Another Good Year for Fundsmith

Terry Smith has issued his latest report to investors on the performance of the Fundsmith Equity Fund. It contains some of his usual acerbic comments on the financial world which I cover below.

Total Return on the fund last year was 25.6% and that beat the MSCI World Index benchmark which was only up 22.7%. As Fundsmith is one of my bigger holdings, that helped to contribute to my own portfolio performance although my overall gain was better. But that compares with the previous year when Fundsmith was well ahead of my portfolio which has more small cap stocks in it. Undoubtedly investors in Fundsmith will be happy with this continued good performance and the fund has continued to attract new investors so is now the largest UK retail equity fund. Many people have concerns that the fund is now so large that returns may drop away but Terry Smith continues to confound them.

The top five contributors to outperformance were Microsoft, Estee Lauder, Facebook, Paypal and Philip Morris with the detractors being 3M, Colgate Palmolive, Clorox, Brown-Forman and Reckitt Benckiser. Terry continues his management style which he defines as buying good companies, not overpaying and then doing nothing. He also likes to invest in companies with a good Return on Capital Employed (ROCE), good margins and good cash conversion. These are good lessons for all stock market investors.

He derides “value investing”, i.e. buying apparently cheap stocks and the alleged rotation from growth into value. He says “most of the stocks which have valuations which attract value investors have them for good reason – they are not good businesses”. He argues that returns from stock market investment come from the growth in company earnings and the compounding of reinvested retained capital, not from buying cheap companies.

He clearly does not intend to change his investment style and makes some critical comments on the Woodford debacle which he assigns to a change in investment strategy with Woodford moving into illiquid small cap stocks in an open-ended fund.

Fundsmith are holding the Annual Shareholders Meeting on the 25th February for those who wish to question Terry on his management, or on why he is not reducing the fund management charges given the growing size of the fund, although they are not expensive in comparison with some actively managed funds.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Objections to Pay at Diploma and the Cost of Zero Carbon

My previous blog post covered the subject of criticism by Slater Investments of many current pay schemes. That at Diploma (DPLM) is a typical example. But at their Annual General Meeting yesterday, which I unfortunately was unable to attend in person as a shareholder, there was a revolt.

The votes cast as disclosed in an RNS statement today were 20% against their new Remuneration Policy and 44% against their Remuneration Report. I voted against both of them of course personally. The board has acknowledged the concerns of shareholders and they will consult further with shareholders plus provide an update within six months.

What is wrong with their remuneration scheme? First pay is simply too high. Over £1 million last year for the CEO when profits were only £62 million and that does not include any LTIP benefits as he is recent joiner. But the CFO got £1.6 million in total. The CEOs pay scheme includes base salary, pension, short term bonus of up to 125% of base (90% achieved) and an LTIP that awards up to 250% of base salary. The Remuneration Report consists of 14 pages when Slater suggests a maximum of two would be sensible. I could go on at length of this subject but in essence the remuneration scheme at Diploma is simply unreasonable and too generous. It displays all the faults that Slater complained about.

I have previously criticised the Government’s commitment to achieving net zero carbon emissions on the grounds of cost. Well known author Bjorn Lomborg has published a good article on this subject in the New York Post. Almost no Governments making similar promises are willing to publish any real cost-benefit analysis. The only nation to have done this to date is New Zealand: the economics institute that the government asked to conduct the analysis found that going carbon neutral by 2050 will cost the country 16% of GDP. If the small nation follows through with the promise, it will cost at least US$5 trillion with negligible impact on temperatures. Just imagine what the cost will be in the UK, for a much bigger economy! See this article for more information:  https://nypost.com/2019/12/08/reality-check-drive-for-rapid-net-zero-emissions-a-guaranteed-loser/

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Slater Investments Warns on Pay, and Flybe Bail-Out

Slater Investments has issued a warning to companies of their “dissatisfaction with the framework of directors’ remuneration in most public companies”. Slater Investments run a number of funds managed by Mark Slater and others with a focus on growth companies.

The letter complains about a “relentless ratcheting of terms and conditions which have meant the interests of directors and investors have grown steadily further apart”. Specifically it complains about the award of nil-cost options which they see as a one-way bet and they also don’t like the hurdles that are set which are often simply e.p.s. rather than total return.

They also don’t like the quantum of pay awards and say: “It has become customary for executive directors to receive a handsome salary, plus the same again in cash bonus and a similar amount in nil cost options – year in, year out. Is a good salary not enough to get directors out of bed in the morning and to diligently work their allotted hours? A bonus should be determined by the return received by investors”. This is a similar complaint to my own made a week ago.

