So shares have generally been a good form of investment, but there is a downside. We have already seen that shares can produce negative real returns for periods as long as a decade. Between 2000 and 2003 UK shares halved in price, as did Japanese shares. German shares fell by two-thirds. They rallied until, in late 2007, they fell again in dramatic fashion. In the 2008 collapse the world index of shares fell by 55 per cent.
It does not take long when looking at statistics like these to form the impression that shares are risky. Share investors must be able to accept that equity markets can fall by very large percentages during a day and that individual holdings can become worthless overnight as companies go into liquidation. If you are unable to accept this degree of volatility perhaps you should be investing somewhere else. Building society and bank accounts beckon. While it is important to acknowledge the possibility of negative share return performance, even over periods as long as 10 years, we must not become too pessimistic. Shares on average gave investors very good returns during the last century. I am convinced that they will do so again, just as long as investors avoid buying when the market is being ‘irrationally exuberant’ and blowing up a bubble. Shares should be viewed as long-term investments and not short-term gambling counters. Good returns are available for equity investors who are prepared to bide their time. Note that even if you had bought shares at the peak of the market at the beginning of 1973 and you had experienced a fall in market value to a mere 27 per cent of initial investment over the first two years, if you had held these shares for a further 38 years your average annual real return would have been 6.2 per cent. Your initial investment of £100,000 would be worth £1.1m in 1973 money or over £9 million in year 2012 money. Clearly patience and resilience in the face of market volatility can pay off. There are good reasons for the superior returns in equity investment. Shares represent the risk capital of businesses. This money is put at high risk. Companies go into liquidation and markets turn down violently. Bond investors settle for a trade-off between lower risk and lower returns (although even they can get overpriced, thereby becoming poor investments).
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I thought it might be useful to put the current downward moves in the market in some perspective, so I've looked up what happened to Berkshire Hathaway when its shares fell significantly and then rose again: How far did it fall and how long did it take to recover? I've also obtained data on the FTSE 100 share index and the Dow Jones as well as information on recessions and recoveries.
Berkshire Hathaway I'm taking BH's share movements as a proxy for the experience of a value investors' portfolio in a bear market and in the recovery phase. It's clear that despite Warren Buffett's talent, Berkshire Hathaway is far from immune from large downward lurches - its shares can fall by 35% or more. More hearteningly, we find that it is not many months before the shares have reclaimed all lost ground. In the crash of 1987 BH shares lost 31% between September and November. If you had bought at $2,900 in November, when there was much fear and gloom on Wall Street, and held for 10 months to September 1988 the return would be 66%. If you had sold after a large fall and so missed out on the climb-back, you'll be kicking yourself in September 1988. Berkshire Hathaway shares August 1987-October 1988 Chart In December 1989 BH shares could be bought for $8,675 each. By September 1990 they had fallen 32% to $5,875. It took only 7 months for them to recover all the lost ground, rising 49% from their low point. Berkshire Hathaway shares 1989-1991Chart In March 1999 BH shares were trading at $80,000. They then fell over the next year by 48% to $41,572. Holding onto to those shares through the recovery over the next 9 months would have resulted in a 71% return ($71,000) from the low point. Berkshire Hathaway shares 1999-2000 Chart In October 2008 BH was at $147,000. It fell 50% over the next 5 months. Then it rose by 69% to $125,000 a year later. Berkshire Hathaway shares 2007-11 Chart So far in this crisis BH shares have fallen only 21% from $346,000 to $272,000, which is fairly modest compared with past downturns. Berkshire Hathaway shares 2019-2020 Chart Lessons
In October 1973 The Dow was trading at 978. Eleven months later it was 40% lower at 584. It took a mere nine ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 I’ve sold all my shares in Northamber (LSE:NAR) at 57.2p making a modest profit over the three month holding period (they were purchased at 50.4p – so only a 13.5% return). The primary motive was to add to a cash war chest, ready for purchasing value shares when the crisis reaches its height. But there are also nagging doubts about this business, made more worrying by the prospect of reduced spending throughout UK society on capital items such as audio-visual equipment and computer peripherals in the months ahead.
