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 )

Disclaimer: Read the About page before relying on any information in this post.

The Internet of Things – Telit and Tern

Most investors in AIM will have noted the unfolding news at Telit Communications (TCM) last week. It has culminated today with an announcement from the company that CEO Oozi Cats (a.k.a. Uzi Katz) has resigned after an independent review did indeed find that he was the subject of a US indictment 25 years ago which had not been disclosed to the board. However, they denied that other allegations about the operations and finance of the company were true. Specifically, they said “there is no substance to the speculative and accusatory articles that have been published and that it stands behind the Group’s audited accounts to 31 December 2016 and the most recently published interim statement”. Will the publisher receive yet another threat of legal action as a result? We will see, although companies are reluctant to spend time and money on such cases and it is more difficult for them (as opposed to individuals) following recent changes in libel law.

Is this yet another example of how AIM regulation is defective? The simple answer is no. Both I and ShareSoc have campaigned for improvements in that area, and the LSE have recently published a paper entitled “AIM Rules Review” which has some helpful suggestions.

But the alleged legal problems of the CEO and his wife were 20 years before the company even listed on AIM in 2015 so no amount of due diligence was likely to have discovered that issue. The more recent allegations – which are about possible fraud at the company – are not an issue of AIM regulation. Possibly more an auditing issue if any such problem exists, which the company clearly denies. However, one has to question the willingness of AIM to list companies based in foreign countries some years back. Why did they list on AIM rather than in Israel or the USA for example? Possibly because they thought there would be less scrutiny. There does appear to be more examination of new listings of late and it’s covered in the paper mentioned above also.

Now I have never invested in Telit, although I have looked at it more than once in the past. There were several aspects about this company (other than the country of residence) that put me off. The nature of the product was one – albeit it’s operating in a hot sector but was there good protectable IP? Others were the lumpy nature of hardware orders, the directors and their pay, the issue of director share sales, the failure to turn profits into cash, the repeated fund raisings…..I could go on.

In summary, this is the kind of company I do not want to own.

It’s probably just another example of a persuasive CEO encouraging investors, often unsophisticated private investors, to punt on a concept of rapid growth in a hot technology sector.

Interestingly another company focused on the “Internet of Things” sector is investment company Tern (TERN) who raised some funds via platform Primary Bid over the weekend via a placing and open offer. The latter closed early due to the demand. Indeed, the COO of Primary Bid said: “We are delighted to have facilitated the fundraise for Tern plc. It was good to see such strong demand for this Offer, demonstrating how popular Technology related companies can be with tech savvy PrimaryBid Investors. More than 50% of all investors subscribing for this offer did so via a mobile device”. Note particularly the last sentence.

I had a quick look at Tern, but had great difficulty in valuing the company because it’s largest investment by a long way is a holding in a company named Device Authority Ltd. Is there any information provided on the revenue or profits of that company in the announcements about the fund raising or in recent past company announcements, or are there any recently published accounts filed at Companies House for this UK registered company? Apparently not, so any “due diligence” is difficult. But Tern does not look expensive at face value because of their revaluation of the investment in Device Authority last year by the company in the same way as any other private equity investment is valued.

Is this another case of over-enthusiasm by private investors to get into this high tech world? We shall no doubt see in due course.

There is another thing which Telit and Tern have in common. They have both been harassed by the same “journalist”. Indeed, director Angus Forrest of Tern even went so far as to report him to the police for harassment in 2015 although the matter was not pursued (harassment can be both a criminal law and civil law case).

Investors are recommended to take a cold shower whenever anyone talks about hot technology sectors. A lot of businesses in them never turn a profit, or give a decent return on investment. You just have to look at the early history of Apple – now the largest company in the world by market cap – to see how tortuous and extended can be the path to success. And most of their early competitors simply disappeared.

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

Disclaimer: Read the About page before relying on any information in this post.

Departures – AA and Blur

Yesterday was the start of many people’s holidays. But two company chief executives are going to be taking longer holidays than they expected.

The Executive Chairman of the AA Plc (AA.) Bob Mackenzie has gone. The announcement from the company said he “has been removed by the board….for gross misconduct, with immediate effect”. According to press reports, this arose from a fracas in a bar, although there is also a suggestion that he may be suffering from a mental illness. Some newspapers just suggested it was a “Jeremy Clarkson moment”.

The share price of the AA dropped 14% on the day, which probably reflects the problems that can arise when you have an Executive Chairman dominating a business. It’s not recommended corporate governance practice and personally I tend to avoid companies who have them.

