Standard Life UK Smaller Companies and FRC Meetings

Yesterday I attended two meetings in the City of London. Here are brief reports on each.

Standard Life UK Smaller Companies Trust Plc (SLS) held a meeting for investors to “meet the manager” in London as their AGM was in Edinburgh this year – only about 10 people attended the latter so there were more in London. I have held this trust for some years and the manager, Harry Nimmo, who has been with the company for 33 years has been a consistently good performer. The management company has recently merged with Aberdeen and is now called Aberdeen Standard Investments but apparently there have been no significant changes internally as yet. Mr Nimmo’s comments are summarised below.

He said they have a discount control policy which is unique to UK smaller companies trusts. They buy back shares if the discount gets about 8%. The investment policy is unchanged and they are not keen on blue-sky or concept stocks. AIM is now a better place than 5 years ago as it is now more broadly based and no longer dominated by mining stocks and blue sky tech stocks.

They have put a new debt facility in place which will ultimately replace their CULS (Convertible Unsecured Loan Stock). The final date for conversion is coming up and investors need to pay attention to that as they are “well in the money”.

The trust shows a ten year CAGR dividend growth of 23.7% and the capital return since 2003 is 851% (plus dividends of course). But there have been some bear markets during his management which one needs to allow for as investors. However, if you had sold the trust after the Brexit vote you would have made a terrible mistake – the company is up 54% since June 2016.

The trust looks for companies that can grow irrespective of the economic cycle, and those with good cash flow and strong balance sheets. Mr Nimmo covered their investment process which is somewhat formulaic using a screening process (I have covered it in past articles) but they do meet investee companies twice a year. They have about 50 holdings in the fund which is a “bottom-up” stock selection actively managed fund.

He mentioned they have 10% in animal care and still hold NMC although as it is now a FTSE-100 stock they have been selling out. They still have a large holding in Abcam and have bought RWS recently. Their second largest holding is First Derivatives where most profits come from outside the UK. They generally do not hold oil/gas/mining stocks and are very light on real-estate [note: I agree with the former and many of my individual holdings overlap with the trusts but I do hold some real estate companies]. An exception though is Workspace who recently produced an excellent set of results with a rapid growth in dividends.

They have also been selling Fevertree as it exceeded 5% of their portfolio value.

I did not manage to stay until the Q&A session as I had to go to a meeting organised jointly by ShareSoc and UKSA with the Financial Reporting Council (FRC). This was a long meeting and I hope one or other organisations will produce a lengthier report on it because it was an exceedingly useful meeting. I will simply highlight a few points of particular interest.

FRC Meeting

The FRC is responsible for audit policy, standard setting and audit quality including investigation and enforcement of past transgressions. So it is a rather important body for those private investors who have come unstuck on an investment because the accounts of the company turned out to be misleading – for example the recent debacle at Carillion was mentioned by one attendee, but I can think of numerous other examples.

The speakers covered the role of audits, both currently and how they might develop in the future (partly as a result of technology changes such as the use of data analytics). After Brexit it is likely there will be a broadly equivalent regime as investors are opposed to “unpicking”.

The FRC reviews about 150 audits every year and grades them into four categories (the reviews are listed on the FRC web site). By 2019 they want 90% to be in the top two ratings which they are not at present. It was noted that KPMG come out worse of the big audit firms. A common reason for audits falling short are lack of professional scepticism.

The FRC also undertakes thematic reviews of particular issues. I raised the issue of the lack of common standards for “adjusted” data commonly reported by companies (such as earnings, or return on capital that I mentioned in previous recent blog posts). The response was it was mandated to explain the definitions of such adjustments but I pointed out this did not help with comparability (e.g. of broker forecasts). The FRC said they will be consulting on this issue shortly, which is good news.

