A month to forget

The most important move during the month was the steady increase in US Treasury bond yields, with the 10-year yield moving from 2.4 per cent to 2.7 per cent, its highest in four years. Fears that the yield on Treasuries would move higher, given the strong US economy, were probably behind the equity sell-off during the closing days of the month. Still, the S&P 500 finished January up 5.6 per cent. Apart from the UK, other equity markets were strong, with Russia up 11.4 per cent, India up 5.6 per cent, the German Dax up 2.1 per cent and the Nikkei 225 up 1.5 per cent.

In currency markets, the US dollar was weak, with sterling gaining 5.2 per cent to $1.42 at 31 January. This might have been behind the UK equity market’s poor showing given the high overseas exposure of FTSE 100 companies. Against the euro, sterling fared less well, gaining just 1.6 per cent.

Oil was strong (helpful for Russia), with Brent crude up 3.4 per cent to $68.87 (£49.78) per barrel. Zinc gained 7.4 per cent, but copper gave up 3.1 per cent. Gold had a good month on US dollar weakness and fears of resurgent inflation, gaining 2.6 per cent to $1,343 an oz. It struggles at around $1,370 an oz, but if it breaks through that level it will be at its highest level in four years and could make further substantial gains. Until it does, I’m happy to watch from the sidelines. To the inevitable screams of ‘I told you so’ Bitcoin had a poor month, falling 30 per cent to $10,151 and some 50 per cent below its December peak. Bitcoin zealots will point out that during its life it has had many pullbacks of 70 per cent or more, and that once the Johnny-come-lately buyers have been shaken out it will resume its upward course. Fascinating to watch and time will tell.

A tale of two profit warnings

The damage to the portfolio was down to just two stocks, Conviviality (CVR) and Card Factory (CARD). According to analysis by Statpro, Conviviality – down 19 per cent during the month – cost me 1.4 per cent of performance and Card Factory – down 34 per cent – a further 1.3 per cent. After that, the next worse contributor was Bioventix (BVXP), which cost just 0.3 per cent. Sadly, there were not any big positive contributors, with Baillie Gifford Shin Nippon (BGS), at +0.2 per cent, the best. My two big positive movers, Satellite Solutions Worldwide (SAT) and Statpro Group (SOG), up 14.1 per cent and 13.1 per cent, respectively, are two of my smallest positions and had minimal overall impact.

Conviviality had warned before its half-year results, published on 29 January, that its full-year profits would be second-half-weighted due to the cost benefits of its new systems not being realised until the second half. Despite management reiterating its confidence in the full-year forecasts, the results sparked a sell-off in the shares. I think investors were hoping that its debt levels would be lower and, although sales growth was robust, were concerned that this had been achieved at a cost to margins. To some extent they were correct, as it signed some big contracts at lower rates. These contracts are long, up to 10 years, and Conviviality is convinced that when its cost savings are realised, operating margins will widen.

So, I think the near-20 per cent drop in the share price was an overreaction; consensus earnings forecasts were reduced by just 2.0 per cent, the interim dividend was increased by 7.1 per cent and, given that we are already half-way through the second half, I am prepared to believe management’s assertion that it will meet full-year forecasts. If it does, at 300p, one is paying 12.7 times April 2018 forecast earnings per share, for 60 per cent growth and a prospective dividend yield of 4.5 per cent. Some have said I should get out my assassin’s rifle, and I concede there is a risk that I may be too optimistic, but I think the shares are cheap enough to warrant the risk. This will never be a high-margin, high-return-on-capital business, but it should be relatively stable and generate plenty of free cash. I would like to see a period without any further acquisitions and share issuance.

Card Factory is another stock where I run the risk of looking foolish. The shares have dropped over 30 per cent since its 11 January trading update. Again, it had already warned that margins would be squeezed due to cost pressures caused by the living wage and from sterling weakness against the US dollar. Many of its products are sourced from dollar-denominated markets and hence saw significant cost and price increases due to the post-Brexit referendum devaluation of sterling.

Due to the squeeze on margins, the special dividend for the year ending January 2019 is likely to be lower. Consensus forecasts are for total dividends of 14.5p, down from 21.1p for the year just ended. But earnings forecasts were reduced by just 4.0 per cent, and it is a business with traditionally strong cash flow, which has previously enabled it to pay special dividends. That leaves the stock on a January 2019 PE ratio of 9.9 and a prospective yield of 7.6 per cent. I was tempted to cut my losses, but again I think the market has overreacted and I will get a better opportunity to sell.

In both cases, management has taken advantage of the drop in the share price to add to their holdings. In a very quiet month on my own dealing front, I followed Karen Hubbard, chief executive of Card Factory’s example and added to my holding at 197.5p on 25 January and I added to Taptica (TAP) at 450p on 16 January.

The importance of dividends (and reinvesting them)

In previous columns, I have mentioned the importance of dividends and the compounding effect of reinvesting them. To demonstrate, in the 30 years to 31 December 2017, £10,000 invested in the FTSE All-Share would have grown to £48,500, but with dividends reinvested would have grown to £144,869. I think 30 years is a sensible period for someone who is saving for retirement. The volatility can be alarming, though. During those 30 years, there were seven down years, ranging from -3.5 per cent in 2011 to -29.9 per cent in 2008. Equities are not the place to park cash you might need in the short term.

I started the JIC Portfolio with £151,110 cash in January 2012. By 31 December 2017, it had increased by 179.3 per cent (£270,940) to £422,050. Of that £271,000 increase, £44,975 or 16.6 per cent, was dividends. I use ShareScope to manage my portfolios; apart from excellent charting and extensive data, it provides me with dividend and capital gains reports. It shows that in the first year, 2012, I received dividends of £2,518, in 2013, £4,613; 2014, £7,027; 2015, £8,653; 2016, £11,067 and in 2017, £11,097.

After a year of historically low volatility, we are currently going through a period of higher volatility, which seems to be causing a lot of angst. It is very easy to fall into the ‘volatility trap’ and be panicked out of holdings. I prefer to stand back and focus on the dividend-paying potential of my holdings. If my projections are correct, I should receive well over £12,000 in dividends this year and, as it is being reinvested in the portfolio, a bit of volatility is neither here nor there. Of course, if one is very clever one could cash up ahead of a correction or bear market and reinvest, but calling the bottom is easier said than done. An acquaintance managed it in 2008, but even he admits there was a huge element of luck in his timing.

Volatility shouldn’t be anything to worry about, unless you are leveraged (forced to sell to meet margin calls), need the cash for something in the short term (in which case it shouldn’t be in equities) or are disposed to bouts of panic. Just taking one of my holdings, why did someone sell Bloomsbury at 150p on 6 February? It was down 12 per cent on the day, 21 per cent down on the 22 January price and was on a prospective February 2018 dividend yield of 4.7 per cent. It’s possible that the seller had identified something more attractive into which to put the money, but I suspect it was because of one of the three reasons above. The stock finished the week at 174p. If you have cash to invest you should welcome volatility. Set your levels and you can pick up some bargains.

Looking ahead

In last month’s column, I said “the most obvious shock might be higher than expected inflation, presaging higher interest rates”. That indeed seems to be the main fear currently gripping markets. On 8 February, the S&P 500 had fallen 10.1 per cent from its 26 January peak, defined as a correction. Hopefully that’s it, but if the authorities are behind the curve and inflation really takes off, that will further hit both bonds and equities. If they tighten too quickly, however, they risk strangling global growth, which is moving ahead at a decent pace for the first time in many years. As things stand, I think those concerns are overdone and that rate increases will be measured and well sign-posted, and that equities remain the best place to be.