The AA is an interesting organisation which provides breakdown cover and other services for many motorists. Back in 1905, it was formed to warn drivers about speed traps. It later transmogrified into a commercial organisation when the members sold out. Now it is one of the largest operators of driver education programmes such as speed awareness courses. That has become a booming industry and more than a million drivers are now attending speed awareness courses each year. This has resulted in the funding not just of commercial organisations such as the AA but more than £40 million per year goes to the police and local authorities. For the first time in English law, it is now allegedly legal to pay the police to drop prosecutions – all you have to do is promise to attend such a course. There is no evidence that it has any benefit in road safety. More information on this dubious practice is present here: http://www.speed-awareness.org (a campaign run by the ABD against it).

The other departure yesterday was of founder and CEO of Blur Group (BLUR) Philip Letts. This was a company that listed on AIM more than 5 years ago and in 2014 traded at a price as high as 665p. It’s now 3p.

This was a company that was a typical “concept” stock. It was going to revolutionise the commissioning by SMEs of services which is still very much an informal market by introducing an internet market. Mr Letts must be a very persuasive person to keep the business alive this long by repeated fund raisings. But it’s a typical example of how unproven business models are very risky investments. Most companies would have changed the business focus and the CEO long ago, or simply wound up, but Mr Letts persisted.

Yesterday the temporary suspension on AIM was lifted as they finally published some accounts. The results were slightly improved in that losses were reduced, but it still looks an unviable business unless the new management can make substantial changes. Mr Letts was removed from the board effective on the same day.

Incidentally I do hold a few Blur shares – market value now £6 so I hope that has not prejudiced my comments. If you get enthused by the hype surrounding some early stage companies, and the persuasiveness of the management, there is one simple thing to do. That is to only invest a very small amount until the company proves its business model and actually shows that the business is likely to be profitable. Revenue alone is not enough, because anyone can generate revenue by spending lots of your money.

The other protection is when the company fails to achieve its stated business plan, to simply sell and move on. Ignore the tendency to “loss aversion” where you hold the dogs in case of recovery. Or if you fear missing out on a big recovery, simply reduce your holding to a nominal level as I did on Blur and saved myself even more money.

So I invested a very small amount initially and then reduced it later to a miniscule level.

Just one point to note is that the company actually spells its name “blur” rather than “Blur” as I have used above, thus ignoring the rules of English grammar. Such affectations in companies to be “different” are always a bad sign in my experience.

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

Disclaimer: Read the About page before relying on any information in this post.

Utilitywise Profit Warning

A trading update from Utilitywise (UTW) caused the share price to fall another 18%. It’s already down from over 350p in May 2014 to 48p the last time I checked. A pretty disastrous investment for many. This was one of those go-go small cap stocks that lots of share tipsters were promoting back in 2013/14. Revenues and profits were apparently on a strong upward trajectory from their sales of utility services to commercial users.

I even bought a few shares myself. But I sold when I came to realise that their revenue recognition practices were in my view somewhat aggressive. So far as I understood it, they were recognising profits on contracts when the customer signed up for an annual or longer contract. From today’s announcement that even included recognising profits on signature rather than contract commencement. But the real problem to my mind is that instead of most businesses where profits are taken on amounts invoiced, which is shortly before cash is paid on them, in this case the cash was received very much later. So I got cold feet and bailed out. I simply don’t like imprudent accounting and aggressive revenue recognition (Quindell was a similar example).

That is basically what is so damaging in today’s trading statement where they cover a change in accounting policy to IFRS 15 which has tougher rules on revenue recognition from contracts. Who were the auditors of Utilitywise? BDO LLP.

Respected investor Leon Boros has already tweeted that with the adjustments to their accounts required, all the historic profits of the company will disappear. As he says “always follow the cash”.

I did write a report on a Mello event for ShareSoc where Utilitywise was one of the companies presenting back in 2013, but it was not a particularly complimentary one – it mentioned possibly regulatory problems, aggressive sales practices and director share sales for example. The revenue recognition issues only became apparent at a later date.

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

Disclaimer: Read the About page before relying on any information in this post.

Transport Costs in London – A Begging Letter from the Mayor

If the FT can comment on the problems of transport in London, why not me? It happens to have been an interest of mine for some years, and is surely a national disgrace. Here’s some useful information on the subject:

The Mayor of London, Sadiq Khan, has recently published a document entitled “Transport expenditure in London” (from the GLA Economics Current Issues Note 54). It claims to be an analysis of how much money is spent on transport in London in comparison with other parts of the country. But in reality it repeatedly simply argues that London needs more. Unfortunately, the facts presented, which is useful information in many ways, actually tend to show that London is already very well funded as regards rail transport, but that the road system has been neglected of late. Here are some of the key points from the document:

It says “Comparing regions based on how much transport expenditure they receive on its own or on a per head basis does not properly account for the need or demand for transport” (page 2). It suggests that rather than using a “per head” basis, it should be on a “per user” basis and proceeds to say “On this basis, the amount spent on railways per passenger journey and the amount spent on roads per 1 million vehicle miles in London were one of the lowest among the GB regions.”  

