Budget Summary – Austerity Coming to an End

Philip Hammond’s budget today can be summarised as:

  • More money for the NHS.
  • More money for the MOD.
  • Money for schools.
  • More money to fix potholes.
  • More money for housing.
  • More money for the Universal Credit scheme.

Yes “austerity” is being relaxed. Changes to taxation are relatively minor, but there will be a new tax on “digital platforms” which is clearly aimed at large companies such as Facebook and Alphabet (Google) who generate large revenues from their operations in the UK but pay very little tax on the resulting profits. There will also be a new tax on plastic packaging (comment: that could have been tougher if the problem of plastic pollution is to be tackled). These new taxes may be at relatively low rates initially but once a new tax regime is in place, the rates tend to go up if history is any guide.

Fuel duty is frozen, beer and cider duty are frozen, spirits duty is frozen but wine duty will rise to match the increase in the cost of living. Tobacco duty will rise also.

There will be a new Railcard for the 26-30 age group to help the millenials.

Personal income tax allowances will rise in April 2019 – £50,000 for higher rate taxpayers. And capital gains tax allowance will rise to £12,000.

All the suggestions about changes to pension tax relief, inheritance tax and AIM tax advantages seem to have been ignored, so there is little to dislike about this budget for stock market investors.

In summary a confident performance from Mr Hammond with an avoidance of unnecessary changes to taxation which helps with longer term planning.

More information available from the Treasury here: https://www.gov.uk/government/news/budget-2018-24-things-you-need-to-know

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

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Which Way Is The Market Headed?

Whenever one meets with other investors of late, a question they ask is “”Which way do you think the market is headed?”. One of my sons also asked me that question and I said to him that I had no real clue, although it might continue in the same direction. I give my reasons in this article.

The weekend papers are full of explanations of the recent market declines, and prognostications about the future, by experienced financial journalists. This was no doubt at the behest of their editors who understand that readers are looking for simple answers. When the markets are in rout, the key thoughts of investors are likely to be should I sell, to protect my portfolio value by moving into cash, or should I buy now that shares are becoming cheaper and possible bargains appearing?

FTSE Chart

Having been through more than one boom and bust in my investing career (chart of the FTSE All-Share in that period above showing percentage change in capital value from 1997), I only make predictions about the market in extremis, i.e. when it looks ridiculously expensive or ridiculously cheap. You can see that so far there has only been a minor correction in the last few weeks. Incidentally that chart shows that the FTSE All-Share is up about 70% in that period while my own portfolio is actually up 270% which I track in a similar way.

Some of the influences that are currently being talked about are the trade wars between the USA and other countries, the impact of Brexit, the ending of QE and higher interest rates, the view that shares had become too expensive, and general despondency. When markets are in decline, all news tends to be treated as bad news. So when the US economy is reported as continuing to grow strongly, this is viewed as negative as it means higher interest rates will come in sooner.

The fact of the matter is that markets are driven by expectations and emotions as much as hard facts. It is undoubtedly true that most investors portfolios are showing very healthy returns in the last few years so everyone is holding on to large profits. That is still true even after the carnage of the last few weeks. But just reading a few tweets issued by investors tells you that many are now showing a loss on the year to date. This makes them nervous.

It’s also true that the long, uninterrupted bull run has pulled many people into stock market investment who think it might be an easy way to make money when cash earns little on deposit and the housing or buy-to-let markets are no longer attractive.

There is one truism though. Once markets start moving in a certain direction, then they tend to continue in the same direction, driven by emotion. Just as share prices of individual companies show high short-term correlation, so do share prices in general. They can both be driven by “momentum” traders now that everyone knows that momentum is a key aspect of successful investment strategies.

Just considering the UK market, where most of my readers are probably invested, it’s also true that UK market trends are dictated by US market trends and other international markets over night. What happens in the morning on trading days in the UK tends to follow what happened in the USA the previous day/night. It’s always worth keeping an eye on the S&P 500 to check that – see this web site for a useful chart of a daily view (or longer periods): https://www.bbc.co.uk/news/topics/c4dldd02yp3t/sp-500

Will that tell you which way the UK market is headed? Only in the sense that trends tend to persist, until they reverse and are driven by international dynamics. Trying to guess which way it’s headed is a waste of time, and effort.

As a result, some folks take the stance that they’ll hold their portfolios unchanged through thick and thin. If you are an institutional investor, where you are paid to invest client’s money in shares, not in cash and your earnings depend on portfolio value commissions, you may not have much choice. But private investors do.