The role of the FRC in “enforcement” was covered. They stressed that their remit does not cover crime, they merely regulate accountants and actuaries although it is of course true that the failure of auditors to identify false accounts is one area they often investigate. It was mentioned that the size of the team on this had grown from 11 people in 2013 to 30 now and they are still looking for more bodies. This really just shows how under-resourced the FRC has been in the past. A total budget of £15m per year was mentioned. Comment: this seems hopelessly inadequate to me bearing in mind the number of public companies (and other organisations) and the number of auditors they have to monitor. It explains partly why complaints to the FRC often seem to disappear into a black hole, or why investigations often take so long as to be pointless. A list of cases under formal investigation is on the FRC web site (See here for that and two linked pages for the full list: https://www.frc.org.uk/auditors/enforcement-division/current-cases-accountancy-scheme which of course will tell you that Globo was commenced in December 2015 and Quindell in August 2015 and have yet to report).

I did suggest to the speaker that the FRC should be a party to the Code of Practice for Victims of Crime (as some audit failures involve the crime of fraud) as the Police, the SFO and FCA are, and which has improved their disclosure culture. This might assist those who report failings to get some feedback on the progress of a case. But the FRC argue that their role is not to investigate crime as such and they are inhibited by legislation/regulation on what they can disclose. However it is very clear to me that too often complaints get made to the FRC, but the complainants are not advised of progress and often have no idea on the outcome. This is an issue they will be looking at.

They hope the extra staffing will speed up investigations. The investigation process was discussed, but for example, Carillion had not even been placed under formal investigation as yet. It was suggested by audience members that the FRC was quite ineffective but recent cases such as AssetCo and Healthcare Locums were mentioned as demonstrating strong action and they have issued fines of £12 million in the last year which is the biggest ever. It was mentioned that fines go to the Treasury which is not ideal.

Confusion between the different regulatory bodies (e.g. the FRC, FCA, SFO, etc) was mentioned by attendees and the speakers, not helped by similar three letter acronyms. One attendee suggested that a unified regulatory body would help (such as the SEC in the USA). Comment: I agree at present it is unclear except to experts on who is responsible for what and the accountability of these bodies to the Government or to any democratic body of investors.

The FRC also has an interest in the UK Corporate Governance Code and the Stewardship Code. A consultation on a new Corporate Governance Code is imminent. There was also a session on the role of the Financial Reporting Lab where both ShareSoc and UKSA members have been involved in the past.

I’ll have to stop here because the budget speech by the Chancellor will commence soon and I wish to listen to it as there may be some major changes on investment tax reliefs. I’ll do another blog post later on it.

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

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Brexit, and the Finances of the Young

The national media continue to try to turn news into controversy. Their words are often incendiary and designed to provoke debate and therefore attention – as a means no doubt of promoting their publications. So their headlines become “verbal click-bait”.

As most people now read news on the internet, the publishers could be considered as acting as “trolls”. Here is the definition in Wikipedia of an internet troll: “In Internet slang, a troll is a person who sows discord on the Internet by starting quarrels or upsetting people, by posting inflammatory, extraneous, or off-topic messages in an online community with the intent of provoking readers into an emotional response or of otherwise disrupting normal, on-topic discussion…….”

Written words are not the only example. Laura Kuenssberg of the BBC has adopted a similar verbal approach in her reporting. It’s not just Labour party members who should be complaining about her hysterical style.

There were a couple of news items this week that caught my attention in this area. There were several comments on the report issued by the FCA on family finances. The report indicated that half of UK adults were “financially vulnerable” and that those in their 20s and 30s were reliant on borrowing (personal loans and credit card debt). It reported that one fifth of 25-34 year olds have no savings at all with many struggling to pay bills. But this was interpreted by some of the media as the new “generational divide”.

But was it not always so? I certainly don’t recall having much in the way of savings at the age of 30 and lived from month to month, sometimes using credit card debt. In other words, I doubt that the situation has been changing over time; although the elderly have become better off lately due to rising state pensions I am not convinced the young have been getting poorer. But the media like to put a “spin” on any news item to grab attention.

As the report shows, the elderly do have more savings as one might expect but they are not evenly distributed. One amusing statement in the report is “A high proportion of retirees do not know how much savings they have”.

It’s a report well worth reading although rather long at almost 200 pages. Here is one useful titbit of information from it: “Around one in five (22%) 45‑54 year olds hold a stocks and shares ISA and the same proportion hold shares or equities directly”. It would have been good to obtain more detail information on that but it just shows there are a lot of shareholders out there.

