2016 was a good year for our investors, in fact it was a very good year. Returns from our multi-asset, risk controlled funds were as follows:-
Fund / Return
|COURTIERS Total Return Cautious Risk Fund: 10.08%|
|COURTIERS Total Return Balanced Risk Fund: 14.45%|
|COURTIERS Total Return Growth Fund: 19.16%|
Our UCITS (Equity and Bond) funds also did very well:-
Fund / Return
|COURTIERS Investment Grade Bond Fund (IShares): 8.64%|
|COURTIERS UK Equity Income Fund (IShares): 14.13%|
|COURTIERS Global (ex-UK) Equity Income Fund (IShares): 35.28%|
With UK CPI inflation at just 1.2% in 2016 (source: ONS, year to November 2016), we delivered strong “real returns”1 for all our mandates maintaining, and increasing, the purchasing power of our clients’ capital. Can we do it again in 2017?
Forecasts For 2017
Five years ago we built a new model for analysing the fundamentals of major equity indices and predicting 10 year returns based on Adverse, Mediocre and Positive scenarios. The Adverse scenario seeks to roughly replicate the effects of the global financial crisis of 2008, with corporate earnings (profits) falling by -50%. The Mediocre scenario assumes a modest decline in earnings (-10%) and the Positive scenario assumes no immediate changes in earnings or dividends, but with book values rising by 10%, and earnings and dividends growing by 10% pa in the subsequent nine years.
Charts 1 and 2 show the forecasts for future returns from the FTSE 100 index and the S&P 500 index, under each of the three scenarios, in December 2011 and December 2016.
In December 2011 the Adverse scenario (an immediate repeat of the 2008 global financial crisis) still offered an average 10 year return that was significantly higher than the 10 year return from UK gilts. This is not the case at December 2016 where, despite the 10 year gilt yield dropping from 1.98% pa to 1.39% pa, returns under the Adverse scenario from the FTSE 100 and S&P 500 are both negative at -1.62% pa and -0.24% pa respectively. Forecast returns from the Mediocre and Positive scenarios have also declined significantly, although both offer better prospects than gilts. The reason for the change in forecasts over the last 5 years is the strong recovery in equity prices. It is unlikely shares will repeat this extraordinarily strong performance over the next 5 years.
Another basis of estimating future equity returns is to use the classic Gordon’s Growth Model2. Chart 3 shows the forecast future equity returns, using the MSCI World index, in December of each of the last five years.
Estimated future global market returns have dropped from 12.22% pa in December 2011 to 9.06% pa currently. The difference may appear marginal, and 9.06% pa still looks like a very good long-term return, especially compared with current interest rates. But the difference in total expected returns is enormous. £100,000 growing at 12.22% pa (the December 2011 forecast) becomes £1,003,241 after 20 years. At the current 9.06% pa, the figure is much lower at £566,643.
Fundamentals from global equities are also less attractive than they were five years ago. The widely used PER (Price Earnings Ratio) was just 11.59 in December 2011. Today it is 18.06. The P/B (Price to Book) ratio was 1.64 in 2011, today it is 2.16. Dividends are lower too: 3% pa in December 2011 compared to 2.5% pa today. In short, the equity market is less attractive than it was in December 2011. Does that make equities expensive?
Although equities may be costlier than they were at the end of 2011, they are still relatively cheaper than they were in December 1999 at the peak of the tech bubble. One could say that equities are both cheaper and more expensive depending on your starting point.
Perhaps a better way of asking the question “are equities expensive?” is to consider the alternatives. After all, if someone sells their equities the money has to go somewhere.
The asset class that looks most expensive is bonds. The fixed return on 10 year gilts (UK Government Bonds) is just 1.388% pa. It is not much better over 30 years where the yield is 2.029% pa. There is very little compensation, for the long-term bond investor, for the risk they are taking that inflation will erode, perhaps dramatically, the purchasing power of their capital.
Index-linked gilts aren’t much better. Ten year issues provide a yield of –1.868% pa, and the 30 year issue –1.510% pa. In other words, the government gives you a cast iron guarantee that your money, at maturity, will buy less than it does today.
How About Property?