Why I bought At 50.4p its market capitalisation was £13.9m, but its cash holdings were over £16m, and it had no debt. The only liability was £7.4m of payables which was more than covered by £9.5m in receivables and £3.3m in inventories. It also had an office building worth north of £3m. Net current asset value from latest announcement (half-year report) £’000s Sept 2019 Inventories 4.5 Receivables 8.1 Cash 14.7 Payables -7.5 Less one-third inventories -1.5 Less one-fifth of receivables -1.6 NCAV 16.7 Value of Chessington office property 3.0 NCAV plus freehold property 19.7Market capitalisation at 57.2p = 27.4m x £0.572 = £15.7m. Thus the shares are trading at a 20% discount to NCAV + freehold property. But annual operating losses in the next recession – that awful new factor - might close that gap fairly quickly. Net current asset value being greater than market capitalisation is where the good news about this company stops. The negatives I list below were just about tolerable in times of normal economic growth and when the share price was 50.4p. But the ramifications of Covid-19 tip the balance against the firm. The directors continue to refuse to give a dece ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 We cannot be sure about any thoughts/projections on how the changes hitting economies and businesses will play out in a world awash with fear about Covid-19 – there are just too many uncertainties.
However, we can look at the words of well-informed and experienced people who might flag-up potential scenarios and probabilities. With that in mind, I’ve put together some salient sentences from various copies of the FT and from this weekend’s Economist in the hope that it might help us form a view on reasonably realistic outturns. When reading this (strikingly negative set of news and opinion) bear in mind that if you hold shares in good companies with low debt, operating in sectors of the economy less sensitive to the supply and demand shocks then your VALUE may not have decreased much at all - taking a ten year view - even though you are witnessing Mr Market’s large PRICE adjustments. John Plender, FT, Thursday: The shock that coronavirus has wrought on markets across the world coincides with a dangerous financial backdrop marked by spiralling global debt…the ratio of global debt to gross domestic product hit an all-time high of over 322 per cent… ...much of the debt build-up since the global financial crisis of 2007-08 has been in the non-bank corporate sector where the current disruption to supply chains and reduced global growth imply lower earnings and greater difficulty in servicing debt… …A comparison of today’s circumstances with the period before the financial crisis is instructive. As well as a big post-crisis increase in government debt, an important difference now is that the debt focus in the private sector is not on property and mortgage lending, but on loans to the corporate sector. A recent OECD report says that at the end of December 2019 the global outstanding stock of non-financial corporate bonds reached an all-time high of $13.5tn, double the level in real terms against December 2008. The rise is most striking in the US, where the Fed estimates that corporate debt has risen from $3.3tn before the financial crisis to $6.5tn last year. Given that Google parent Alphabet, Apple, Facebook and Microsoft alone held net cash at the end of last year of $328bn, this suggests that much of the debt is concentrated in old economy sectors where many companies are less cash generative than Big Tech. Debt servicing is thus more burdensome. Increased defaults on banks’ loans together with shrinkage in the value of collateral in the banking system…asset prices could be vulnerable even after the coronavirus scare because the central banks’ asset purchases drove investors to search for yield regardless of the dangers. As a result, risk is still systematically mispriced around the financial system. In a downturn, some of the disproportionately large recent issuance of BBB bonds — the lowest investment grade category — could end up being downgraded. That would lead to big increases in borrowing costs because many investors are constrained by regulation or self-imposed restrictions from investing in non-investment grade bonds. {one-half of al "investment grade" bonds recently issued are rated just above junk levels. If they fall in to junk ratings then many institutions are forced to sell them] Much of this debt has financed mergers and acquisitions and stock buybacks. Executives have a powerful incentive to engage in buybacks despite very full valuations in the equity market because they boost earnings per share by shrinking the company’s equity capital and thus inflate performance related pay [a major prop to the markets in recent years]. Yet this financial engineering is a recipe for systematically weakening corporate balance sheets. The IMF’s latest global financial stability report - a simulation showing that a recession half as severe as 2009 would result in companies with $19tn of outstanding debt having insufficient profits to service that debt. The potentially unsustainable accumulation of public sector debt and of debt in the non-financial corporate sector highlights serious vulnerabilities, notably in China and other emerging markets, but also in the US and UK. And the continental