The question I posed at the end of that article was: “If not property, then where?” It might be beneficial to disinvest from property but the investor must then select one or more alternative asset classes or sectors to redirect this money.
Money-market rates are hovering around 5 per cent. This appears reasonable against a rate of inflation some 2 per cent lower, depending on which index one cares to use, giving a real rate of return with no risk to capital or income. Deposit-based investments could therefore be an attractive home for the disinvested property fund monies in the short term.
As regards fixed-interest investments, a good starting point is the gilt market. Redemption yields on mid to long-term gilts are around 4.5 per cent a year at the time of writing. This is lower than cash but potentially reasonable comparative value if interest rates fall towards or below that level, leading to increased capital values from gilts. This provides a reasonable real rate of return and a good level of capital security and guaranteed rates of return.
So, cash or gilts could be the answer to the closing question from my last article but they could be seen as a bit dull and boring for some investors, even if they do not represent the majority of a portfolio’s value. An oft-used quote springs immediately to mind: “Take any port in a storm.” In my adaptation, this infers that cash and gilts (ports) are a decent place for an investor’s money (ships) during the storm (falling property markets). A bit contrived, you might think, but I believe it is apt.
But another sea-faring quote springs to mind: “A ship is safe in harbour but that is not what ships are for.” I would consider this to infer that the investor’s money would indeed be safe in cash or gilts (the harbour) but money (the ship) is there to make money, even though chances may have to be taken (“that is what ships are for”).
In deciding where disinvested property fund money should be directed, we must consider for each client whether to head for a safe port or sail the seas.
In this article, I will start to examine and discuss one of the main ways in which the client might sail the seas by investing in equities. I will, by the way, conclude this periodic review of the use of different asset classes within a portfolio in my next article by considering corporate bond funds investing in issues of different investment and sub-investment grades.
First, equities. The FTSE 100 has been bouncing about between 6,000 and 6,600 over the last year or so. This is quite a narrow trading range considering the number of days this year in which the index has either risen or fallen by a significant amount, often around 200 points, representing about 3 per cent of the index.
Strong buying has appeared every time this index seemed to be heading for the lower end of this range, reversing the falls. Conversely, sellers have been appearing every time the index has threatened to break through and stay above 6,600, thus reversing the short-term bull runs. Indeed, the day before writing this article the market fell by 200 points.
These fluctuations have been occurring during a period of continuing earnings and dividend growth from most companies, with profit warnings from only a relatively small number of companies, usually from the same sector. Looking at the fundamentals, there seems no obvious reason why the market should have fluctuated to this extent. Sure, reasons are given for every sharp movement ranging from interest rates rising or falling, inflation rising or falling and consumer spending and/or borrowing threatening to overheat the economy or reduced spending threatening a recession. Investment commentators often seem to be able to use the same reason to explain a FTSE rise as a FTSE fall.
For my money, I simply look at the fundamentals. A particular favourite equity fund of myself and my firm stresses that its investment strategy is to look for profitable companies with solid earnings and dividend growth. This fund tends not to wheel and deal in shares on a frequent basis. When it identifies an appropriate investment, it tends to hold it for its medium to long term attractions. And why not?
Ignoring that particular fund, which has been one of the top performers in its sector for a while, even a quick look at mathematical fundamentals tells a story.
The price-earnings ratio on the FTSE 100 at a level of around 6,400 is 11.7. For those not familiar with this ratio, this means that if a company distributed all its profits as dividends, an investor buying into the share today would get back all his investment in dividends in 11.7 years, even if earnings did not increase or, conversely, assuming earnings did not fall, within that period. Of course, at the end of that 11.7 years he would still have his shares.
Taking the inverse of this p/e ratio tells a more immediate message. If the company in its last year had paid out all its earnings as dividends, the investor would have benefited from an income of 8.55 per cent.
This takes no account of future potential earnings growth and so, I suggest, gives solid fundamental support to FTSE 100 shares, that is, the biggest 100 shares quoted on the UK stockmarket as measured by capitalisation. The same yield figure can also be arrived at by multiplying the actual dividend yield paid out by the dividend cover factor.
Again using the FTSE 100 at 6,400, the actual yield is stated as 3.17 per cent, being the dividends paid out, regardless of levels of earnings. The dividend cover factor is stated as 2.7, indicating that the dividend could have been 2.7 times higher than that actually paid. By multiplying this yield by the cover factor, we get 3.17 per cent x 2.7 = 8.6 per cent. This is the same percentage (allowing for rounding) as using the p/e calculation. This is not coincidence, it is pure maths.
What we have, then, is an investment which could pay out 8.6 per cent without dipping into capital so long as earnings remain stable. If a fund simply matches the FTSE 100, it should mathematically be able to continue to provide these returns. But what if a fund can identify companies with consistent profits and earnings growth and no obvious immediate threats?
I will continue this discussion in my next article, using the starting point that I firmly believe the mathematical fundamentals indicate excellent value in equities but comparing the equity market with the recent experience of commercial property, especially as regards regular monitoring.
I will then conclude this short series of articles by looking at the corporate bond market. This has been depressed in recent years but is perhaps ready for investors’ money which cannot decide whether to head for the port or continue to sail the seas.