Tony's Yarrow Investment Blog - December 2009

Written by Tony, 23 December 2009

Cautiously Optimistic Wise

Around this time last year, Warren Buffett repeated his famous remark that he tends to feel scared when others are greedy, and greedy when others are feeling scared. He was buying shares at the time, and, as so often in the past, he has turned out to be right, as stock markets around the world are a good deal higher now than they were then.  Buffett isn’t just being awkward and difficult when he invests against the crowd – he sees that there are always opportunities when no one else is looking, and conversely, when everyone is hunting for bargains, there tend to be none.  If anything, investors appear to have got more rather than less scared as the rally has developed this year.  Recently, people have said things to me like ‘The UK economy is broken. There’s simply no point investing here for the next decade’ ‘It’s a shame that the UK doesn’t make anything anymore’ ‘The stock market is very overvalued now after this year’s huge and unjustified rally’ ‘When the housing market falls back, it will take the stock market with it’ ‘China’s economy will falter, and then the whole world economy will be in the mire’ ‘Once the QE programme comes to an end, sterling will collapse’.  I take all these comments seriously, and can see the truth in all of them, but none of the above considerations stop me from believing that our clients have good prospects in store for 2010. By the end of this blog, and after the odd detour en route, I hope you’ll agree.


Ten years ago, the cult of the equity was about to meet its come-uppance.  Central banks, worried about the possible effects of Y2K (the chaos which was expected to result from computers not being programmed to cope with a date beginning with a “2” had pumped money into the financial system, and the technology bubble was moving towards its climax. Shares were expensive, and government stocks (gilts) were pretty cheap.  With brilliant timing, the managers of the Boots pension scheme sold all its shares in October 1999, and bought gilts instead.

As we now know, this has been a decade to invest in gilts, and one to avoid shares. Let’s have a closer look at a typical share, and a typical gilt. Vodafone’s shares enjoyed extraordinary performance in the 90’s, but on New Year’s Eve 1999 that was all about to end, and the total return for Vodafone holders over the past decade, with all dividends reinvested, was minus 41.2%. If you’d held it through a fund, with charges to be deducted, the return gets that much worse. On the other hand, our old friend Treasury 5% 2012, which was launched early in the decade, on May 30th, 2001, has given a total return of 48.3% since then, with remarkably low volatility.

What’s the position now?  Well, Vodafone seems to us to have gone from ludicrously expensive then to attractively cheap today. Early in 2000, Vodafone traded on a price-earnings multiple of 75 times, paid almost no dividend, and was about to make the foolish purchase of Mannesman, and overbid for its 3G licence.  Today, Vodafone is a better company than it was then, mature, internationally diversified, and cash-generative.  The price-earnings multiple is 7.6 times, a big discount to the market, and the dividend yield is 5.5%.  The share price has fallen 54% from £3.07 at the end of the last decade, to £1.42 now.

When it was launched, Treasury 5% ’12 paid 5.0%. This was attractive at a time when inflation stood at 1.8%. The base rate was 5.25% at the time, but interest rates were expected to fall, and a fixed rate was attractive, with the prospect of getting your capital back in due course.  Today, the price of the stock is £ 1.0735, which means that with just two-and-a-bit years left to maturity, if you buy today you’re guaranteed to lose money if you hold the stock to maturity in March 2012, when you’ll get £1.00 back. The ‘redemption yield’ is the return you would receive if you held the stock from now to maturity, i.e. the income you’d receive less the capital loss. This figure comes out at 1.46%pa.  In other words, the return you could expect today is 70% lower than what was on offer when the issue was launched, despite the UK government being in a much bigger mess now than then, and only a quarter of what Vodafone is offering you in dividends.

You wouldn’t have to be a genius to predict that over the next decade shares will do better than gilts.  Another way to look at this is to say, whose finances are in good shape and whose aren’t?  Some companies had strong balance sheets before the recession.  Others (the life assurers Legal & General & Aviva spring to mind) have worked hard to repair theirs, while by contrast the UK government’s balance sheet has never been weaker.  Ten years ago it was the other way round – many companies were dangerously overstretched following a take-over boom, while the government’s finances were sound (it seems a distant memory now, but they actually were prudent in their first term of office from 1997-2001). Do weak government finances prevent strong companies from performing well? We’re going to find out, but we don’t think they necessarily do.  Ben Rogoff, who manages the investment trust Polar Capital Technology, a 4% holding in TB Wise Investment, believes that the tech. sector will be strong over the next few years.  He points to the fact that growth opportunities will be hard to find in the next few years, so companies will be looking to grow their profits by becoming more efficient, which will involve technology investment. Importantly, many US companies are cash-rich, so they can afford to do so, and their cash isn’t earning anything.  We agree with Ben Rogoff.  Also, you don’t hear much about tech these days.  Many investors got burned in 2000-3, got out, and haven’t returned. Tech isn’t yet a fashionable over-valued sector.