Another example of media hysteria is the reporting on the Brexit negotiations. Will it be a hard or soft Brexit? Will the bill be £20 billion or £100 billion? Are Tories threatening to quit if there is any compromise, or revolt against the rule of Theresa May? Will Jeremy Corbyn scupper the whole affair by underming the Bill going through Parliament to support it? Who really knows, but it all makes for good headlines.

The Financial Times has become one of the leaders in scare mongering over Brexit with regular articles of a polemic nature by Martin Wolf and Simon Kuper on the topic. The latest example was by Martin Wolf in yesterdays FT. Now I have never thought much of Mr Wolf’s opinions on financial matters since he supported the nationalisation of Northern Rock, but his latest article (headlined “Zombie ideas about Brexit that refuse to die”) is pure hysteria. I don’t mind the occasional editorial opinion piece on Brexit, or some reporting on the potential technical difficulties if not slanted, but this piece was just propoganda in essence. It pointed out all the difficulties associated with a “hard” Brexit where no trade deal is agreed beforehand, but that is well known and most folks do not think that is likely. It certainly did not give a balanced view of the arguments for or against Brexit and what our negotiating stance should be. In reality there is likely to be a compromise of some kind – that is what politics usually ends up being about – compromise after compromise. Indeed it is one of the frustratations of anyone in the political world that achieving revolutions, rather than compromise, is not just difficult but exceedingly time consuming.

It is certainly regrettable that the Financial Times, since its takeover by Nikkei in 2015 has become much more politicised, and there is less factual reporting and more opinion. Perhaps it is just pandering to the views of most of its readers (the London-centric financial players and international businessmen) but if they expect to influence politicians or the wider community they will be disappointed.

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

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Response to Financing Growth Review

The Government is currently consulting on “Financing Growth in Innovative Firms” (otherwise known as the Patient Capital review). It covers the perceived problems in building world-beating companies from a small size in the UK, and the ways the Government provides support to early stage companies. That typically means the VCT, EIS and SEIS schemes with their associated tax reliefs and other possible “support” programmes where the Government funds them directly.

Anyone who invests in this area, directly or indirectly, should respond to the public consultation – the deadline is the 22nd September to do so. That is particularly so because reading between the lines it seems that some folks in the Government feel the tax reliefs are too generous and even suggest that investment would take place even without the tax reliefs. But my view is very different – I certainly would be very unlikely to invest in VCT and EIS funds without generous tax relief. They frequently generate dismal investment returns and have very high management fees plus administration costs. In reality, the historic record has been very patchy and the tax reliefs only help to offset the duds (which were difficult to identify in advance).

As someone who has experience of this sector both as an investor and a director of companies needing to raise capital, I have put in a personal submission on the topic. It is present here: Financing-Growth

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

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Barclays Stockbroking Complaints

Several newspapers and on-line news services have reported this week on the debacle at Barclays. They launched a new “Smart Investor” site to replace their Barclayshare share trading service. The complaints range from failure to advise new account log-in details, support service uncontactable, old features missing (or perhaps simply moved elsewhere and not easily found in some cases), higher charges (fees restructured), to some account types or share holdings being no longer permitted.

Barclays have integrated it with their on-line bank account service which probably makes sense, but they clearly got some basic things wrong with this kind of migration which are:

  1. Beta testing of the new software on real customers must have been limited in scope, if done at all.
  2. All clients were moved at the same time and forcibly. No parallel running, no options for clients to choose when to migrate, etc.
  3. If possible, avoid “big bangs”. Changes to systems should be done gradually and in stages to avoid massive new learning processes by clients.

When will IT teams learn that folks get “habituated” to software and get very unhappy when it’s changed, even when the new system works well and has more features (and in Barclays case, it obviously had some problems). It’s like moving the products on the shelves of supermarkets so the customers can’t find their favourite foods any more. Now Paypal did a similar migration recently, and the new menus were hopeless to begin with, but they allowed you to drop into the old menus for some time. So only some minor cursing was the result. But Barclays may lose some of their 200,000 stockbroking clients from this debacle it seems.