They plan to vote against remuneration reports which are longer than two pages [Comment: that means most of them at present], and vote against any schemes with nil cost options and against unresponsive members of the remuneration committee. Mark Slater and his firm are to be congratulated on taking a stand on this matter. I hope other fund managers will follow his example.

To read the letter sent to companies, go here: https://tinyurl.com/wu9jh9q

The UK Government is bailing out airline Flybe. It was obviously running out of cash and was saved from administration by the Government deferring passenger duty tax payable, a possible Government loan and more cash from the owners. Is this a good thing?

Flybe operates a number of short-haul flights in the UK and the rest of Europe. Some UK airports are apparently dependent on its operations. Is it really essential to maintain these operations when roads and rail links provide alternative transport options in most cases, albeit somewhat slower perhaps? State aid to failing companies has a very poor record in the UK – the motor industry was a good example of that. One of the few good things about the EU is its tough rules on state aid. I hope that the UK will not diverge from its principles now we are departing from the EU.

Why is bailing out failing companies a bad idea?  For several reasons. First because it effectively subsidizes poor companies which then compete with profitable companies to their disadvantage. Second, it rarely works because a bad business usually remains a bad business. For example, Flybe has been perennially unprofitable and had to be rescued via a takeover in March 2019 when it was delisted. You can see the financial track record of the company on this Wikipedia page: https://en.wikipedia.org/wiki/Flybe

Airlines are one of those businesses that I avoid. They suffer from the business model problem that they are always trying to maximise passenger loading as the economics of airlines means they need to fly the planes full to make money. This means they cut prices to fill volume when business is bad, but their competitors do the same (and their competitors can be other transport modes on short-haul flights such as buses or trains).

It has been suggested that the worlds’ airlines have never overall made money since the airplane was invented. I can quite believe it.

I see no good economic reason why the Government should bail out Flybe in the way proposed. If it owns some profitable routes, other airlines will take them on. There might be merit in reviewing air passenger duty in general which is a tax on travel that does not apply to other transport modes, or perhaps in providing some specific funding to unprofitable routes as suggested in the FT if there are good arguments for doing so and with onerous conditions attached. But the principle should be “no money unless the business is restructured forthwith with some certainty that it can be made profitable”.

Otherwise the danger is “moral hazard” as Lord King mentioned when refusing to bail out Northern Rock, not that I think he was particularly wise in that case. It is suggested that it just encourages the directors of companies to believe they will be rescued regardless of their incompetence. The threat of no more assistance ensures directors take more care it is argued and provides an example to others. Banks may be rescued with cash that the Government prints to shore up their balance sheet, but putting cash into airlines is typically just used to fund operating losses.

Businesses that are subject to Government regulation are always tricky to invest in. If they are not subsidising the competitors, they are restricting competition by regulation. Which one of my US contacts was explaining to me a couple of weeks ago as one reason for the demise of PanAm.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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New Year Share Tips – Are They Worth Following?

It’s that time of year when financial magazines and newsletters analyse their past share tip performance and give their New Year tips. Are the tips worth picking up or even reviewing?

One approach you might think would be effective would be to simply back those publications who had the best historic performance. One review I picked up on Twitter (I am not sure of the original source) gives the Investors Chronicle (IC) as the winner in 2019 with a 37% return with The Independent bottom of the table. However, the performance varies from year to year – for example the IC had a negative year in both 2017 and 2018, while the Guardian had negative returns in all three of the previous years. Perhaps not many investors read the Guardian but that may be to the good.

One problem of course is that the tip writers may vary even within a publication from year to year and few put their names to the articles. In essence backing the share tips based on the “form” of the publications or the writers is not going to work. Even if the writers stay the same, and their “styles” of investment such as a focus on growth or value, what works one year might not work in another.

Another failing is that some writers rely on advice from well known fund managers who tend to “talk their own book”. So the Questor column in the Daily Telegraph, written by Richard Evans, tipped Bioventix (BVXP) as “AIM stock of the year” on Friday (10/1/2020). That was after talking to Keith Ashworth-Lord of Sanford DeLand Asset Management who has a big holding in the company. The share price rose 9% on the day this tip was published which as a holder of the stock I am quite pleased with, but I would not previously have rated it as other than a “hold” personally.