My view is that trying to be contrarian in market declines makes no sense except in extremis. Following the trend is sensible, until there are obvious highs and lows where reversals might take place. So I sell on the way down, and buy on the way up, while trying not to over-trade (i.e. not react to short term moves which tend to be expensive in terms of spreads and broking charges). I also take into account the nature of the stocks and any capital gains tax liabilities that might result, i.e. I will sell those showing a loss or hold those where tax would be incurred. That also means I prefer to sell those in my ISAs and SIPPs where tax consequences can be ignored. The current market is also a good time to rationalise my portfolio which has too many stocks in it and is overdiversified.

In relation to the nature of the stocks, those hardest hit by any general market decline are those that are small and speculative so they are the first to go. In a market rout everyone starts looking at whether the company is making real profits, generating cash and paying dividends in the short term, not to a sunlit horizon in the future.

That’s not to say that I have suddenly fallen out of love with growth stocks. But there is good growth and there are speculations. Companies that have good technology, good business models, and are generating good returns on capital are still the ones I like to own. The recent figures from Amazon and Alphabet (Google) were seen as negative because the growth in sales and profits appeared to be slowing – but they are still growing at a very brisk rate in comparison with old economy stocks. They are both now very big companies so at some point growth was likely to slow, but there are many smaller technology companies who can achieve great growth rates irrespective of the overall state of the economy.

At this point I do not see that we are near a turning point, but neither do I try to predict one. Shares look neither ridiculously expensive or ridiculously cheap unlike say back in 2008 for example when doom and gloom pervaded everywhere. There is no good reason to pile back into bonds with short term interest rates still low and the UK and US economies looking healthy.

To track the trend while managing cash I follow a simple rule – if my overall portfolio falls by £10,000 I sell £10,000 worth of shares and put the resulting cash on deposit. That way assuming you have an unleveraged portfolio you can never go bust. If my portfolio and the market start to rise, I’ll move the cash back into shares.

In summary, I am following market trends and in the meantime am just looking to hold good quality companies and buying more where there are suitable buying opportunities, while disposing of the dogs. I don’t try to bet against market trends.

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

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Frying in Hell and Investing in Oil Companies

Last night and this morning, the national media were dominated by the news from the Intergovernmental Panel on Climate Change that we are all going to fry in a rapidly rising world temperature unless we change our ways. CO2 emissions continue to rise and even to limit temperature rises to 1.5 degrees Celsius requires unprecedented changes to many aspects of our lives.

The suggested solutions are changes to transport to cut emissions, e.g. electric cars, eating less meat, growing more trees, ceasing the use of gas for heating and other major revolutions in the way we live.

So one question for investors is should we divest ourselves of holdings in fossil fuel companies? Not many UK investors hold shares in coal mines – the best time to invest in coal was in the 18th and 19th century. That industry is undoubtedly in decline in many countries although some like China have seen increased coal production where it is still financially competitive. See https://ourworldindata.org/fossil-fuels for some data on trends.

But I thought I would take a look at a couple of the world’s largest oil companies – BP and Shell. How have they been doing of late? Looking at the last 5 years financial figures and taking an average of the Return on Assets reported by Stockopedia, the figures are 2.86% per annum for Shell and 0.06% per annum for BP – the latter being hit by the Gulf oil spill disaster of course. They bounce up and down over the years based on the price of oil, but are these figures ones that would encourage you to purchase shares in these businesses? The answer is surely no.

The figures are the result of oil exploration and production becoming more difficult, and in the case of BP, having to take more risks to exploit difficult to access reserves. It does not seem to me that those trends are likely to change.

Even if politicians ignore the call to cut CO2 emissions, which I suspect they will ultimately not do, for investors there are surely better propositions to look at. Even electric cars look more attractive as investments although buying shares in Tesla might be a tricky one, even if buying their cars might be justified. Personally, I prefer to invest in companies that generate a return on capital of more than 15% per annum, so I won’t be investing in oil companies anytime soon.

But one aspect that totally baffles me about the global warming scare is why the scientists and politicians ignore the underlying issue. Namely that there are too many people emitting too much air pollution. The level of CO2 and other atmospheric emissions are directly related to the number of people in this world. More people generate more demand for travel, consume more food, require more heating and lighting and require more infrastructure to house them (construction generates a lot of emissions alone). But there are no calls to cut population or even reduce its growth. Why does everyone shy away from this simple solution to the problem?