Stockbroking platforms are really important to get right as they involve large value transactions by often sophisticated traders but there have been several examples over the years of new platforms failing to meet the basic needs of clients.

What do you do when this happens? Move your account to someone else? If only it was that simple.

From several experiences of doing this, all I can say is that you won’t have much difficulty finding someone to take it on, but the process often takes months with endless hassles along the way.

Indeed I have complained to the Financial Conduct Authority (FCA) about this in the past – see https://www.sharesoc.org/blog/regulations-and-law/stockbroker-transfers-more-evidence-of-unreasonable-delays/

Anyone who meets this problem should also complain to the FCA and encourage them to tackle it. If you can switch a bank account in 7 days (and that’s mandated), why not a stockbroking account?

The complexity partly arises from the use of nominee accounts and the problems with funds rather than direct shareholdings, but these difficulties are surely fixable if we had a decent share and fund registration system and stockbrokers were motivated to get the issue sorted out. Needless to point out that stockbrokers don’t like to make it easy to switch so won’t do so unless pushed because they like to lock their clients in (hence the use of nominee accounts also of course).

In the meantime, if you do decide to switch you may find it easier to move all your holdings into cash first – but you need to be wary about the tax implications of doing so.

This FCA web page tells you how to complain about Barclays new service, and about delays in transfers, here: https://www.fca.org.uk/consumers/how-complain . But if you wish to complain about the general lack of action on broker transfers, you could write to David Geale, Director of Policy, FCA, 25 The North Colonnade, London, E14 5HS.

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

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AIM Rules – Response to Consultation

The London Stock Exchange (LSE) is currently undertaking a consultation on the AIM Market Rules (see http://www.londonstockexchange.com/companies-and-advisors/aim/advisers/aim-notices/aim-discussion-paper-july-2017.pdf ).

Anyone can respond to this and the deadline is the 8th September. Those who invest in AIM shares will be aware of some of the past problems in AIM companies and tightening up some of the Rules that apply to AIM companies may surely help to improve the quality of the market. For example, it covers new rules that might help AIM to be more selective in regard to the companies that list on the market.

I have submitted a response to this consultation which is here: http://www.roliscon.com/Roliscon-Response-AIM-Rules-Review.pdf

Investors in AIM should do likewise, otherwise the responses will be dominated by Nomads and company promoters.

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

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Investment styles – Phil Oakley, Richard Beddard and Roger Lawson

Last week Phil Oakley, who mainly writes for ShareScope/SharePad, published a very interesting article entitled “A Blueprint for Better Long Term Investing”. This described his investment style in essence and contained lots of good tips from an experienced stock market analyst. For example: “Focus on businesses not stocks”, “Don’t overpay for quality companies” and “Avoid information overload”. It’s well worth reading and is here in full: Oakley-Article

Experienced investor Richard Beddard also joined that company recently and published an article entitled “Shares to Hold to the Grave, and Beyond…”. Again it covers his investment style and how he analyses companies. It can be read in full here: Beddard-Article

As both of their styles are similar to my own investment approach, I thought I would have a stab at a similar type of article to cover my own investment style, particularly as there seem to be some popular misconceptions about it, and some misreporting on it of late. That is also a good starting point to some further plans for writing about stock market investment that I have. My article is entitled “My Investment Philosophy” and is present here: Lawson-Article

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

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FT Article on Small Investor Voting

Yesterday in the FTMoney supplement, FT writer Aime Williams explained how small investors could influence companies. But unfortunately it misled readers on some points. I have sent Aime the following communication:

“I read your article entitled “Small investors stand up and be counted” in this weekend’s FT with interest. It is good that the article shows how private investors can have an impact on companies, and it will no doubt encourage people to attend AGMs.