Many share tips in the national media and reputable investment newsletters will rise in price on the day the tip is issued – indeed even before you have got up for breakfast. Investors then pile in further over the next few days and if you follow that herd you are going to lose money. After a few weeks, when the company’s performance does not instantly shoot up or there is little news, the speculators lose interest and the share price falls back again.

It’s worth pointing out that it does of course depend on whether you are a long-term investor or a short-term speculator. Such share price movements may be great for speculators , most of whom I suspect lose money, but for long-term holders like me share tips can be positively dangerous. My approach is therefore as follows:

I use share tips as ideas for research. Only one in ten is worth more analysis and if I consider it worthy after that I would buy a few shares and see how the company and its share price develops. Most companies fail on the “due diligence” phase. I am not a “plunger” who bets a lot on any new holding. I am looking to find companies that I can hold for the long term and in which I wish to take an opening position. Apart from anything else, moving a lot of cash out of existing holdings to invest in new ones is often a mistake, I have learned from past experience. It’s the syndrome of looking for the pot of gold at the end of the rainbow, i.e. picking new investments you don’t know much about but which someone else thinks are a great proposition, and abandoning ones that you do know.

What are the kinds of tips that I avoid?

Firstly I hate the “recovery story” kind. These are where a company with a pretty dismal historic performance has improved analyst forecasts (which is what most tipsters focus on). For example, Investors Chronicle has Burberry (BRBY) as one of their 2020 tips. The supporting article has lots of positive comments about the changes taking place in the company and its “transformation”, but a quick look at the financials gives me doubts. Revenue in the last 3 years, which is a key metric for any retailer, was static or falling and the forecasts for the next two years are only slightly higher. Earnings per share follow a similar pattern. Even under new management, is this a growth business or a just another rather mature company in a crowded sector (revenue about £3bn) flogging expensive clothes to suckers? Is there any real innovation or growth above inflation taking place is the key question?

Another example of a recovery story is Momentum Investor tipping Marks & Spencer (MKS) based on their move into on-line groceries via the joint venture with Ocado. But the wisdom of this tip was soon disproved after the company issued a trading statement on the 9th of January with dismal figures for clothing sales. The share price is down 12% since then. Too many “skinny” fit men’s trousers was one problem as the company tried to be more fashionable so that’s just another management failure partly arising from the sclerotic supply chain at the company. Tipping shares can be a quick lesson in humility of course which is one reason why this writer does not do it. Let those who get paid for their alleged wisdom continue to do so though so we can have the occasional laugh at their folly.

Window supplier Safestyle (SFE) was tipped as a recovery story by ShareWatch but is likely to still make a small loss in 2019. Are profits really going to come back in 2020 and will investors regain confidence in the business and its management? I do not know the answer to those questions so I am unlikely to invest in it.

Secondly, I ignore sudden enthusiasm for boring companies. Another of IC’s tips was Johnson Service (JSG) which provides textile rental and cleaning services – hardly a new business and one that I doubt has barriers to entry. The company is growing, but on a forward p/e of 19 and relatively high debt, I cannot get enthusiastic.

Apart from drain-pipe trousers, something else I used to favour in the 1960s that is back in fashion is ten pin bowling. Two companies that were tipped by Momentum Investor and mentioned in Investors Chronicle – Ten Entertainment (TEG) and Hollywood Bowl (BOWL) may be worth looking at. TEG (which I hold) was also tipped by ShareWatch. These companies are changing from not just being bowling alleys but indoor family entertainment centres with other games available and good food/drink offerings. Some also stay open long after the pubs have shut. You can see why they are experiencing a revival in demand with more centres opening. The key with share tips is to follow the new trends, not the old ones.

Thirdly I ignore tips that back racy stocks already on high valuations. For example Shares Magazine tipped Hotel Chocolat (HOTC). This is a chocolate retailer that seems to have a good marketing operation and decent revenue and profits growth but on a prospective p/e of 45 it seems too expensive to me. The slightest hiccup would likely cause a sharp drop in the share price so there looks to be as much downside risk as upside possibility to me.

Lastly, I ignore tips in sectors I don’t like or businesses I do not understand – the former includes oil/gas and mine exploration, airlines and banks. Shares magazine tipped Wizz Air (WIZZ) and Lloyds Banking (LLOY) for example but they are not for me. Businesses I do not understand might include some high tech companies with good stories of future potential but no current profits.

To reiterate, share tips are useful for providing ideas for research but blindly following them is not the way to achieve superior investment performance.

Preferably share tips should confirm your views on shares you already hold – such as Bioventix, Ten Entertainment and several others I hold which have been tipped in the last couple of weeks. That may be a reason to buy more, but not in any rush.