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

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Royal Bank of Scotland on BBC2

Some readers may have watched the BBC2 programme on Tuesday about the collapse of the Royal Bank of Scotland (RBS). It showed the hubris of Fred Goodwin – suites at the Ritz, private jets and a new headquarters opened by the Queen in which he had an enormous office. But when I posted a brief comment on the Stockopedia blog to the effect that the bail out had political overtones, it got some criticism. Indeed to my mind the programme seemed to suggest that Alistair Darling and Mervyn King were heroes who rescued the bank, and the country, from financial disaster and there was no contrary opinion on the merits of what they did.

So here’s some more explanation of the problems of RBS and how they should have been tackled.

RBS certainly was acting aggressively before the crash in 2008. It had one of the lowest capital asset ratios of any bank and then proceeded to acquire ABN-AMRO after competing with Barclays in a bidding war. RBS seemed to expect the profits from ABN-AMRO to improve its cash flow. Although it’s not easy to see the cash flows in banks, they can run out of cash particularly when loans they have borrowed become due for repayment.

One needs to understand that all banks operate on a knife edge – they have massive liabilities backed by massive assets, with only a thin slice of shareholders equity in the middle. So you will find in the December 2008 balance sheet of RBS that it had assets of £2,401,652 million, liabilities of £2,321,154 million and shareholders’ equity of only £80,498 million.

When the financial crisis arose as a result of the realisation that the US sub-prime mortgage market was heading for a fall, liquidity in the bank loan market disappeared. That is what caused the crash at Northern Rock – see: https://roliscon.blog/2017/09/02/northern-rock-10-years-after-collapse/ for past comments on that. Northern Rock was not balance sheet insolvent which would have triggered administration, it was cash flow insolvent. It just ran out of cash because folks were withdrawing cash from the bank and it could not refinance the short-term loans it had taken out in the money markets. Similar problems caused the collapse of Lehman Bros and Bradford & Bingley and the former had world-wide repercussions. The whole world was suffering a banking liquidity crisis.

There were of course subsequent steps taken to tighten up on the bank asset ratios which meant they had to raise more capital. That put many banks into an even more difficult situation. There also was a growing realisation that many banks had assets on their balance sheet that were questionable in value, i.e. debts might not be repaid but they had not been written down because of defective accounting standards (see more in today’s FT on that subject).

In addition the UK Government made the mistake of nationalising Northern Rock and Bradford & Bingley which told any international investor of equity, or even debt, into UK banks that they had no real security. The Government could prejudice their investment using the new legislation that was introduced, at the drop of a hat.

As the BBC programme described, there came a day when RBS had to tell the Governor of the Bank of England that they would run out of cash in a few hours. The collapse of RBS would certainly have undermined the whole UK banking system with other banks also crashing as they had outstanding loans to RBS. The Government’s answer was to launch a massive “recapitalisation” of RBS and other banks via forcing then to sell equity stakes in return for cash. They were given no option but to accept overnight. This effectively meant a nationalisation of RBS because they acquired control of it, along with major stakes in other banks.

Was there a different way they could have taken? Banks frequently run out of cash because of the narrow equity they hold. They can go for years without a hiccup, paying out good returns to shareholders in the meantime, until minor events disrupt this idyll. But the Bank of England can always provide loans to relieve the cash flow pressure if nobody else will. The Bank can of course effectively print money if necessary to do that. RBS did of course undertake a massive rights issue (the largest ever) to strengthen its balance sheet but that was not sufficient. Could they have got by with funding from the Bank of England when the crunch came? I suggest they might. I suggest the prime reason for the approach that was taken was the desire of the Labour Government (headed by Gordon Brown and Alistair Darling) to take control of the banking sector.

In reality other countries tackled their similar problems in different ways. But the UK was the most severely hit by the financial crisis. It was of course not just RBS that had exposure to US sub-prime mortgages. Other major world banks had similar difficulties. But the approach taken in the UK destroyed confidence in the UK financial sector in very short order.

That does not of course make any excuse for the mismanagement of RBS by Fred Goodwin and the general incompetence of the board of RBS in the critical period. But it is all too easy to lay the blame for the UK banking crisis on one individual – it’s called “personification”. But there were no heroes either.

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

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The Impact on Investors of the Labour Party’s Plans

I commented briefly yesterday on the plans by John McDonnell of the Labour Party to give employees shares and possible future nationalisations – see: https://roliscon.blog/2018/09/24/labours-plans-for-confiscation-of-shares-and-rail-system-renationalisation/

More information is now available on the share scheme and the more one studies it the more one realises that whoever devised it does not understand much about business and the stock market. In other words they were typical politicians with no experience of the real world I would guess.

