Crash-proof your portfolio

In the past few years, global equity markets have enjoyed a stellar run, aptly characterised by Fahad Kamal, a senior market strategist at Kleinwort Hambros: “If you had assets five years ago and you haven’t made a lot of money, I don’t know where you have been hiding.” Indeed, the FTSE All-Share has generated total investor returns of 14.6 per cent in the past year alone, while the S&P 500 has risen 24 per cent and rung up nearly 40 historically high closes. The current bull run – which has seen global equity markets climb since post-financial crisis lows in 2009 – is the second-longest since World War Two, only matched by the dot-com boom of the late 1990s.

But that longevity has concerned bears lurking in financial hubs around the world. Negative predictions for the year ahead range from “a slight correction” to “the biggest crash in history”. Although forecasting the end of a bull market based on its length is “like trying to judge a book by the number of words”, according to Mr Kamal, it is not merely this bull’s age that suggests a correction is overdue.

For a start, equities are expensive. Technology, biotechnology and online retail are particularly stretched – driven by the wave of optimism about future digital trends. Meanwhile, historically defensive sectors such as consumer health carry extremely toppy valuations, which are unmatched by their potential earnings growth. 

But fund managers don’t think the markets have the same bubble characteristics that preceded the crash in 2000. “There are stretched valuations, but no speculative mania,” said George Godber, a value investor at Polar Capital. Indeed, even in the most expensive area of the global equity markets – US tech – valuations are well below those of the tech bubble, based on the cyclically adjusted price-to-earnings metric devised by Nobel-Prize-winning economist Robert Shiller.

Bubbles tend to occur when investor excitement about certain markets is unfounded by financial metrics. In the UK, by contrast, investors are exceptionally gloomy. And can you blame them? Political upheaval, dismal growth projections and a weakness in sterling has left the country distrustful of financial markets.

But while most companies do not display the characteristic risky enthusiasm of a bubble, bitcoin certainly does – and that might matter to more traditional markets. Investors' desire for crypto-currency has risen meteorically, sending the price of bitcoin up 900 per cent in the past year (at the time of going to press). And yet, most investors and regulators have very little understanding of how bitcoin is valued, how its software works and what is driving the price. We know nearly nothing about its shadowy origins, its miners or its uses and – given its sky-high valuation – that is concerning.

But does the bitcoin bubble have the potential to unravel stock markets? It certainly seems illogical to suggest that one massive sell-off could spill over into other areas of investment, but markets are rarely rational when everyone is ‘fear selling’. After all, a crisis in credit default swaps fuelled the 2008 stock market meltdown and a widespread lack of understanding of the derivatives market led to the 1987 crash.

Market watchers are also forecasting the start of the end of quantitative easing – the monetary policy which Stephen Message, manager of the L&G UK Equity Income fund, described as “incredibly accommodative” to equity valuations. The extra cash provided by central banks in recent years has been recycled into equities and property, increasing liquidity and thus artificially inflating valuations. With global economies now on the mend, central banks in both the US and UK have started to increase interest rates, which signals the end of quantitative easing. This has the potential to remove the liquidity that has supported many markets.

And finally, to top off the gloomy picture, margin debt is higher than ever before. In the US, in particular, a lot of stocks are being bought on margin; therefore if (and when) there is a correction, these debts will be called in. Although this is unlikely to trigger any type of stock market crash, it could exacerbate the downside should any external shock trigger a sell-off.

What would Warren do?

Warren Buffett always says the ideal holding period is forever. But now – with the markets stretched and value hard to come by – the legendary fund manager is rumoured to be sitting on a lot of cash. Unfortunately, Mr Buffett was not available to confirm or deny these rumours to the Investors Chronicle, but don’t fear – there is no shortage of expert advice in the UK.

“Following a prolonged period of growth in the market, investors may find that they are running unbalanced portfolios with overweight positions in successful investments,” says Will Walker-Arnott, an investment manager at Charles Stanley. “While I believe that the bull market in UK equities will continue in 2018, I would argue that this is now an opportune moment to bank some profits and rebalance portfolios. For my clients I don’t like to have one holding in excess of 5 per cent of the portfolio value.” Mr Walker-Arnott also pointed to the cheapness of capital gains tax in comparison to other taxes in the UK and advises that investors “should take advantage of this window”.