But the comments from Richard Stone of the Share Centre are to say the least, somewhat inaccurate. The 2006 Companies Act did help to enfranchise those in nominee accounts in relation to giving them the ability to vote, but to say that ‘investors in nominee accounts have had the same rights as direct shareholders since the 2006 Companies Act’ is simply wrong. For example, Members of the company (i.e. those on the share register) have the ability to challenge a poll, or apply to a court to object to a change from a public to a private company. Those rights are lost if you are only a beneficial owner in a nominee account. That has been confirmed in past legal cases.

There is also the problem that there is no legal obligation for brokers to enfranchise investors except in the case of ISA accounts, and most stockbrokers do not even inform their clients of that fact or make it practically easy for them to vote. The Share Centre does but many do not. In addition there are difficulties with AIM companies.

In reality the widespread adoption of nominee accounts rather than investors being on the share register of a company has fatally undermined shareholder democracy and the vast majority of retail investors now do not vote.

The documents on this web page, which I wrote, spell out the facts about the nominee system and shareholder rights: https://www.sharesoc.org/campaigns/shareholder-rights-campaign/

It is still true that we need a complete reform of the existing system so that shareholders in companies, however they hold their shares, are given the ability to vote and to attend General Meetings, without artificial barriers. We also need regulations to ensure that they can vote easily and that Companies and Brokers inform everyone entitled to vote or attend meetings when the time arises to do so. Only then will shareholder democracy be restored.”

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

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Hate Crime, Fake News and Market Abuse

Yesterday saw a lot of media coverage after the Crown Prosecution Service announced that online offences of “hate crime” would in future be treated as seriously as offline offences. This is in response to the rising volume of such abuse on social media.

What is a “hate crime”? In summary, it is abuse based on race, ethnicity, religion, disability, sexual orientation or gender identity. Why just those categories? Don’t ask me – I am looking forward to abuse of baldies and fatties being made hate crimes. But this is just one aspect of the problems created by social media where anonymous posters can attack anyone whose views they do not like. Anyone in public life now regularly suffers the most vile comments from people who do not like their opinions – just ask any Member of Parliament who can tell you about it. Indeed, I have suffered from it myself.

Sometimes they do this because they know they can hide behind an anonymous google or hotmail account on the net, or by using a fictitious name. But even when it is clear who they are, there is little legal or social pressure to inhibit them. Indeed a new word has been invented to cover such behaviour – internet “troll”, which Wikipedia defines “as a person who sows discord on the Internet by starting quarrels or upsetting people, by posting inflammatory, extraneous, or off-topic messages in an online community (such as a newsgroup, forum, chat room, or blog) with the intent of provoking readers into an emotional response or of otherwise disrupting normal, on-topic discussion, often for the troll’s amusement.”

In extremis this can degenerate into “harassment” which is now a criminal offence in the UK, in addition to being subject to civil claims. For example, repetition of false allegations that cause alarm or distress is harassment. Again this is so much easier to propagate on the internet and in social media. Indeed one problem is that it can be going on without the victim being aware of it because there are now so many different platforms on which it can appear that even monitoring for it is not easy.

Another very topical subject which is linked to the above is that of “fake news” which allegedly had an impact on the US Presidential election and the Brexit vote in the UK. In effect, social media can be used maliciously to distribute false information with the intention of changing public opinion.

This can also be seen in financial markets where fake news can be used to affect share prices. Just create a rumour about a takeover bid on social media and the share price of a company will take off before the company can even deny it. Profits can be made from such behaviour, and even if the company denies it they may not be believed. Now simple cases like this are undoubtedly offences under the Financial Services and Markets Act but there are very few convictions for it. Social media have become impossible to police by the authorities in practice.

A Commons Select Committee was inquiring into fake news before the General Election caused the inquiry to be abandoned (along with all other business in Parliament). See https://www.parliament.uk/business/committees/committees-a-z/commons-select/culture-media-and-sport-committee/inquiries/parliament-2015/inquiry2/ . No report will be produced, but there was a substantial number of submissions to the inquiry. One that is particularly worth reading as it covers the abuses of financial commentators is present here: http://data.parliament.uk/writtenevidence/committeeevidence.svc/evidencedocument/culture-media-and-sport-committee/fake-news/written/48219.html

For example, it says: “Short selling and market abuse – FN (Fake News) is a short sellers dream.  Before the advent of online FN short sellers had to rely on word of mouth rumour and the occasional share tipster. Today the magnification possible wields instant and widespread damage.”

