The Market, Dunedin and Standard Life Smaller Companies Merger, and Aston Martin IPO

Is it not depressing when you go away for a week’s holiday and your portfolio falls every day in that time? I do monitor any exceptional movements while on vacation but try to avoid trading. It just seemed to be a general downward trend and reviewing the movement over that week my portfolio is down 1.73% while the FTSE All-Share is down 1.72%. So that is what I had already surmised.

Those stocks that seemed to have become overblown did fall and there were some like Scottish Mortgage Trust (SMT) were hit by specific news – in their case the events at Tesla. But the fall in my portfolio last week was less than it went up the previous week. I feel not quite so depressed now I have done the analysis.

Anyway, I am back from holiday now and on my desk is a proposed merger of Dunedin Smaller Companies Investment Trust (DNDL) and Standard Life UK Smaller Companies Investment Trust (SLS). I need to take a decision on this as I hold the latter.

DNDL is smaller than SLS and following the merger of DNDL’s manager, Aberdeen Asset Management, with Standard Life the merged manager now has two trusts with a similar focus. SLS has a superior performance record – 100.7% net asset value total return versus 68.9% for DNDL over the last 5 years. The merged trusts would be managed by Harry Nimmo who has managed SLS for some years.

The directors argue that the merger makes sense because it will result in reduced on-going costs and improved liquidity in the shares, although they don’t quantify either claim. There is no immediate change proposed to the fund management charges on SLS. DNDL will be paying the costs of both parties if the merger goes through.

It no doubt makes sense for the manager to merge these trusts. Not much point in having two trusts in the same stable with a similar focus and they will save on management costs. It also makes some sense for DNDL holders but does it for SLS shareholders?

Enlarging a trust or fund can degrade future returns particularly in small cap funds. This is because buying larger quantities of smaller company shares is more difficult and exiting is also difficult. In other words, the manager may find they cannot be as nimble as before. Alternatively the number of companies in the fund has to grow and we surely know that this is a recipe to reduce returns as there are only so many “good ideas” out there. The more companies in a portfolio, the more likely it is to approximate to a tracker fund.

Therefore, I think I will vote against this merger for that reason.

But what alternatives were there for DNDL shareholders? The company could have changed the manager to avoid the conflict of interest. Or simply wound up if it was too small to be viable. Perhaps a wider international focus when SLS is UK focused would be another alternative.

Luxury car maker Aston Martin is to float on the market. I agree with Neil Collins comments in the FT this weekend – “never buy a share in an initial public offering”. He suggested those who are selling know more about the stock than you do. Car companies, particularly of niche brands, are notoriously tricky investments. Aston Martin has been bust as many as seven times according to one press report. As Mr Collins also said “The private equity vendors are dreaming of a £5 billion valuation for a highly geared business with a decidedly unroadworthy past”.

Car companies exhibit all the worst features of technology businesses. Product reliability issues (which was a bugbear for Aston Martin for many years), very high cost of new model production, Government regulatory interference requiring major changes for safety and emissions, competitors leapfrogging the technology with better products, and sensitivity to economic trends. In a recession few people buy luxury vehicles or they simply postpone purchases – so it’s feast or famine for the manufacturers.

There can be some initial enthusiasm for companies after an IPO that can drive the price higher but the hoopla soon fades. Footasylum (FOOT) was a recent example but McCarthy & Stone (MCS) was another one where investors found that the market proved more challenging than expected.

Resist the temptation to buy IPOs!

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

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Return Versus Risk and Tips from Terry Smith

There was an interesting article by Fundsmith founder Terry Smith in the Financial Times on Saturday under the heading “Think globally and add a dash of small caps”. His articles are usually full of wisdom.

In this case he first tackled the issue that the Capital Asset Pricing Model (CAPM) tells you that your returns relate to how much investment risk you are willing to take on. This might be seen as common sense – why would anyone take more risks if they did not get a better return? But based on an academic study of actual stock market returns, low risk seems to give better returns. This is a persistent anomaly.

But my reservation on this truth is that risk was measured by the volatility of the share price, which is a conventional way to calculate the risk of an individual share. But it simply does not tell you the major risks that a company faces. It only tells you about the level of variability in the share price over the short term, or the amount of speculation there is in the stock. For example, it will not tell you that the company operates in a market that is rapidly changing or the company’s products are subject to technological obsolescence. There are many risks that are simply not reflected in conventional risk metrics which only a study of the market in which the company operators and its business model will reveal the truth about.

Terry also discussed the other conventional wisdom that asset allocation is responsible for most of the returns one obtains – he quoted a figure of 91.5% from another academic study. He said this has led “a large portion of the investment industry to focus almost exclusively on asset allocation”. That’s as opposed to the choice of individual assets.