Rental yields on UK residential property are currently around 5% pa. Remember, with residential property the responsibility for maintenance of the building rests with the landlord (the vast majority of leases are not full repairing in the residential sector). This means that you have to allow for repairs to be paid from income. Rents also have to be collected, agent’s fees paid and void (unoccupied) periods allowed for. In most cases, this makes the investment uneconomic in the absence of capital growth which, of course, every home-owner is hoping for. But growth is not guaranteed, and if the economy stalls and families become concerned about the possible outcome of a “hard Brexit”, then residential property prices may stagnate, or even decline.
Commercial property generally provides for the occupier to be responsible for the cost of repair and dilapidations and the yields are often much higher than those available in the residential sector. However, for most people commercial property is too costly. Even if you have £5 million kicking around, and you do find a decent property for this price, you will have little diversification, so you will be relying on a favourable outcome from the type of property you have chosen, the area in which it is situated and the ongoing quality of the tenant. Personal direct investment in commercial property is the prerogative of the mega-rich.
So back to the original question, “are equities expensive?”. They are more expensive than they were five years ago, less expensive than they were 17 years ago, and generally still better value than bonds, property and cash.
For the longer-term investor, equities offer higher prospective returns, better protection against inflation and more liquidity than other asset types. In return for these improved longer-term prospects, equity investors have to accept short-term fluctuation in prices (volatility) and the risk that some companies could go bust entirely (which is why broad diversification is essential).
I don’t think the prospects for equities over the next five years are as good as they were in 2011, but share values are not expensive, and for the long-term investor equities offer better opportunities than most other asset classes.
So you’re right. 2016 was a very, very good year for investors. All our mandates made good money. The new mandates that we launched, Global (ex UK) Equity Income and UK Equity Income performed exceptionally well. It doesn’t get much better than this, as I’ve been reminding everybody in the Investment Team – enjoy the moment because it’s not always like this. With inflation at just 1.2% in the UK last year, what we did for our investors was increase the purchasing power of their capital which of course in the end is the target.
Developing Income - Fundamental Principals
So yes, some fund managers had bad years. I think if you look at the Equity Income sector, particularly the UK Equity Income sector, some managers in that sector had a mare – they barely delivered positive returns for their clients, whereas our UK Equity Income mandate did over 10% in 2016 which was fantastic. I think the important thing from our point of view is that we use a very, very strong quantitative process. We try and stop our analysts and our managers getting carried away with the emotions and we keep them focused on the fundamentals and last year, if you stuck to your fundamentals and you stuck to the main point of your mandate, which is getting income in your UK Equity Income portfolios, you did alright and the sector average* did just over 10%. So actually I think those managers that struggled last year, some of which are big household names – I think they lost the plot. I think they need to get back to doing what they should be doing which is trying to develop income and rising income for the long term.
*FTSE UK Equity Income Index
The Cost of Equities
Are equities expensive? That depends on your perspective. They’re a lot cheaper than they were in the heat of the tech bubble crisis of December 1999. They’re more expensive than they were in December 2011 because we’ve had five very good years’ returns and I think that if you look over the last five years there has been a sea change.
We do an estimated long term future return, we update it every month and it’s based on what’s called the Dividend Discount Model which is a classic method of calculating future returns, and we do it across all developed equities, across the whole world by using the constituent parts of the MSCI World Index. Now the estimated return from the MSCI World Index in December 2011 on that basis was 12.22%. The estimated return in December 2016 was 9.06%. Now, the difference is small but over a long period it has a big impact and I’ll put it in context for you:
If somebody invested £100,000 in December 2011 at the forecast return of 12.22%, their £100,000 would over 20 years turn into just over £1 million. If you invest that money in December 2016, then the forecast return over 20 years is just over £560,000. Small difference in the estimated return, but a big difference in the projected future value.
So, if you’re investing today in the equity market, your forecast returns are nowhere near as good as they were five years ago, but as you’ve still got an estimated return of just over 9% and inflation is running at 1.2%, and bond yields in the UK over ten years are currently around 1.35%, then it looks reasonably good value compared to other asset classes. So, in answer to that question about whether equities are expensive or not, what you say is they’re more expensive than they were in December 2011 – they’re a lot cheaper than they were in December 1999 and they’re generally better value than other asset classes. And you’ve got a better prospect of maintaining the purchasing power of your money with equities than you have with bonds or cash.