The fact that the QE is about to end is not necessarily disastrous – you only need to bump-start a car once.  Fiscal and monetary policy continue to be hugely stimulatory. Interest rates are being held at 0.5%.  Government borrowing is at very high levels – £20 billion last month.  Pretty scary, on one level, but very accommodating.  Policies designed to end recessions aren’t seen to be working till long after they have, because the numbers lag far behind the event. In the last downturn, Alan Greenspan, the Chairman of the Federal Reserve (the ‘Fed’) kept US interest rates at 1.0% until he could be sure that the economy was on the road to recovery.  By the time he dared to start raising rates, he had already stimulated a major bubble.  People expect ‘an anaemic recovery’ next year.  Historically, recoveries tend to be in proportion to the recessions that preceded them.  2009 has been the worst year for the UK economy since 1921, with a 5.1% contraction (ONS figure).  2010’s recovery may not turn out to be quite as anaemic as we’ve been told to expect.


One notable feature of this year’s rally has been the lack of a significant correction. Charts are useful because they show us what other investors are doing.  The charts have been very consistent since March. As soon as we have seen a period of weakness, the buying begins again and takes the market to new highs.  Today, as I write, UK stock market stands at 5381, just one point below its post-crash closing high made on November 16th. The market is without question in an uptrend, and it will stay in its uptrend until there is a major change of direction, of which there have been just four in the last two decades.

The yield ratio of the stock market against gilts and cash remains supportive.  The ratio of directors buying shares in their own companies in proportion to those selling – long thought to be a reliable leading indicator – remains strongly positive.  To give you a flavour of this, each week we monitor the number of directors buying shares in their companies as a proportion of the total transactions including sales. Only transactions worth more than £100,000 count.  A number over 50% indicates more purchases than sales. The last ten weeks, with the earliest first, have gone 58%, 54%, 54%, 60%, 79%, 58%, 75%, 72%, 40%, 65% (average 61.5%).  The ratio isn’t as high as in the summer, but gives no cause for concern.

We expect company profits announced mainly in March for the 2009 year-end to be good, which may surprise some experts, and should support the market.  This is because the downturn has not been as bad as expected, so sales have held up while costs have been cut. Also, results will look good in comparison to 2008, which was a bad year.

We expect most of the action to come in the first third of 2010, and wouldn’t be surprised if the UK stock market has a 6 in front of it at the end of that time.  Should that happen, the market will almost certainly feel a lot less cheap than it does at the moment, and profits will have to be taken.

We treat our forecasts with the same scepticism with which we treat other people’s.


It looks unlikely that any detailed proposals for the curbing of public spending will emerge until after the forthcoming General Election, but already the debate is hotting up. In the Pre-Budget Report, the Chancellor announced a proposal to prioritise schools, presumably over universities.  On Radio 4 this morning there was a debate on this very subject.  The Union representative pointed out that the universities cost £8 billion, while raising £60 billion through research.  The government representative argued that cuts would have to be made. What wasn’t mentioned was the high cost of government monitoring and general interference in the universities and other professions, which is where the biggest savings could be made.  It is felt to be a good thing for university teachers to produce research. However, once they are targeted on the production of research articles, there is a pressure to produce a larger number of shorter, lower-quality articles, than one really good, long one. Another way to measure the validity of academic research is by citation (the number of times a research article is quoted in other articles).  The natural outcome of this target is that academics tend to quote their own previously-published work, and that of their friends, as often as possible.  And, as my colleague Ben has pointed out, there is pressure to publish the results of experiments that worked, rather than ones that didn’t.  The point is that quality can’t be measured, and as soon as you introduce targets, you distort the thing you’re trying to measure.  The easiest way to get our budget back into balance is to realise that most of this activity is futile – for example, the banks failed under the noses of the FSA, the UK’s financial super-regulator.  The biggest challenge this country faces is to escape from the red tape we’ve increasingly tied ourselves up in, and to wean ourselves off the distorting culture of targets.  This will only happen when governments and regulators begin to understand that the more time professionals spend on compliance, the less time remains to do the job, as a result of which it gets done in a more compliant way, but less well overall.