Mr Smith also criticized the parochial approach of many investors who only invest in their home markets (e.g. UK listed shares for UK investors even though many such companies have very international businesses). He went on to suggest a portfolio of global large-cap stocks plus some small/mid-cap stocks can “achieve the seemingly impossible feat of generating additional return whilst reducing risk”. This is because such a portfolio that might comprise 35% of small cap stocks is more likely to be near the “efficient frontier” for which investment professionals aim.

He concluded by saying that “we should all manage equity portfolios on a global basis and add an element of small-cap exposure”. That might be a puff to some extent for his Fundsmith fund, which I hold – perhaps suggesting Fundsmith could provide one element in this strategy. But it is certainly an approach I have found to be a wise one.

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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Hedging Against Brexit

As we edge towards an abrupt Brexit as agreement with the EU has turned into a game of chicken, it’s worth considering some options. Or as my M.P. Bob Neill said about divorce on Twitter “the current system of divorce creates unnecessary antagonism in an already difficult situation” (he was talking about personal divorce in the UK as head of the Justice Committee but our EU divorce is looking very similar – acrimony is the word for it).

Perhaps the Prime Minister will find a way through to a sensible settlement now she is reported to have personally taken charge of the matter. But as investors we should not rely on such a chance.

One solution is simply to move your share investments into companies that are listed overseas and do most of their business elsewhere than the UK. Don’t wish to buy overseas companies directly? Simply buy one of those “global” investment trusts or trusts focused on particular sectors – Europe, the USA, China, India, et al. Or ensure you invest in UK companies with large exposure to overseas markets other than the EU – there are lots of those.

One aspect that caught my attention this week was the suggestion that the UK should stockpile food and medicines to ensure there were no shortages. But taking food alone, fresh food does not generally keep for very long unless you have a refrigerated warehouse. Even then there are limits. As one supermarket chief was reported as saying in the FT today that it was “ridiculous” and showed “complete naivety”. The reason is simply that supermarkets and their suppliers operate “just in time” systems where deliveries often depend on overnight shipping of goods from Europe. Likewise car manufacturers and other engineering companies rely on complex supply chains that depend on the same “just in time” processes and very quick delivery times. There is a solution to this problem which is to store more items. Non-perishable goods can be stored for a very long time to provide a buffer to the flows of goods. One hedge tactic might therefore be to invest in warehousing companies – Segro and Tritax BigBox REITs come to mind (I own them), although Lex in the FT suggested today that “optimism is already baked in” to the share price of Segro after their interim results announcement. The share prices of those companies have been driven by the internet shopping boom where goods are held in warehouses rather than shops, and rapid delivery is essential. More warehouse demand caused by Brexit might add another wave of warehouse building and increase rents.

When it gets nearer the date next March for Brexit, perhaps we should be doing some personal hoarding of French cheese, Dutch salami and German sausages to guard against short-term supply chain disruptions, but I doubt I will be panicking. UK producers can gear up and many other suppliers in the rest of the world will suddenly find they are much more price competitive. Tariffs on imports of food from outside the EU can currently be very high (e.g. an average of 35% on dairy products which is why you don’t see much New Zealand or Canadian cheese in the shops lately – see https://www.ifs.org.uk/uploads/publications/bns/BN213.pdf for details).

That does not mean of course that food will be much cheaper as the UK Government might impose some tariffs to protect our own farmers, but you can see that it is quite possible that the supply chains will rapidly adapt once we are outside the EU regime. But long haul supply lines will require more warehousing and more dock facilities.

Or our Government could take the Marie Antoinette approach to food shortages – “let them eat cake” she said, or “let them buy British products” instead perhaps. Was that not a past Government campaign which could be revived? Such “Buy British” campaigns ran in the 1960s and 1980s to inform my younger readers. I am of course joking because so far as I recall they had little public impact. They did not have any influence on the preference to buy German or Japanese cars, although many of the latter are now made in the UK. But in a new post-Brexit world we should expect some surprises and the need to change our habits.

One joker suggested we might need to eat more non-perishable food, i.e. tinned peaches rather than fresh. But that just shows that there are ways around every problem. If the current heat wave persists we will of course be able to grow our own peaches. But betting on the weather is as perverse as betting on the outcome of Brexit. All I know is that we are likely to survive it. Hedging your bets is the best approach.

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

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Book Review: Debtonator by Andrew McNally

Now here’s a book well worth reading on your summer holidays. It’s called Debtonator by Andrew McNally. Indeed if you are taking a long-haul flight to your holiday destination, you might be able to read it in one sitting. Like all good books it is short at only 98 pages excluding notes and index, and the format is small as well. But there is an enormous amount of information embodied in there.

It covers the problems caused by excessive debt in the modern world. The author explains how the balance of company finance has moved from equity to debt which has had many negative effects. He links the rise in income inequality, a major social concern in leading economies, to the excessive use of debt and the discouragement of investment in equities by Governments and pension regulators. The housing market is another example of the distortion created by too much debt at very low cost, engineered by Government and central banks.