The scheme would apparently operate by companies with more than 250 employees being forced to hand over 10% of the shares in a company to an employee trust fund. That would be over a period of time – possibly ten years – and presumably that would be by the issuance of new shares rather than confiscating existing shares, but it still means 10% dilution for investors.

Shareholders normally get a vote on the issuance of new shares but presumably that could be legally subverted. Otherwise the scheme would cover about 11 million employees. However, foreign owned companies would not be covered so that excludes perhaps a third of the employees (the Labour Party apparently admits they would not be and it is difficult to see how legally any such law could be enforced on them).

One simple way for companies to avoid the scheme would be to move their country of registration elsewhere – no need to change where their shares are listed, just move domicile. We could see a host of companies re-registering in such places as Panama! An unintended consequence that I am sure the Labour Party would not like.

The shares accumulated in the trust fund would pay dividends to the individual shareholders out of the dividends paid to the fund by the company. But there would be a cap of £500 per employee. Any amount payable above that cap would revert to the Government. It is estimated this might generate £2 billion a year to the Government after 5 years – another large tax hike in addition to proposed increases in Corporation Tax the Shadow Chancellor is promising.

Employees could not buy or sell the shares held on their behalf, so presumably could not take them away when they leave or retire. So in practice those companies with high staff turnover would see the dividends accumulating for the benefit of the Government, particularly if the £500 cap remain fixed, i.e. unindexed.

But the company could avoid paying out this windfall to the Government simply by not paying dividends. Many companies don’t pay dividends anyway. Alternatively they could pay a dividend in shares (a “scrip” dividend), or offer to buy back shares occasionally via a tender offer or market share buy-backs– these would not be dividends and hence would be excluded.

Another problem with the scheme is that companies who had a few less than 250 employees could decide not to expand and hence become subject to this scheme, i.e. this would discourage companies from growing which is not what the Government wants. Alternatively they could create new separate companies owned by the same shareholders to expand their business and avoid it that way.

Apart from the 10% dilution that will hit not just direct investors but those investing via pension schemes, you can see that this scheme is not just daft because of its unintended consequences and likely avoidance, it’s an insidious way to raise taxes on companies and investors very substantially.

The only good aspect of the scheme is that it would help to give employees a stake (albeit indirect) and hence interest in the company they work for. It might also ensure some representation of their interests because the trust fund would be controlled by employees and could vote the shares. But there are much better ways to provide both those benefits.

In conclusion, the idea of an employee trust fund sounds attractive at first glance but it has not been properly thought through. A lot more consideration needs to be given to come up with a workable scheme that does not prejudice companies and their investors. Any foreign investor who saw such a scheme being imposed on his UK investment holdings would promptly run a mile – and don’t forget that most of the UK stock market is now owned by foreign investors. The impact on the Uk stock market, and the economic consequences of investors taking their businesses and investment money elsewhere beggars belief.

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

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Lehman Collapse, Labour’s Employment Plans, Audit Reform Ideas and Oxford Biomedica

There was a highly amusing article in today’s FT by their journalist John Gapper explaining how he caused the financial crisis in 2008 by encouraging Hank Paulson, US Treasury Secretary, to resist the temptation to rescue Lehman Brothers. So now we know the culprit. Even more amusing was the report on the previous day that the administrators (PWC) of the UK subsidiary of Lehman expect to be left with a surplus of £5 billion. All the creditors are being paid in full.

Why did Lehman UK go bust then? They simply ran out of cash, i.e. they were cash flow insolvent at the time and could not settle payments of £3bn due on the day after their US parent collapsed. Just like Northern Rock where the assets were always more than the liabilities as also has been subsequently proven to be the case.

Perhaps it’s less amusing to some of the creditors of Lehman UK because many sold their claims at very large discounts to third parties rather than wait. Those that held on have been paid not just their debts but interest as well. So the moral is “don’t panic”.

Lehman’s administration is in some ways similar to the recent Beaufort case. Both done under special administration rules and requiring court hearings to sort out the mess. PWC were administrators for both and for Lehman’s are likely to collect fees of £1billion while employing 500 staff on the project. It may yet take another 10 ten years to finally wind up. Extraordinary events and extraordinary sums of money involved.