As at December 23rd, TB Wise Investment is up 29.1% for the year to date, compared to a 25.5% gain for the UK stock market, and 21.8% for the Active Managed sector.  Performance has been strong throughout the year apart from a period in late October and early November, from which the fund is now recovering. Several sectors in which the fund invests – UK smaller companies, private equity and Japan, for example – all went out of favour at once.  More surprisingly, the international investment trusts we hold went out of favour too.  The asset values didn’t go down much, but the prices did, making the discounts bigger than I have seen for a decade. We have been able to increase these holdings at attractive levels.  Valuation anomalies don’t usually last long, and most of the underperforming trusts have picked up sharply in December. The Ecofin utilities trust has risen 16.5% this month, while more recently Caledonia Trust is up 5.6% since yesterday morning.  If the market turns its attention to quality and value, the fund will do very well next year.


Last year TB Wise Investment fell by more than a falling market, and this year it has risen by more than a rising market. It is easy to conclude from these two years that the fund is very gung-ho and punchy, whereas as fund manager I try to be careful and patient, and avoid overvalued assets where over-optimistic forecasts are priced in. Looking back over the seventeen years since I have been managing this fund, which was originally called the Wise Investment Clients’ Fund, there have been several distinct periods.

From early 1993 to October 1998.In a rising market, the Clients’ Fund was the top-performing managed fund in the UK.

From October 1998 to January 2000, in a mainly rising market, it was in the bottom 10%.

From January 2000 to the end of June 2007 during which time the market first lost around half its value, and then recovered almost to the point it had started from, the fund was 4th out of 409 funds in its sector.

From July 2007 to December 8th 2008 in a falling market the fund was one of the worst performers.

From December 8th 2009 to datein a mainly rising market the fund is once again in the top 10%.

There is a very marked pattern here, but it isn’t as simple as that we beat a rising market, and collapse in a falling one. There is a distinct tendency to come either near the top or the bottom, though fortunately the top-performing periods have tended to be much longer than the others.  I believe that this results from our value-investment approach, which involves holding cheap assets.  By definition, these are ones that most other investors don’t have.  Our worst performing periods, both lasting around 18 months, were at times when there was a very strong theme in the market, which we were avoiding.  In the first period it was technology and the internet, and in the second, it was mining and emerging markets. We avoid fashionable assets because, however good the story, once all the potential is in the price, you are far more likely to lose money in that asset than make it.  But sometimes the price can run up a very long way, before it turns down, and the Wise funds will struggle during those times. However, our best period yet for outperformance of other funds, 2000-3, came directly after our worst one, 1998-9.

We are at a similar point today as in early 2000, where there are excellent assets that investors just don’t seem to want.  For example, British Empire Securities, one of TB Wise Investment’s biggest holdings.  Since May 1st, the fund has risen just 3.3%, while the market (UK stock market) is up 28.8%.  Over the whole decade, the fund has returned 173% (10.6% per annum) while the UK stock market has managed just 7% altogether. There has been no change of investment mandate, of style or of manager. All that’s changed is that British Empire doesn’t happen to hold the type of shares that are fashionable just now.


Wise Income has made an overall return of 27.7% in the year to date, slightly behind Wise Investment, though Income’s performance has been the stronger of the two recently. In a low-interest rate environment, and where so many sources of income have disappeared, our focus for the year ahead will be to maintain and if possible improve the overall level of the dividend payment, using market volatility to add to any assets delivering reliable income streams when their prices are weak. As money will tend to flow from lower-yielding to higher-yielding assets, maintaining a high level of yield should lead to an acceptable capital return. The structure of the fund hasn’t changed much in the past few weeks, with around 12% in fixed interest, 10% in direct property investment trusts, and the rest in shares, of which the bulk is in the UK.


Hugh, Ben and I have been reading and thinking about China over the last few weeks in particular. My next blog will include a summary of our views on the opportunities and challenges that the region presents.

In the meanwhile, best seasonal wishes from me and all of us at Wise.


This blog represents Tony Yarrow’s views as at 23th December, and does not constitute financial advice.

Tony manages TB Wise Investment and TB Wise Income.