Now there are of course many more “commuters” who travel into London by train and other public transport on a daily basis than you get in the other major UK cities, let alone in the more rural areas. In addition many of these journeys in London involved multiple stages, i.e. separate trips, including changes of mode, which they are probably counting as separate journeys because they are otherwise difficult to measure. So they are selecting a measure that favours their argument.

In addition, they say that “In particular, London has seen the largest decline in road expenditure per 1 million vehicle miles since 2007-08”. Well one can quite believe that when London has had minimal expenditure on roads while cities like Birmingham have greatly improved their road networks in recent years.

They do point out that the number of passengers using public transport in London at peak hours far exceeds that of other major cities but their table of numbers of trips by mode shows that almost as many get made by car as by bus/tram and they are more than double those by rail. Mr Khan wants to change that of course, and the Mayor, and his cycling mad predecessor, have been increasing the number of cycle trips but they are still a small fraction of those by other modes (see page 9).

The report gives some figures on public sector expenditure by region, and London receives 29% of all of it, plus another 11% is spent in the South-East. The North-West is the next biggest at 11%. This just shows how much more subsidies, both capital and current expenditure, is spent in London and the South-East than the rest of the country – but the Mayor would like even more! See page 12.

In terms of expenditure per head, London is about twice as high as any other region and amounts to about £981 in 2015-2016 per head. To look at this a different way, the expenditure per passenger journey on the railways in London was approximately £6.94 in 2015-16. Bearing in mind that most rail trips within London probably cost less than £7 you can see how massive these subsidies are (i.e. more than 100%).

The rest of Great Britain gets even bigger rail subsidies per trip at £10.30, but one has to bear in mind that many such trips would be much longer and more expensive.

In terms of road expenditure per region per user, London is relatively high but Scotland is even higher (see page 21). But London’s has been declining and has “one of the lowest spends per vehicle mile in Great Britain”.

Page 25 of the report also gives a useful breakdown of “Sources of Funding for Transport for London”. Some 47% comes from fares, 25% from central Government grants (i.e. out of taxes), 17% from borrowing, and 11% from “other income” (that would include the Congestion and LEZ charges). So Londoners get a subsidy equivalent to 53% for public transport. But this report argues Londoners pay proportionally more for its own infrastructure investments in comparison to other regions.

The recently published Mayor’s Transport Strategy argued that public transport users subsidise car drivers. On the data contained in this report, that is clearly nonsense. Public transport users are massively subsidised and the Mayor is asking for even more. See here for more information on that and how you can object: http://www.freedomfordrivers.org/against-mts.htm

The full report on Transport Expenditure in London is present here:

https://www.london.gov.uk/sites/default/files/transportexpenditure_final_cin54.pdf

Roger Lawson

Property Companies and TR Property AGM

Yesterday I attended the Annual General Meeting of TR Property Investment Trust (TRY). I have held shares in this company for a long time, and it’s always useful to attend their AGM as you get a useful update on trends in the property market from the fund manager (Marcus Phayre-Mudge of late). As he mentioned, the fact that they hold property directly, as well as holding shares in property companies gives them a unique insight into the state of the market.

Apart from holding TR Property, I also hold some direct property company shares which are British Land, NewRiver, Segro and Tritax Big Box. Not claiming to be a property expert, have I made the right choices there? Answers will be obvious later.

Segro announced their interim results yesterday also. Segro, like Tritax, are focused on large warehouses. They reported adjusted eps up 6.5%, and NAV up 2.6% with the dividend increased by 4%. The share price rose 2.8% on the day and has been in a strong positive trend in the last few months. Marcus was particularly positive about the Segro results and said there was tremendous rental growth in that sector with a 94% retention rate which is remarkably high. So no problems there.

As Marcus made clear, the property market is at present only doing well in certain sectors and certain geographies. TR Property is very well diversified though as it covers the whole of Europe (one might consider it as another of those Brexit hedging stocks with only 36% of holdings in the UK and they have been reducing that). The commercial property market is somewhat cyclical and was expected to decline in the UK, particularly after the Brexit vote. London offices were perceived as being vulnerable. There is also the impact of the internet on large retail stores. They are reducing exposure to retail but not to convenience stores. Shopping habits in the UK are clearly changing substantially, but less quickly in the rest of Europe. Marcus said they have been trying to focus on buying more physical property but the market has been surprisingly strong.