However, in return for that potential out-performance what the equity investor has to accept is that on a day-to-day basis, a week-to-week basis, a month-to-month basis, the value of their capital wobbles and we think you’re going to get more wobbles for your return in 2017 than you did in 2016.
Property as an Asset Class
Yes, I think you can compare property to equities in some ways. I think both of those asset classes have shown themselves to be very good at protecting the purchasing power of clients’ money. However, there are big differences, particularly with regards liquidity. If you’re invested in big companies in developed markets; Europe, UK, US, Japan etc. then generally you can trade those shares quite easily and with pretty small spreads, so liquidity’s generally very good. If you put a lot of your money into bricks and mortar it’s not as easy to trade but then again in fairness, people only tend to put their money into bricks and mortar if they’re looking at the very, very long term. Bricks and mortar delivers a good rent. If you’re owning houses then it varies depending on where the house is and the quality of the tenants you’re getting but it can be anything from sort of 3 – 3.5% up to 5 – 5.5%. What investors have to remember however, is that on virtually all tenancies for residential property, the onus of repairs sits with the owner – the tenant doesn’t have to make those repairs, so out of the rental income the buy to let investor has to fund the upkeep on the property, making good – developing it, decorating it etc. That’s not true in the commercial sector, because generally the leases are a fully repairing basis, and you can get some very good yields in that sector - 5,6,7,8%. However, unless you’ve got £4-5 million kicking around, you’re probably not going to get direct access to bricks and mortar investment. And if you’ve only got £5 million around, you like commercial property and you buy one, that’s a huge concentration into just a single asset. So I think that whilst you can get some good deals in property, it is also susceptible to changes in the economy and the UK has got to get over some hurdles coming up, particularly the negotiations around Brexit, and it’s nowhere near as liquid as equities. Give me a choice, as a long term investor I’d choose equities most of the time, and the reason is commercial properties have to be occupied – I would rather invest in the tenants that are occupying them than the properties that they occupy, because in a way if the tenants don’t do well, the bricks and mortar won’t do well anyway, and I do like liquidity.
Our approach for 2017 is going to be quite different to the approach we took in 2016. We still felt the market had legs in 2016. We were becoming increasingly cautious about bonds. As it were, bonds peaked in the autumn and have started to decline subsequently. We’re staying pretty clear of the long bond market. That’s a little risk because if interest rates suddenly take a big turn downwards and bond prices shoot up we’re not going to collect much of that but we will avoid any carnage in the bond market, and with unemployment low in places like Germany and the UK and the US, there is now more scope for inflation, because you haven’t got a lot of unemployed people to throw at an increasing demand for goods. So if demand goes up, it’s very difficult for Germany, the UK and the US to respond to it, and to up productive capacity through investment takes a while. So that could be an issue for the bond market.
The equity market we think will be wobbly – much more wobbly than it was in 2016. We think it’s good value over the long term. We think long term investors staying out of equities have got to put their money somewhere else and where do you put it? Cash yields less than 1%. Ten year bonds yield something between 1.3% – 1.5%. It’s not very attractive when inflation is on the up, so equities still offer that better long term protection. What we will do this year is look to secure better protection on the portfolios in the form of put options when we can buy them, when they’re not hellishly expensive which tends to be when expected volatility is lower, and I see us doing a lot more of that this year.
Now let’s be clear, if there’s a major collapse in equity prices, we won’t avoid all the carnage, but as we’ve done previously, we will try and limit it within the clients’ risk appetite, and we’ll be a little more cautious this year about retreats in the equity market, and try to avoid the worst of them, if they occur, without missing the up side if that occurs. So, it’s a bit of a balancing act for this year – not going to be an easy year, but then again that’s why clients pay us to take these decisions on their behalf.
Warning – the views expressed in this summary and any video and video transcripts are reached from our own research. COURTIERS cannot accept responsibility for any decisions taken as a result of reading this document, watching the featured video or reading the video transcript and investors are recommended to take independent professional advice before effecting transactions. The price of stocks, shares and funds, and the income from them, may fall as well as rise. Past performance is not necessarily a guide to future returns.
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