Shaniel Ramjee, a senior investment manager for multi-asset at Pictet Asset Management, agrees that extracting some cash could be a sensible strategy. “Take profit from the stocks that have done very well, especially defensive ones,” he advises. “It is time to reduce some of that allocation and think about going into more cyclical areas such as industrial and commodities. We are not feeling too shy about banking profits. We’ve reduced the risk in our portfolio in the past few months and we’re happy to sit on some cash.” Pictet is not alone in this strategy. Polar Capital’s value fund has a 4 to 5 per cent neutral cash position, while the average cash position of ‘steady growth’ portfolios in the UK is estimated at 7 per cent.

But with interest rates so low and bond markets expensive, most fund managers are still favouring equities. “We look for areas where investors can make real returns above the level of inflation,” said Mr Ramjee. Meanwhile, Simon Gergel from The Merchants Trust thinks “the UK is far more reasonably priced than some markets, particularly the US, and there are many companies with sensible valuations”.

Some – including Fahad Kamal from Kleinwort Hambros – are particularly optimistic. Current sentiment “is not going to end any time soon, at least not to the extent that it could lead to a big market sell-off. Where there is a lot of exuberance there is also a lot of risk, but there is not a lot of exuberance right now”. He thinks “valuations are toppy, but not at scary levels”, and when it comes to momentum, “things are on fire”. “So, stay in, be diversified and be aware of a change in momentum, sentiment or valuation.”  

Neil Woodford, founder of the Woodford Equity Income Fund – the lowest ranking fund in its peer group this year – is notably less enthusiastic. In an interview with the Financial Times he said he believes stock markets around the world are in a “bubble” that when it bursts could prove “even bigger and more dangerous” than some of the worst market crashes in history. “Whether it’s bitcoin going through $10,000, European junk bonds yielding less than US Treasuries, historic low levels of volatility or triple-leveraged exchange traded funds attracting gigantic inflows — there are so many lights flashing red that I am losing count.”

It’s tough at the top

But what should the average investor do? The following case study highlights the problem many face right now.

January 2017: Mr Smith – a fanatic gamer – has decided he is going to put some money in a company that he feels familiar with. Frontier Developments (FDEV) leaps out. It’s a video game developer that boasts a couple of its own titles and has also created the software and graphics behind well-known gaming franchises. Not willing to part with too much of his hard-earned cash, Mr Smith decides to invest £1,000 at 278p a share.

June 2017: Something wonderful has happened. Frontier Developments has gone from a struggling work-for-hire video game developer to a company with two of its own popular titles. Its shares have risen 51 per cent in the past six months, meaning Mr Smith has made a £510 return on his original £1,000 investment. Frontier’s shares now look pretty expensive, but Mr Smith is confident that the run of good fortune will continue and decides to stay fully invested. Besides, interest rates are miserly, so putting the money in the bank doesn’t seem like a great alternative and bonds are even more expensive than equities.

December 2017: A good decision. Frontier’s share price has risen another 210 per cent in the past six months and Mr Smith has made another £3,170. His original £100 investment is now worth £4,680. But Mr Smith is now faced with a conundrum. To take or to run profits? He’ll kick himself if the share price collapses and he misses out on all those gains. But he’ll also be annoyed if he sells and the company keeps climbing, after all if he had cashed out in June, he’d have missed a huge chunk of profits.

The challenge for the fictional Mr Smith is likely to feel very familiar to equity investors. In the past 12 months, 30 British companies with a market capitalisation of over £100m have seen their share prices at least double. The temptation to cash out is certainly high, particularly now murmurings of uncertainty about the longevity of the bull market are beginning to carry more weight. But investors are still facing the conundrum of low interest rates and expensive alternative investment options. Plus even if markets do correct next year, some of the highest of fliers could continue rising in the long term. After all, a company is only expensive if its valuation is unsupported by its financial growth.

So how does an investor who has enjoyed a fantastic few years in the equity markets ready themselves for a sell-off? Are there any momentum stocks that look likely to keep rising after a correction and are there any that have reached – or are nearing – their peak?

To give some clarity to these seemingly unanswerable questions, we’ve taken the 114 UK listed companies that have enjoyed a share price rise of at least 50 per cent in the past year and assessed whether their financial metrics are supportive of continued growth in 2018.

