Monthly Archives: August 2015

Points of View: No need for long term investors to panic

Global equities have seen their sharpest falls since the 2008 financial crisis as extreme volatility in the Chinese stock market stoked fears of a China-led global economic slowdown. The falls came after the Shanghai Composite dropped an incredible 8.5% in a session the official Chinese news agency dubbed “Black Monday”.  At the centre of this volatility are concerns that China’s growth is slowing below acceptable levels.  Indeed, such worries have intensified since Beijing unexpectedly devalued the country’s currency a little less than two weeks ago.

The state of the Chinese economy matters as it is now comparable in size to the US and makes up 15% of the global economy. Moreover, it has contributed half of global growth over recent years. Slowing growth in China therefore means slower global growth and the fear is that this could lead to another “2008 moment”. Such fears look misplaced, though. First, China has a large current account surplus when commodities are excluded – as such its slowdown will continue to be painful for commodity exporters (the price of oil has fallen to a six year low and average commodity prices are trading at their lowest levels this century) but should not force the global economy into recession.  Second, China’s credit bubble has been fuelled by domestic savings, meaning a financial crisis in China does not mechanically imply a global crisis.

The FTSE 100 has now fallen approximately 15% since its peak in April.  Such falls are painful in the short term but are somewhat irrelevant to long term investors: dividend income has not dropped since April and the world will no doubt keep turning, advancing and growing in the long term. The nature of the stock market is that large drawdowns happen sporadically, but history ultimately shows that these are good times to add to long term investments rather than sell in panic.

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Restriction on pension tax relief for higher earners

In the first budget under the new Conservative Government in July 2015, measures were announced to reduce pension tax relief for the highest earners. Under current rules, most people will be entitled to contribute up to £40,000 gross per year, whilst receiving tax relief at their highest marginal rate.  You can also carry forwards any unused allowance from the  previous 3 years.  This is set to change in April 2016, where individuals earning over £150,000 per year will be restricted.  They will lose £1 of allowance for every £2 earnt over £150,000.  The allowance will therefore gradually reduce down to a minimum level of £10,000 where their income reaches £210,000 per annum.  This will bring them in line with those drawing a flexible income from their pension pots, who also have a contribution allowance of just £10,000 per year.  The individual will still be able to carry forward 3 years worth of unused allowance, but only to the extent of the maximum that would have been available in each year.  These changes may allow for a brief window of opportunity to introduce significant sums into the pension pots of high earners until these changes are due to come into force in April 2016.  You should speak to a financial adviser to establish how these new rules could affect you.

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Points of View: China’s Currency

Last week the People’s Bank of China surprised global markets by devaluing its domestic currency, the Renminbi, more commonly referred to as the Yuan. The Chinese currency is strongly related to the US dollar because China still manages its exchange rate within a range of the dollar. The devaluation gave rise to rumours of currency wars, whereby countries use exchange rate policies to keep their export products competitive on global markets. However, the Chinese government described its unexpected move as a “one-off step to make the currency more responsive to market forces” and dismissed any rumours by stating that they had “no intention or need to participate in a currency war”. In the past, China had exercised wide discretion in setting exchange rates and this recent attempt to make their financial system more market-oriented implies that the Chinese central bank will step in less to influence rates going forward.

China has been trying for several years to secure qualification of its currency as one of the  denominations used by the International Monetary Fund (IMF) for its reserve assets, known as Special Drawing Rights (SDR). Indeed, the IMF published a note approving of China’s move to let the market play a greater role in setting the value of its currency and this should strengthen its case for the Yuan to join the US Dollar, British Pound, Euro and Japanese Yen in the SDR basket.

Looking forward, the market will want to see evidence of a clear and stable strategy that does not induce further policy surprises.

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Points of View: Share splits

This week I am looking at something a bit different: share splits and companies’ rationale behind them.

So what is a share split? Also called a scrip or bonus issue, this is a type of corporate action whereby a company increases the number of shares held by each shareholder by a specific multiple.  As a result, the share price reduces by the same multiple such that the total value of the shares remains the same. From a company’s perspective, there are two main reasons for carrying out a share split: (1) reducing a high price, which improves marketability, and (2) increasing the number of shares in issue and hence liquidity (i.e. the ease of trading).