An editorial in the FT today supported reform of employment legislation as advocated by Labour’s John McDonnell recently. He proposed tackling the insecurity of the gig economy by giving normal employment rights to workers. I must say I agree with the FT editor and Mr McDonnell in that I consider that workers do have some rights that should be protected and the pendulum has swung too far towards a laissez-faire environment. This plays into the hands of socialists and those who wish to cause social unrest. Even the Archbishop of Canterbury suggested the gig economy was a “reincarnation of an ancient evil” and that it meant many companies don’t pay a living wage so employees rely on state welfare payments. A flexible workforce may give the country and some companies a competitive advantage but it takes away the security and dignity of employment if taken to extremes. The Conservative Government needs to tackle this problem if they wish to be certain of getting re-elected. If you have views on this debate, please add your comments to this blog.

Mr McDonnell also promoted the idea of paying a proportion of a company’s profits to employees – effectively giving them a share in the dividends paid out. That may be more controversial, particularly among shareholders. But I do not see that is daft either so long as it is not taken to extremes. After all some companies have done that already. For example I believe Boots the Chemists paid staff a bonus out of profits even when a public company.

Another revolutionary idea came from audit firm Grant Thornton. They suggest audit contracts should be awarded by a public body rather than by companies. This they propose would improve audit standards and potentially break the hold of the big four audit firms. I can see a few practical problems with this. What happens if companies don’t judge the quality of the work adequate. Could they veto reappointment for next year? Will companies be happy to pay the fees when they have no control over them. I don’t think nationalisation of the audit profession is a good idea in essence and there are better solutions to the recent audit problems that we have seen. But one Grant Thornton suggestion is worth taking up – namely that auditors should not be able to bid for advisory or consultancy work at the same company to which they provide audit services.

Oxford Biomedica (OXB) issued their interim results this morning (I hold the stock). They made a profit of £11.9 million on an EBITDA basis. OXB are in the gene/cell therapy market. What interests me is that there are some companies in that market, at the real cutting edge of biotechnology with revolutionary treatments for many diseases, that are suddenly making money or are about to do so. That’s often after years of losses. Horizon Discovery (HZD) which I also hold is another example. Investors Chronicle recently did a survey of similar such companies if you wish to research these businesses. It is clear that the long-hailed potential of cell and gene therapy is finally coming to fruition. I look forward with anticipation to having all my defective genes fixed but I suspect there will be other priorities in the short term particularly as the treatments can be enormously expensive at present.

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

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Trump Impeachment and No Deal Brexit Planning

Donald Trump has suggested that if he was impeached the stock market would crash and everyone would become poorer. And make no mistake, if the US market crashes then so will other worldwide stock markets including the UK as there is a high correlation between international stock markets.

Is that likely if he was impeached? No it is not. Stock markets can be remarkably immune to political crises. Just look at the negligible impact of the turmoil in the UK as politicians debate Brexit and there is the major threat of a very left-wing Government. What moves stock markets is economic crises, not political ones. Changing the US head of state would have little impact on the US economy.

In any case, the chance of impeachment looks relatively low. Paying hush money to past contacts is not a crime unless campaign funds were misused which currently appears unproven.

In the short term there is perhaps more threat to the UK stock market from a “no deal” Brexit. Having had a quick read of the papers published yesterday by the Government on planning for such, I am not panicking (see https://www.gov.uk/government/collections/how-to-prepare-if-the-uk-leaves-the-eu-with-no-deal#money-and-tax ). The regulatory issues can be accommodated without too much difficulty. What concerns me more is that if customs facilities are not improved well in advance, we might have long queues of vehicles on the motorways here in Kent.

Meanwhile Chancellor Philip Hammond has been stirring the Brexit debate pot with a letter to the Treasury Select Committee which includes this statement: “This January provisional analysis estimated that in a no deal/WTO scenario GDP would be 7.7% lower (range 5.0%-10.3%) relative to a status quo baseline. This represents the potential expected static state around 15 years out from the exit point.”

Anyone who thinks they can forecast the economy so far as 15 years ahead is plain bonkers in my opinion. Economists don’t manage to accurately forecast the UK economy one year ahead let alone 15. Such long-range forecasts are always based on numerous assumptions, most of which are undermined by unforeseen events which have not been taken into account. The Chancellor also forecast that Government borrowing might increase by £80 billion a year because of the reduced GDP by 2033 unless spending or taxation was changed. All this looks like scaremongering to me of the worst kind.

I may favour doing a deal with the EU along the lines of Mrs May’s proposals to assist with trade, but having a no-deal Brexit does not scare me.

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

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