European banking system is conspicuously weaker than that of the US. The Economist [It’s] important to get people to come forward for testing…in America 28m people are without health coverage and many more have to pay for a large slug of their own treatment...people cannot afford to miss work…a quarter of employees have no access to paid sick leave… In China, manufacturing activity in February shrank to the lowest level in since managers were first surveyed in 2004. No amount of cheap credit can stop people falling ill, repair broken supply chains or tempt anxious people into venturing out. In America the response [to Covid-19] has been a shambolic missed opportunity…American bungling...letting the disease spread much further and faster than it might have...test kits were faulty. By March 1st, when S Korea had run 100,000 tests for the virus, America – which saw its first case on Jan 23rd – had run fewer than 500. In America, both the health-care ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 The total return an equity investor receives consists of two elements:
Dividends. These are generally paid every six months from the after-tax profits of the company. Directors decide the proportion of earnings to be paid to shareholders, subject to shareholder approval. Note, however, that a company may not pay dividends. The reasons for this include that the company is currently unprofitable, or that it is fast-growing and needs to use all cash generated to invest in productive assets. Capital gain. The share price rises over time due to an increase in the underlying value of the business (or to temporary enthusiasm for the shares by investors, which may or may not be rational). So, where do the terrific returns on shares come from: is it predominantly from dividends or capital gains? Well, over a single year the returns on equities are largely due to share price movement; dividend income contributes a relatively small amount. However, long-term returns are overwhelmingly due to dividends. For example, if a UK equity investor had chosen to spend dividends received on a £100 investment made in 1900 as each year passed, rather than reinvest, by now capital gains alone take the fund to about £20,000 (nominal return). On the other hand, another investor who reinvested dividends over the same period would have had a fund worth over £3m (nominal return). I bought shares in TClarke (LSE:CTO) in November 2015 at 79.16p, since when they have paid 13.61p in dividends. They were sold last week at 112.15p, having made a return of 58.8%.
The prompt to look for portfolio constituents to sell was the recession threat. TClarke was selected because it is a cyclically company, and therefore vulnerable to an economic downturn, sitting on an above average cyclically adjusted price earnings ratio. A look at the company I bought TClarke at a time when it was struggling to get over the construction industry recession following the 2008 financial crisis. Back then it had many unprofitable legacy contracts for the installation of the electrical and mechanical parts of buildings: prices in the industry had been held down by competing sub-contractors too keen to maintain turnover at the expense of margin. The company has now somewhat insulated itself from the worst of the next downturn by providing a superior-skilled differentiated service to main contractors, e.g. installing all the gizmos for an “intelligent building”. However, it is far from immune from a reduction in construction activity. It’s net margin at 3% is a triumph in the world of contractors (yes, that is considered a high margin in that sector) - but is worrisomely small in panicked world. Previous newsletters on TClarke: 5th – 26th November 2015, 20th – 22nd April 2016, 9th May 2016, 19th – 22nd April 2017, 19th – 25th April 2018, 19th May 2018 Cyclically adjusted price earnings ratio, CAPE When I bought the shares stood on a CAPE of 8.4 on the basis of reported “basic” earnings, and a CAPE of 7.3 using the manager’s “adjusted” earnings numbers. Both were well below the market average of 13 or 14. Pence per share EPS (Basic) EPS (“adjusted”) Dividend 2010 8.91 12.44 8.5 2011 9.69 7.34 3 2012 2.05 4.4 3 2013 2.51 4.14 3.1 2014 -1.58 1.06 3.1 2015 0.13 8.16 3.1 2016 5.45 11.60 3.2 2017 13.44 12.37 3.5 2018 14.99 15.38 4.0 2019 expected 17.50 17.50 4.4 AVERAGE 7.31 9.44 The CAPE in 2020, using basic eps is 112.15p/7.31p = 15.3, which is slightly above the market average of 14. It is by no means outrageously expensive, but at a time of fear I prefer to have cash rather than hold its shares. Pension deficit We can imagine one shocking turn of events that might imperil the company - the possibility it might be unable to meet its legal obligations regarding the defined benefit pension scheme. The deficit stood at £26.1m or 62p per share in June 2019. (The make-up was assets of £41.9m and liabilities of £68m). And this deficit is set within a balance sheet that is held up by intangible assets of doubtful worth. Balance sheet, June 2019 (market capitalisation = 42.1m shares x 112.15p = £47m) £m June 2019 ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 I’ve sold my “A” non-voting Dewhurst (DWHA) shares for £7.22, not because I judged it to be over-valued but because I wanted to rebalance my portfolio so as to have more cash available for post-Covid purchases.