Note that I see no problem with short selling so long as it is not “naked” and where the seller has a genuinely held view on the financial prospects of a company. But the ability to affect market activity by issuing slanted news commentary from the market operator is surely dubious.

Bloggers and other “financial journalists” who comment on companies are often not regulated by the FCA, can operate behind anonymous front operations or from foreign jurisdictions that are not subject to UK libel laws. In any case UK libel laws are ineffective in tackling the abuses that can be propagated as the aforementioned article explains.

Such writers and their publishers actually have a financial motive sometimes to generate the most debate by making the most outrageous claims because this will generate more hits and links to their web site. That helps to sell advertising on the site, to attract more visitors, which generates more publicity and so the circle continues.

Regrettably the law is only slowly catching up with the problems created by social media. A story put on social media can get around the world several times in a few hours, while any legal action can take months.

These problems created by “fake news”, or simply somewhat inaccurate news, might be helped if there was some way to get the news corrected. But try asking Google to remove a false story or outrageous claim. They are unlikely to do so. They even resisted strongly the EU demand to support the “right to be forgotten” about the past history of individuals (even when palpably false) and even as implemented it is of limited use.

Now the defenders of this new world argue that it is necessary to avoid regulation so as to preserve free speech. But we have surely reached the point where fuller consideration of these issues needs to be undertaken. At present, the risk of abusive attacks is likely to inhibit people getting involved in public life so free speech and democracy will be undermined rather than protected.

These are undoubtedly complex issues, difficult to cover in a short article, let alone suggest some solutions. But what do readers think, without getting into a debate on the merits of short selling?

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

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How Many Stocks?

There was an interesting article in this week’s Investors Chronicle by John Rosier which discussed the number of holdings he had in his portfolio. He had attended a presentation by a well-known private investor who had 25% of his portfolio in one stock. John questioned whether he held too many stocks in his own portfolio (32 according to his portfolio list). He mused that Neil Woodford held 135 stocks in his UK Equity Income Fund but the largest 10 positions made up 42% by value. Mark Slater who runs the MFM Slater Growth Fund also had 42% in his top 10 but Nick Train in his Finsbury Growth & Income Trust has 75% in his top 10.

Now this caused me to examine my own portfolio. I actually have 95 equity holdings, and at this point in time, no bonds or other fixed interest stocks. The figures for my portfolio are:

37% in the top 10.

60% in the top 20.

85% in the top 50.

So it’s moderately concentrated and only slightly less concentrated than those mentioned above apart from Nick Train’s. As John Rosier said in his article, the concentration of the portfolio in the largest holdings is more important than the total number of holdings.

One interesting aspect is that this concentration is not just from design. It has arisen because I tend to buy more of the winners and sell the losers. Indeed, it would have become even more concentrated but I have a rule that I do not like to have any holding go over 5% of the total. That limit is even lower for smaller cap stocks because they are obviously more risky and my innate conservatism leads me to prefer to avoid large shocks to my overall wealth.

If I was younger, and not solely depending on my investments to finance my living standard then I might be able to take a more aggressive stance. Indeed, at my age (71), most financial advisors would say I should have well over 50% in fixed interest but I have taken a different view as to what is safe and what is not. More diversification, particularly across many small cap stocks with many on good dividend yields backed up by cash (ignored in the above calculations), gives me some protection. In addition with some smaller AIM stocks, it can be very difficult to buy or sell large blocks of shares so getting out when you want to can be very difficult if you have a big stake. So investors who hold AIM shares are probably sensible to have more shares in their portfolios than those who concentrate on FTSE shares alone.

Perhaps the issue with my portfolio is that there are 45 stocks I hold that make up only 15% of the overall portfolio value. Why bother with them? Some of these are ones where I am building up a holding from an initial low level, and some are simply small cap speculations where I am still learning about them. A few are VCTs that I bought years ago and find it difficult to dispose of without incurring capital gains tax. Others are holdings not in my ISA and SIPP accounts where disposing of them altogether would crystalise a capital gains tax liability when I am already over the annual allowance. There are a few “duds” where the holding shrank to a very small size as I gradually sold it down as a result of following the share price trend.