One example is Fidelity Special Values, a £560m investment trust that conducted a 5-for-1 share split effective 29 June 2015; in other words, for every 1 old share held, investors received 5 new shares. Since its launch I   n 1994, the price of the old shares had increased from £1 to over £10 just prior to the split. The Board believed this high share price created difficulty for investors who participate in monthly savings plans or dividend reinvestment schemes as it often resulted in a cash surplus. The lower price of just over £2 following the subdivision has subsequently enabled investors to start investing more precise amounts of capital.

For investors, the overall impact is minimal: with an increasing number of shares held electronically, the necessary adjustments for dividend pay-outs and capital gains tax are made on their behalf.

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Stocks in Focus: Intertek

This week I am commenting on Intertek, the global inspection, product testing and certification company. I have written about the company before but I mention it again today after the share price rose 11% on Monday in reaction to the announcement of its results for the first half of the year. This price increase partly reflected the fact that the results were positive and ahead of expectations.

Specifically, the results showed that organic revenue grew 0.9%, operating margin grew 0.4% and free cash flow grew 67%. The large increase in the share price, however, was perhaps more to do with the upbeat commentary regarding the positive momentum it is seeing in most of its businesses.  Furthermore, expectations were modest given its exposure to falling capital expenditure in the oil & gas industry through its Industry & Assurance division, where revenues and profits have been falling. Indeed, management guided that we may see a bigger decline in this division in the second half of the year. However, it appears investors are starting to look through this isolated weakness (not least because the group’s exposure to oil & gas capital expenditure accounts for a relatively modest 13% of total revenues) and see that most of the group is performing well with a positive outlook. Going forward, it will be interesting to see if this positive change in sentiment persists.

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Investment Trusts versus Unit Trusts

If you were given the choice of investing in two funds with identical mandates run by the same manager, and were told that one of them had increased in value far more than the other over the last 10 years, you would understandably wonder why there was such a gap in the returns generated. The key difference between these two otherwise identical funds is the way they are structured. One is an investment trust with its shares traded on the stock exchange (known as a closed-ended company) and the other is a unit trust (alternatively known as an open-ended investment company or OEIC). From this seemingly minor distinction in corporate structure flows the difference in performance that can become wider with every passing year.

One of the main reasons for outperformance by investment trusts is that as they are companies in their own right, they are allowed to borrow additional capital to invest. This is known as gearing, and if the money borrowed can earn more than is being paid out in interest charges shareholders will enjoy an extra return on their investment. Open ended companies are not allowed to borrow money and do not have the ability to ramp up their returns in this way.

Another advantage enjoyed by investment trust managers is that they are not forced to sell holdings in their portfolio to meet redemption requests in a falling market. Shares in investment trusts are traded on the stock market and can simply be sold on to another investor. Unit trust managers usually have a certain amount of cash as a cushion against redemptions, but may be forced to sell perfectly good holdings at a time when the market is falling.

Given all of this, why wouldn’t you choose to put your money into the investment trust version of an otherwise identical fund? There are two reasons, one of which is that the ability to gear up can be a double-edged sword. To increase the size of your fund by gearing will generate a higher return in a rising market but magnify losses in a falling market. The other reason is to do with the fact that shares in investment trusts generally trade at a discount to the underlying net asset value (NAV) of the portfolio. The discount varies according to factors such as supply and demand, and there is always the risk that any gain in NAV will be wiped out by a short-term widening in the discount.

The risk of getting caught by the double whammy of magnifying losses and a widening discount – the two often happen at the same time – makes it essential that the investor understands the need to take a long term approach, and is prepared to suffer some discomfort in falling markets in the expectation of a better overall return.

Of course, there are occasions when the open ended fund route is the best one to take. Investors are not always comfortable with the greater volatility of investment trusts, and it is far easier and more cost effective to make regular contributions to an open ended fund. There will also be times when it is more sensible to use an open ended fund, for example when the equivalent investment trust is standing at a premium to NAV.

The below graph shows two things: the long-term outperformance of a closed-ended fund structure that utilises gearing; and the need to hold the investment over the long term.

Key   Instrument     6m 1y 3y 5y 10y    
A Jupiter European Opportunities 12% 27% 95% 171% 322%
B Jupiter European Inc 12% 24% 68% 93% 210%

Source: Trustnet

A trend line drawn through a market cycle of almost any length shows that the market will rise to the benefit of the investor who is prepared to take a long term view. This is why our discretionary portfolio management clients will be used to seeing investment trusts forming the major part of their exposure to collectives.

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