Dewhurst A’s were selected to be turned into cash because they were trading close to intrinsic value, not because Mr Market had pushed them up beyond a reasonable level. Ordinarily I would have held on to this Buffett-style investment when it traded near – or even slightly above - intrinsic value. But we do not live in ordinary times. I judge the supply and demand shock of Covid to the world macroeconomy to be so great that I feel much more comfortable with a large buffer of cash (as well as my put options on the Dow). I bought Dewhurst shares at various prices over the last 6 years: April/June 2014 at £3.11, December 2014 at £3.75, November 2017 at £5.46, February 2019 at £5.54 and April 2019 at £5.64. You can read Newsletters setting out rationales. I still regard Dewhurst as an excellent company, and I will be looking to buy back in later in the year or next year if I can achieve a value price. Summary of previous analysis A different share structure There are 3.3m Ordinary shares carrying voting rights and 5.1m Non-voting ‘A’ shares. Thus, any overall earnings or valuation figure should be divided by 8.4m shares to derive per-share numbers. The Ordinary shares and the ‘A’ non-voting ordinary shares rank equally in all respects pari passu except that the ‘A’ non-voting ordinary shares do not carry the right to receive notices, attend or vote at meetings of the company. Market capitalisation: 3.3m Ordinary shares x £10 = £33m 5.1m Non-voting ‘A’ shares x £7.22 = £37m Total market capitalisation = £67m Brief description of the firm A manufacturing and electrical component distribution company that designs and manufactures components for lifts, ATM and other keypads, and for trains. It also supplies handrails for escalators and various traffic products such as large road bollards. In June 2018 it greatly expanded the distribution, wholesaling and retail selling of lift components and other electrical items, through the purchase of A&A Electrical Distributors for £12.25m, offering a range much wider than what it manufactures itself. Revenue, Earnings and Dividends The various businesses making and selling components for lifts has grown to about 80% of turnover. In rough terms: one-third of sales are in UK, one-eighth in Europe, with one-quarter in North America and one-third in Australasia and Asia. Sales, earnings and dividends (including TVC business which was sold 30th Sept 2019 (yearend) - both operating profits and capital gain made on TVC’s sale are included) Sales, £m Earnings per share (p) Dividend per share (p) 2010 37 40.97 6.36 2011 42 34.35 6.69 2012 52 44.48 7.02 + 5 special 2013 44 15.7 8.0 2014 47 43.87 9.0 2015 46 50.21 10 + 3 special 2016 47 40.75 11.0 2017 53 52.65 12.0 2018 55 47.93 12.50 2019 66 116.23p 13.0 In the table above the 2019 earnings number is raised due to the inclusion of a capital gain on selling the TVC subsidiary – we can now remove that element as well remove the profit contribution made by operating the TVC business in the financial year. Underlying earnings of continuing businesses only (in 2019 that means excluding capital gain on sale of TVC and the £1.1m profit after tax TVC made):... ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 The modern financial system encourages savers to plough their money into real assets to produce wealth. It is this wealth that all the social services (health care, education, etc.) rely on for resources. There simply would not be this wealth without the revolution in social technology over the last two hundred years. We need to mobilise the savings of millions of people. We do that by permitting limited liability, by developing well-regulated primary and secondary markets, by having strong property rights defendable in the courts, and by having financial institutions that assist firms or investors to find one another, to form contracts, to provide specialist knowledge and to monitor the progress of companies. In this way the financial system is the vital lubricant of the economy. Investors, even though they act in their own self-interest – they want to become rich – in doing so bring about the creation of vast quantities of real assets, leading to greater social well-being.
This is not an original thought. Even before the formal creation of the Stock Exchange, Adam Smith in 1776 pointed out the value to society of individuals acting for profit. The businessman by directing … industry in such a manner as its produce may be of the greatest value, intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. (The Wealth of Nations, 1776) So, be proud to be a capitalist. Your saving results in wealth creation. Hold the banner high: I invest to make myself rich, but I also allocate resources to firms that I think can use them best to produce goods and services people need and/or want. In a world without equity and bond investors looking purely for profit the railways would not have been built, the drugs industry would be a lot smaller and Silicon Valley would still be producing fruit. Adapted from the book: The Financial Times Guide to Investing |
Glen ArnoldI'm a full-time investor running my portfolio. I invest other people's money into the same shares I hold under the Managed Portfolio Service at Henry Spain. Each of my client's individual accounts is invested in roughly the same proportions as my "Model Portfolio" for which we charge 1.2% + VAT per year. If you would like to join us contact Jackie.Tran@henryspain.co.uk investing is about making the right decisions, not many decisions.
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