The key to managing the 95 holdings is to use some automated software tools to track one’s portfolio and the individual holdings to ensure you don’t miss any share price break-outs (up or down) or any news – I use several such products and services.

Having pondered this question of “how many stocks”, I am not uncomfortable with the current structure of my portfolio but it’s probably worth doing this exercise regularly and clearing out some of the smaller holdings once per year.

Another aspect to consider is of course how diverse the holdings are in terms of them operating in different market segments – to avoid the problem of them all moving together. It is very obvious from studying the reader portfolios regularly published by Investors Chronicle that many private investors have too many holdings – typically multiple funds that are likely to move in step.

I hope this article has prompted readers to look at their own portfolios and the concentration they have in them.

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

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ETFs and Index Trackers – More Dangerous Than You Think

Lots of financial pundits have encouraged investors to be “passive” investors rather than try to pick stocks, or invest in funds that do that latter (“active” funds). Even the FCA has recently criticised active funds for being more expensive and the additional management fees end up impacting negatively on overall returns over time. So persuasive writers such as John Bogle have convinced many to take the “no brainer” route of buying Exchange Traded Funds (ETFs) or other index tracking funds.

But there are surely dangers creeping up on all of us from this approach evidenced by several interesting articles in the Financial Times and Investors Chronicle in the last week.

On the 7th August John Plender in FTfm showed how index tracking funds break prudent portfolio rules. He warned about the concentration of holdings in Nasdaq stocks where the top five holdings (Apple, Google (Alphabet), Microsoft, Amazon and Facebook) represent 41 per cent of the index. He said “Concentration risk that is forbidden to an active manager is considered reasonable if it happens to be an index. This is dangerous nonsense”.

The Editor of Investors Chronicle published an editorial that warned that one of his worries was the huge inflows to passive funds and said “But I am concerned at the presentation of ETFs as an investment panacea because it has created the impression that investing is easy and riskless”. That is surely very true as private investors have simply bought more and more lately in a steadily rising market in recent years, driven by “momentum” trading styles. They don’t look at the valuations of what they are buying (hey – the index must be the best valuation is it not), they just buy and sell regardless based on trends. As the IC editor also said “What happens when the US bull market comes to an end?”. A good question indeed to which there is an obvious answer – a market crash as investors who have never been through a bear market capitulate.

Just today we have a front page article in the FT headlined “surging flows into exchange traded funds drive US stocks bubble anxiety”. It covers the record breaking in-flows into ETFs this year so far. It includes a good quote from Howard Marks of Oaktree Capital: “When the management of assets is on autopilot, as it is with ETFs, then investment trends can go to great excess”.

I certainly agree that investors need to examine very carefully the costs of the funds they invest in, if they do not wish to invest directly in shares. There may even be a place for index trackers in a portfolio – not that I hold any. But the real worry is that ETFs are now distorting the market and protecting yourself against that distortion, or from the likely collapse when everyone realises the emperor has no clothes, is not easy. It has led to a general rise in asset prices, in particular share prices, while simply staying out of the market while this is going on does not make much sense either.

The situation is surely analogous one of the causes of the great Wall Street crash of 1929 where “trusts” dominated the market and were sold to investors on the basis that they only went up. That was not helped by trusts investing in other trusts in a kind of pyramid scheme, and by low cost finance to purchase shares on margin – and we surely cannot get much lower interest rates than we have now. Restrictions on credit was one immediate cause of the 1929 crash, causing margin calls to be invoked and a spiral down.

There is no simple solution to protect oneself against the hysteria of momentum investing and index tracking, but the most vulnerable shares are undoubtedly those that form a large part of any index. Those are the ones where valuations may become unrealistic and where active traders may not feel it wise to try to sail against the wind. So the message is surely to look askance at unreasonably high valuations in relation to earning or cash flows in companies. Simply “buying the index” when everyone else is doing so is not a sound approach.

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

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