As regards other tips like the best countries, or the best sectors, or whether to invest at all based on economic forecasts or Brexit prognostications here’s a good quotation from John Redwood in the FT this week: “The safest thing to forecast at the beginning of the 2020s is more of the same”. An economist with real wisdom for a change.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Directors and Fund Managers Pay is Excessive

On the latest data, the pay of FTSE-100 CEOs has fallen slightly. A report from the CIPD and High Pay Centre notes that the average pay has fallen from £3.9 million to £3.5 million for the year in 2018 (the latest for which figures are available).

Business Secretary Andrea Leadsom said “Today’s figures will be eye-watering for the vast majority of hard-working people across the UK. The numbers are better than they were….but the situation is still concerning, especially in those cases where executives have been rewarded despite failing their employees and customers”.

To remind readers, there is no evidence that high pay of executives results in improved performance of companies according to academic research. Highly paid CEOs pay themselves large amounts because a) they can do so; b) remuneration committees are poodles and rarely confront the issue because it is not in their interests to do so; c) shareholders, particularly institutional ones, have no incentive to challenge excessive pay.

Instituting votes on pay and other measures have not really changed the underlying problems. For example, LTIPs which were originally promoted as a way to align directors interests with shareholders, but were in reality a way around tough US pay regulations, have led to a rapid escalation of pay and we still see LTIPs that pay out bonuses of 200% of base salary and more, on top of other short term cash bonuses. Incentive schemes that pay out multiples of base salary are actually just lotteries with no rational basis other than an easy way to ramp up total pay on dubious grounds. In my view the only way to control pay is to have regulations that limit total bonuses to a fixed and low percentage of salary – 50% would be about right for maximum performance. And most of it should be paid in shares not cash.

That might sound draconian, but it would reinstate what a bonus should be – an extra award for recognition of outstanding performance and the ability of a company to pay more, even though executives are expected to do their best anyway for which they get paid a salary. Calling such bonuses “incentive” payments is simply wrong – there is no evidence at all that they incentivise higher performance.

Excessive rewards in the financial sector also extend to fund managers. The latest example is that Neil Woodford and his partner Craig Newman shared £14 million in dividends from Woodford Investment Management in the year ending March 2019. The pair took out £112 million since the Woodford Equity Income Fund was launched. These are the rewards for building investment funds that were a major failure. Soon after March 2019 the Equity Income Fund was closed to withdrawals and the Investment Management company is now being closed down.

Rewards to fund managers bear little relation to the work put in or the success of their activities. Star fund managers with great reputations, as Woodford once was, can collect large amounts of assets under management and the fixed percentage fee basis for funds, that does not shrink as the size of the fund grows as it should, can result in obscene amounts of pay. Terry Smith of Fundsmith is another example, although investors in that fund are probably satisfied with his performance. Perhaps a claw-back mechanism for underperforming funds is the answer?

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Speedy Hire and Burford Capital

There are a couple of interesting articles in this week’s Investors Chronicle. One of their share tips for 2020 is Speedy Hire (SDY) which I own some shares in after attending a presentation by the company at a ShareSoc meeting in October. I was somewhat impressed by the apparent turnaround in the business that the management has achieved. You can read a write-up of the presentation here: https://roliscon.blog/2019/10/04/speedy-hire-presentation-burford-analysis-and-treatt-trading-statement/

Another very good article in Investors Chronicle was on the subject of fair-value accounting. It should be essential reading for all Burford Capital (BUR) investors. It explains how Enron used mark-to-market accounting to value long-term contracts. Their reported profits surged as they recognised future profits but the cash did not appear so the management then went from creative accounting to downright fraud by the use of off-balance sheet vehicles.

In reality it was using “mark-to-estimate” accounting as there were no public markets for the assets that could provide a sound valuation. How is this relevant to Burford? That company is in the same position in that the majority of its profits come from fair value gains on the value of the legal cases it is pursuing. As in Enron, the cash flows are very different to the reported profits. In 2018 the reported operating profit was $344 million but the cash outflow was $198 million.

As I said in my blog article mentioned above, I have always been doubtful about the merits of the company and one reason is the answer to the question “Do profits turn into cash?” The answer is “Not in the short term at Burford”. They are effectively recognising what they consider to be the likely chance of success in current profits. But winning legal claims is always in essence uncertain. I have been involved in several big cases and your lawyer always tells you that you have a very good chance of winning as they wish to collect their fees, but even if you win collecting any award can be uncertain”. In essence the accounts of Burford rely to a large extent on management’s estimates of the chance of winning cases and hence the future profits.

