the 77 countries under review were in recession that year.
Part of the problem is that forecasts tend to be backward looking. A Harvard study by Lant Pritchett and Larry Summers found that economists had the tendency to extrapolate past trends in assuming countries would continue to grow at recent rates. Yet the report pointed out that the opposite is often the case: “regression to the mean is perhaps the single most robust and empirically relevant fact about cross-national growth rates”.
A further problem for economic forecasters is that they are trying to predict the biggest variable of all when determining growth rates – that is human behaviour when it comes to saving, spending and investment decisions. Economic output and growth consists of the aggregated activity of millions of people who are factoring into their everyday decisions variables which are both seen and unseen by economists and observers alike.
The poor record on forecasting is not confined to economists. The record of 22 strategists forecasting year-end levels for the S&P 500 between 2000 and 2014 showed they got it wrong by an average of over 14 per cent a year. Company specific forecasts do not fair much better. In 2018 stockbroker AJ Bell reported that the 10 FTSE 100 companies most recommended as a ‘buy’ by analysts actually fell by over 9 per cent during 2017. Yet the 10 with the most ‘sell’ recommendations ended the year up by a similar amount.
Suggesting forecasts for just a year is particularly irrational. Longer-term trends and company fundamentals rarely progress at an even pace or in a straight line – patience is required when it comes to valuations, which remain the key determinant of stock market returns over time. The successful investor fully appreciates Sir John Templeton’s observation that “This time is different” are perhaps the four most dangerous words in investing.
Therefore, while the portfolios may contain a blend of strategies and preferences at any point in time to reflect their particular remit, the overall objective is to invest in good quality companies for the long term and to focus on what is known (the management and portfolio) rather than on what is not (market and economic forecasts). It is an approach that has served the nine portfolios well.
Market opportunities
In general, when deciding asset allocation, and where appropriate to portfolio remit, investors should retain faith in the compounding power of well-chosen equities over the long term. The portfolios therefore exhibit a bias to ‘growth’ and smaller businesses. However, valuations suggest certain value-focused strategies and holdings should be harnessed particularly when income is sought. Accordingly, the portfolios embrace both as necessary to achieve their objectives.
A range of corporate bonds will continue to assist those portfolios seeking income and diversification. The portfolios have benefited in expecting interest rates to remain low for longer than consensus forecasts. This unusual scenario is born out of higher than normal debt levels (rather than lack of demand, which has characterised previous recessions and crises), which governments and central bankers have become increasing anxious to address. Inflation is preferred to default.
Other less correlated and inflation-friendly assets such as renewable energy, infrastructure and commercial property also continue to have a role to play, despite the premiums to net asset value (NAV) of the first two – the extent of each being dependent on the level of diversification required. Exposure to such assets should gradually increase as time passes to help protect past gains and raise income levels – the portfolios covered in this column being two of five reflecting such an investment journey over time.
As for geographical allocation, the UK will remain well represented in the portfolios. Having been out of favour and very cheap in part because of political and Brexit uncertainty, exposure was increased last year and the portfolios are now benefiting. Sentiment was always trailing the fundamentals, as previous columns on the UK and Brexit have highlighted. And although we have seen a bounce, the market continues to look attractive on almost any valuation metric when compared with others, and should continue to catch up.
Furthermore, a decent parliamentary majority makes a good trade deal with the EU more likely by the end of this year, especially after 48 years of regulatory and tariff harmonisation courtesy of our membership. Political will on both sides is what is required. Additional market catalysts could include a stable if not stronger currency, the prospect of trade deals in a few years with countries outside the EU, and better economic growth and prosperity generally courtesy of lower taxes. A political belief in the country also helps the narrative.
This will not stop the pruning of portfolio holdings should valuations suggest. The narrowing of discounts can to a large extent be justified, given the prospect of good NAV growth from a relatively low base. To best capture the market’s potential a smaller company preference will also be retained while maintaining portfolio balance relative to remit.
Outside the UK, the portfolios tend to favour the Far East and Japan at the expense of Europe and the US – in large part this is influenced by valuations relative to long-term prospects. The EU remains our least favoured market given key problems remain, including the lack of a working mechanism to transfer surpluses from rich countries to poor together with policies that make for poor relative growth rates and high unemployment. Once again, smaller companies look better value.
The portfolios are underweight the US again on grounds of valuation. However, investors need to be cognisant of the weighting of the highly rated technology sector within the S&P 500 index. This underweighting is somewhat compensated for by exposure to favoured themes such as technology and biotechnology, which themselves have high exposure to the US. It is also balanced by some income and value-focused exposure.
The Far Eastern and Japanese exposure is born of good prospects, an entrepreneurial approach, an increasingly shareholder-friendly and dividend-paying culture, and attractive valuations relative to long-term potential and other markets. A frustration has been the relatively modest market gains in Japan relative to potential, but it is hoped this will change in 2020 – the omens certainly look encouraging.
Recent columns have focused in some detail on some of these markets and sectors including Japan, the UK, technology, smaller companies and commercial property. Of course, markets will continue to be volatile. But history suggests volatility should be seen as an opportunity for those investors looking to the long term. Portfolio disciplines allied to sound investment strategies can help to make for calm assessment at such times – regardless of short-term forecasts.
Portfolio activity
Since last reporting on the breakdown of the Growth and Income portfolios as at 30 September 2019 (‘Patience is usually a virtue’, 11 October 2019), there has been relatively little activity. The Growth portfolio added to existing positions in Montanaro UK Smaller Companies (MTU) in November and HICL Infrastructure Company (HICL) in December at prices of £1.12 and £1.59, respectively – the purchases being funded from the portfolio’s cash level. There were no changes to the Income portfolio.
John Baron waives his fee for this column in lieu of donations by Investors Chronicle to charities of his choice. As these are live portfolios, he has interests in all of the investments mentioned.