Low-risk momentum: Run profits

• Strong revenue momentum: 20 per cent one year increase
• Strong earnings momentum: 10 per cent one year increase
• Making cash: Average operating cash conversion of at least 100 per cent in the past three years
• Not too expensive: Price-to-earnings (PE) multiple less than 20 times
• Share price justified by earnings growth: Price-to-earnings growth ratio (PEG) of 1 or lower

Source: Bloomberg

Strong revenue, earnings and cash flow can support a company through times of turbulence. These 10 companies are among a handful to tick most of the boxes, meaning a crash shouldn’t have too much of an impact on the long-term investment case. We therefore recommend shareholders run profits.

Games Workshop

All too often, corporate recovery plans involve desperate cost cutting, without addressing the underlying problems in the business. Not so for Games Workshop (GAW). The stars aligned for the game and model retailer when it initiated its digital push at the same time as a wave of nostalgia for fantasy figurines – perhaps sparked by the Game of Thrones TV series – swept the globe. The result is that both profits and the group’s share price have more than doubled in the past year and investors who bought into the recovery strategy in late 2016 are probably feeling pretty smug.

True, some of the top-line momentum has come from helpful currency movements – GAW generates most of its revenues outside of the UK – but that has been supported by underlying sales growth of 21 per cent. Operating profits grew 85 per cent in constant currencies in the year to May 2017 and the momentum has continued in the current financial year. But still the shares carry a forward price-to-earnings multiple of just 13 times, which is way too low considering the continued stellar growth.

Dechra Pharmaceuticals

Stateside expansion has also been the shining light for veterinary pharmaceuticals specialist Dechra (DPH). In the year to June 2017, US revenues nearly doubled at constant currencies thanks to exceptional performances from recently acquired businesses, while the wider business benefited from positive trends in the global pet and farm animal markets.

Qualms over the fact that Dechra has bought in a lot of its growth this year should be eased by the fact that the company has delivered compound annual earnings growth of 29 per cent in the past three years, has a solid pipeline of new drugs and substantial financial firepower. After booking revenue of £359m in the year to June 2017, Dechra found itself in the top 10 global veterinary pharmaceuticals companies by revenue for the first time. These giants account for 85 per cent of the total market, with the remaining 15 per cent made up of a large number of small companies. There are, therefore, many more opportunities for Dechra to keep shopping. It may be tipping towards the ‘too expensive to buy’ point, but we think investors would be foolish to jump ship.

High-risk momentum: Take profits

• Weak revenue: less than £50m or a lower than a 20 per cent annual increase
• High capex requirements: EPS losses
• Poor cash conversion: Average operating cash conversion less than 50 per cent
• Expensive: Forward price-to-earnings multiple of more than 20 times
• Share price unjustified by earnings growth: Price-to-earnings growth ratio (PEG) of more than 1

Source: Bloomberg

A lack of earnings (or negative earnings trajectory due to rising costs), minimal cash profits and exorbitant valuations are major red flags in even the healthiest of markets. Under the pressure of a crash, these are the companies that are likely to be hardest hit and – if sentiment remains sour – the slowest to recover. Investors will have more than doubled their money on eight out of our 10 highest-risk companies and we therefore recommend banking some profits before the tides turn.

Blue Prism

It has been said that, in the not-too-distant future, all jobs will either involve controlling robots or be controlled by robots. Blue Prism (PRSM) is helping to make that a reality. The group has developed a robotic process automation system, best described as virtual 'robots' that are trained to automate back-office tasks in big businesses. Demand is high: in the second half of the financial year to October 2017, the group signed 400 software deals – including 206 new customers, 181 upsells to current customers and 13 renewals. 

But developing a new breed of workforce does not come cheap, which is why losses per share are expected to keep widening until at least 2019. Cash outflows are also high and it is near impossible to assess the true underlying value of the shares, which have risen 1,823 per cent since the company listed in March 2016.

Bluejay Mining

Bluejay Mining (JAY) isn’t merely earnings and cash flow negative, it doesn’t make any revenue. Valuing it is therefore close to impossible. The excitement behind the share price in the past year is based on the fact that it is sitting on potentially the most plentiful, profitable bank of mineral sands in the world. Bluejay has received authorisation and plans to start mining its resource next year.

The good news is that Bluejay’s mine is in Greenland – one of the safest mining jurisdictions in the world. Meanwhile, the global mineral sands market is tightening, meaning the group’s eventual produce could be in high demand. And yet mining and production is not cheap work and with no cash inflows to speak of and just £5.8m on the balance sheet in June 2017, the group may need to return to the market to raise more funds next year. If sentiment swings against it, that might be tricky.