Incidentally a few respondents to my mention of my portfolio performance last year in a previous blog post and tweet requested details of my portfolio holdings and investment strategy. My response was that I don’t like disclosing the details mainly because listing all my holdings and providing reasons for them would be tedious but clearly one reason for success is avoiding companies such as Burford where profits do not turn into cash. As regards my investment strategy this is well covered in my book Business Perspective Investing https://www.roliscon.com/business-perspective-investing.html.

As I point out in the book, attending presentations by management or attending Annual General Meetings can give you useful information and the ShareSoc events are very relevant to that objective so I recommend them.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

Year End Review and Future Forecasts

Following folks on Twitter suggests that there was an enormously wide variation in the overall portfolio performance of private investors in the last year. But without people saying what they invest in and how big and diversified their portfolio is, I am not sure the information provided helps much. I also worry about how they calculate their performance figures and whether it includes dividends reinvested because I never find it a simple thing to do as none of the software products I use give me a correct figure so I still have to do the calculations manually.

One feels wary of publishing such data because when you have a good year you appear to be a clever dick with an inflated ego, while in a bad year you look a fool. Consistency is not applauded on social media. But here’s a summary of my portfolio performance.  Total return for the year (including dividends) was almost exactly 30% return on my capital invested at the start of the year. As my target is simply to consistently beat the FTSE-AllShare which was up in capital terms by 14.3% last year and dividends would have added another 4%, I am happy with that outcome.

My portfolio is very varied with a slight emphasis on UK small and mid-cap shares but it does include a very few FTSE-100 shares and several large investment trusts and funds including some overseas focused ones. One of the reasons for outperformance was probably betting on a successful resolution of the Brexit impasse before the General Election, which has clearly had a very positive impact on markets, particularly in UK small cap stocks.

It was partly a good year because I had few bad failures – Patisserie was the worst, but when you have a large number of holdings, as I do, then there are always one or two disappointments. Others I managed to get out of without much damage but Patisserie had trading suspended at the initial announcement of possible fraud and never returned.

Well at least I beat Warren Buffett’s Berkshire Hathaway last year. He only managed an 11% gain last year while the US market gained 31.5% last year, including dividends. No doubt some clever sod will suggest that I could have saved a lot of effort and just invested in an S&P 500 tracker but that would have been a risky strategy because the US markets can be very volatile. Incidentally Berkshire now has cash of $128 billion. Buffett is clearly finding it difficult to invest the money. Perhaps he is slowing down at aged 89 and if he has another bad year like the last one folks might be encouraging him and his partner to retire. But few investors achieve outperformance every year – one needs to consider performance over 5 or more years.

My portfolio also includes some Venture Capital Trusts (VCTs) which would have generated a less good overall return because they tend to be vehicles for turning capital into tax free dividends. As usual they mainly showed small capital losses although two VCTs focused on AIM stocks did relatively well for a change.

What of the future and where should we be investing? I am still keen on technology stocks and here’s a useful quotation from Alan Turing who is soon to appear on new £50 notes: “This is only a foretaste of what is to come and only the shadow of what is going to be”. He wrote that in 1949 about the future use of computers, but it still applies as many new and innovative businesses based on software and the internet are still being founded. However, I think the valuations of early-stage unprofitable companies are getting overblown (e.g. in fintech and biotech) so I suggest one needs to be careful.

One slight negative in my portfolio performance last year was that total dividends received fell slightly. That’s probably because I sold a few high yield shares – with a buoyant economy it hardly seemed the best place to be. I hold no builders, no banks or other financial institutions and no oil companies at present and generally do not as I am prejudiced against them.

The slight cloud on the horizon is that Boris Johnson has to conclude a free trade deal with the EU in the coming year, or face a difficult decision. That might cause some business uncertainty in the meantime. But I doubt if it will affect those companies with quality businesses. As I have been saying for the last 6 months, it is business perspective investing that enables you to generate good returns, and that is very much the basis of my good performance last year. Plus avoiding too many investment disasters as I said in a previous blog post.

If you were hoping for details of my holdings, or share tips for the future, you will by now be disappointed. What made money for me last year, may not do so this year, and giving tips for the coming year is a very risky proposition. Such tips tend to encourage churning of portfolios and increase the readership of publications giving them but it is not necessarily a productive exercise. I prefer a strategy of buying good companies and holding them for as long as it makes sense to do so.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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