Switzerland, Benelux and Sweden were the worse geographic areas, and one shareholder commented very negatively on the political and social problems of late in Sweden. Rental growth in Paris and Stockholm is taking place and we might even get some in Spain as properties are filling up.

He made it plain that two sectors are performing well in the UK – “big box” warehouses, and convenience stores. So my holdings of Segro, Tritax and NewRiver are in the right place. But TR Property also hold those two big companies of British Land (pedestrian performance of late with asset value declines) and Land Securities (now renamed Landsec – Marcus said he hoped it did not cost them much to change). He has a bigger holding in the latter, but apparently he may not be totally happy as he mentioned he held a meeting with them recently, and it was not just to have a cup of tea.

He was positive about the share buy-back announced by British Land but suggested it was not big enough to make much difference. British Land is currently on a big discount to NAV so it probably makes sense when I am generally opposed to market share buy-backs. The discount discourages me from selling the shares at present.

TR Property managed to achieve a Total NAV Return of 8.0% last year which was very similar to the previous year and ahead of their benchmark. The depreciation of sterling helped the valuation of their European holdings. The share price discount is currently 7.8% which is slightly below their average. The dividend grew by 26% last year due to strong revenue growth, and currently yields 3.0%.

Marcus was positive about the future because capital markets are still good for property with very cheap debt. There has been record bond issuance by property companies – fixed for longer and lower, which they are encouraging.

He is slightly worried about Brexit and our politicians – “not sure they could negotiate themselves out of a paper bag”.

There were about 70 shareholders present at the AGM at a new venue (Marriott Grosvenor on Park Lane) with defective air conditioning. Shareholder votes were overwhelming in support of all resolutions, except that Chairman Hugh Seaborn got 5.9% against on the proxy votes. Not clear why and did not get the opportunity to ask him about that.

In summary, a useful AGM for those interested in the property sector (which I hold to offset my go-go growth stocks as property tends to be relatively defensive in nature, with share prices more driven by asset values and rental yields).

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

Disclaimer: Read the About page before relying on any information in this post.

Why Institutions Cannot Control Pay

An interesting article in the Financial Times FTfm supplement on Monday helped to explain why pay is so out of control in public companies. In an interview with Rakhi Kumar of State Street Global Advisors, she made it plain what the problem is.

State Street may not be a household name in the UK, but they are one of the world’s largest fund managers. Fourth in size behind only Blackrock, Vanguard and UBS according to Wikipedia. Last year State Street had more than 4,000 pay proposals to review globally. They used a filter to identify 1,000 proposals that were the most controversial (implying that they did not even look at the other 3,000 and automatically voted “for” the others rather than abstained). They only voted against 300 of them.

It’s actually even worse than the above comments indicate because only this year have they started to include “quantum” of pay in the screen. In other words, the amount of money paid to chief executives was not even considered in the screen. So outrageous levels of pay would not even have been looked at. One can see exactly why companies like State Street, Vanguard and Blackrock who dominate all major stock markets have been criticised for their role in letting pay get out of hand.

Now this writer has a large portfolio consisting of over 70 stocks. I receive all their Annual Reports and vote all my shares at the AGMs where practical to do so (regrettably not always easy in nominee holdings). I have the same problem as State Street in that I do not have time to read the detail of all the Remuneration Reports which now can stretch to more than 30 pages. So here are a few tips on how to handle the task to help folks like State Street:

State Street may not be a household name in the UK, but they are one of the world’s largest fund managers. Fourth in size behind only Blackrock, Vanguard and UBS according to Wikipedia. Last year State Street had more than 4,000 pay proposals to review globally. They used a filter to identify 1,000 proposals that were the most controversial (implying that they did not even look at the other 3,000 and automatically voted “for” the others rather than abstained). They only voted against 300 of them.

  • I speed read the comments of the Remuneration Committee Chairman to see if there is anything of note.
  • I review the quantum of pay for the two highest paid directors (which for UK companies is easy now there is a “single figure audited remuneration” table). Is it reasonable in relation to the size and profitability of the company? If not, I vote against the Remuneration Report (and Policy if that is on the agenda). Any figure over £1 million, regardless of the size of the company I am likely to consider unreasonable. Similarly, any company where pay has gone up while profits and/or dividends have gone down is viewed negatively. The pay of non-executives I would also glance at.
  • I look at the LTIPs (which I generally don’t like at all) and bonus schemes. Any of those that enable more than 100% of basic pay to be achieved I vote against.

So that’s it. A quick and effective approach to making decisions on pay which can take about 5 minutes. It may not be perfect, but it is better than abdicating one’s duty altogether.

ShareSoc has published some Guidelines on how to set pay which gives more details and may be more helpful for smaller companies if you want to consider things in more detail.

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

Disclaimer: Read the About page before relying on any information in this post.