The author suggests we need to move to an equity financed, rather than a debt financed economy and proposes how that could be achieved. Reform of the tax system is one aspect of achieving that.

He is also scathing about the current costs of equity investment for retail investors due to high “intermediation” with too many people taking a cut of the real investment returns before they arrive in the hands of the beneficial owners. That’s despite his apparent long career in the investment industry.

The book is a very good summary of what is wrong with the modern financial system. But it also gives the reader some tips on how to become one of the wealthy few rather than the impecunious many. You need to take a direct stake in the real economy where companies are generating real returns, and minimize the costs imposed by advisors, brokers, platform operators and all the other gougers who erode the returns.

In summary one of the best books I have read lately on the defects in the modern financial world. A little gem of erudite analysis.

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

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Just Eat – Capital Markets Day

I recall other ShareSoc Members complaining about how some companies publicly announce “Capital Market Day” events on the morning that the event takes place. This ensures that private investors are excluded as only institutional investors are given advance notice. A very good example was that for Just Eat (JE.) yesterday. Given in an RNS at 7.00 am in the morning, with the event commencing at 9.00 am.

Usually such announcements say something like “no new information will be provided”, or in this case it said “no update on trading will be provided”. But in fact there was obviously very significant new information provided because the share price fell 7.1% on the day, mainly in the afternoon.

There was a webcast provided and I tried to listen to a recording of it in the evening but it kept breaking up so I did not hear anything of interest. The Financial Times reported this morning that “management comments about costs and profitability jolted investors”, and that “investment levels in the coming years would remain elevated and margins were likely to flatline at its marketplace business”. Consensus forecasts were likely to fall it suggested. There was no announcement this morning from the company clarifying what was said or why the share price fell.

This debacle follows a similar sharp fall in the share price following an unexpected statutory loss due to exceptional write-offs in the annual results in March. It is also clear the market for food delivery is changing rapidly with new entrants in addition, meaning the sector is getting more competitive and more investment seems to be required.

I did previously hold a significant number of shares in the company but sold the remainder today. Just too many unexpected events at this company. I hate unpredictable companies and lack of clarity in management statements (or no statements). When confidence in a company and its management evaporates, it’s always time to sell in my view.

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

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Scottish Mortgage Investor Meeting

Yesterday I went to the meeting for investors held by Scottish Mortgage Investment Trust (SMT) in London. This was a useful event as they normally hold their AGMs in Scotland. Needless to say this company’s name is now grossly misleading as it does not invest in mortgages nor in Scotland but is a “global” investment trust. It has a great track record in the last few years and has a focus on growth companies. Their top 10 investments are Amazon, Alibaba, Illumina, Tencent, Tesla, Baidu, Kering, Inditex, Netflix and Ferrari which gives you a good idea of their focus. Here are some of the words of wisdom from manager James Anderson:

He finds the stock market ever more puzzling. Investors think daily headlines help you to invest but there is no correlation. Comment: I think he is saying ignore the political gyrations and such matters as Brexit. He suggested that people way cleverer than us get the world wrong and referred to the work of Hans Rosling and that of Hendrik Bessembinder who reported that 0.4% of all US stocks created half the wealth. Comment: Anderson implied that the key was to pick a few of those really successful growth companies because they will have the biggest impact on overall returns.

SMT therefore tries to identify businesses that are focused on growth markets with great potential – at least 40% per annum. Typically they are also run on a completely pragmatic basis.

Anderson thinks that deflation is highly likely in the next few years as companies they are investing in are reinventing the world. For example healthcare may become a lot cheaper as diagnostics improves and reduces the burden of expensive late stage interventions in cancer and heart disease.

Catherine Flood talked about the companies they are invested in and about the biotechnology sector where genome mapping is creating major opportunities. They have a rising number of private companies in their portfolio.

In response to questions, Anderson said they sold Apple two years ago because growth prospects seemed limited and had reduced their holding in Facebook for other reasons. He also questioned whether the kind of investment strategy following by Warren Buffett will continue to work in future as markets get disrupted by new companies using innovative technology. We may be facing a different world in future where “value” is less important.

As regards their large number of holdings in Chinese companies, Anderson was not worried about the political risks in China and expected China to become the dominant world economy in the near future. They are leading in technology in some areas (e.g. NIO in electric cars).

Overall this was an educational presentation as we got some understanding of the investment strategy of the company which clearly has worked well when economies have been buoyant and markets have been heading consistently upwards. The share price is at a premium to assets of 3.6% at present so might be vulnerable to a correction if there is any hiccup in the global economy. There was no mention of cash flows, return on capital or other “fundamental” measures of value in companies which tells you something does it not. But if you wish to invest in global growth companies, this is certainly one investment trust to consider.

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

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