Fund liquidity – the key issues

June 7, 2019 by colinwmclean 0 Comments

How should investors view fund liquidity?  After an unexpected high-profile fund gating, this risk is now front-of-mind for advisers and clients.  More regulation lies ahead, but debate is needed. There is a danger that the wrong lessons will be drawn from recent events.

Stockmarket liquidity ebbs and flows, with wider sentiment often exaggerating investor pressure on funds.  When money is flowing in strongly, liquidity is usually good in funds and in the broader market.  First questions are: is the fund vehicle well-matched to objective and strategy; is the investor horizon in line with the likely timeframe of investment and underlying liquidity; and has the manager put any capacity limits in place that recognise the investible universe and likely liquidity in that?  The issues are not just from small companies, or private companies – unquoteds.  Big percentage holdings matter whatever the company size.

A fund manager should also be able to demonstrate to clients that processes are in place to monitor liquidity, that information must go to the portfolio managers responsible, and also to independent governance.  The emotional conflicts involved mean that intervention comes not just from those with regulatory responsibility, but also from directors largely independent of the commercial income streams involved.  A fund authorised corporate director (ACD) has serious responsibilities, but typically also is paid fees from a fund that grow with the size of the fund.   What makes absolute sense commercially, may not be appropriate as a whistleblowing mechanism.  This should be borne in mind when an ACD revalues upwards an unquoted portfolio holding in a fund.

Some fund managers have decided to avoid unquoted holdings, despite the growth potential these may have or even an apparently imminent IPO.  This recognises that it is an area of specialist expertise.  The timescales, vehicles, and client expectations and communications are all different from listed investments.  And the inherent conflict in an open-ended fund – where a manager must have confidence over valuations and liquidity as a fund experiences inflows or outflows – is hard to manage.  Managers themselves are conflicted in this – putting a lot of responsibility on the ACD, compliance and governance.  It is difficult to accommodate departing shareholders without forcing remaining investors to hold more of an unquoted.  The funds are designed to scale up and down, but unquoteds cannot do this readily.

Of course, even with a policy to avoid unquoted investments, a manager still needs to maintain a fair value process as from time-to-time companies will be suspended, markets closed for the day, or collapsing liquidity requires a stock price adjustment.  In practice, few managers and ACDs are structured to provide daily oversight of this process.

Liquidity monitoring should be firm-wide – there is little value in knowing that an individual fund’s position is liquid to the desired degree if that information is not combined with all the similar holdings in other funds run by the same manager.  This points to the dangers of scale.  In the drive for harmonisation of portfolios within the same investment firm – and in wealth managers across all clients with similar objectives – stock concentration has been encouraged.  At the same time, the largest capitalisation, most liquid stocks, have been disappointing – over the very long term outperformed by the indices of mid-cap companies.  Diseconomies of scale, disruption, globalisation, low productivity and disinflation may all contribute to this.

It does mean that managers tend to look to less liquid stocks for performance.  Liquidity may normally be reasonable in these – but it will not be the liquidity of the largest FTSE 100 companies.  And, for some companies that continually raise money liquidity may be patchy, with a changing shareholder register and lack of broad analyst coverage.  All of these suggest that investment firms should set capacity limits on strategies and funds, carefully reappraising these in the light of overall stockmarket liquidity.

Unfortunately, commercial and regulatory pressures have encouraged an increase in fund scale.  To this is added the social proof of feeling more comfortable alongside others who have backed the same manager.  This is a network effect, reducing marketing costs if distributors and the press are unanimous in their endorsement of a “guru”.  Despite the academic evidence that very long periods are needed to demonstrate investment skill, track records of three or five years are often used for this endorsement.  And, where longer term records are cited, these are often disjointed with few questioning the data.

Many years ago, regulation outlawed commission structures that incentivised volume sales targets.  Rightly, it was recognised that this posed a conflict with best advice.  Now, the downward pressure on fees appears to be at risk of delivering similar conflicts.  It sounds good to cut fees for platform costs for bigger funds, but this brings other parties into the same conflict between liquidity and fund size.  Even without a direct volume incentivisation, a discussion along the lines of “if the management fee was even lower, we could sell much more and everyone’s total revenues would be higher” achieves much the same result.

Since the gating of property funds in 2016, in the aftermath of the Brexit referendum, regulators have searched for better rules.  The arrival of independent directors on fund boards later this year may help.  But, there may need to be separate approaches for institutional investors and private clients in a fund, use of tenders as a gate is removed, and external supervision by a valuation specialist of the restructuring process during a fund closure.

Underlying today’s problems are some unhelpful forces.  Fund scale is now driven as much be cost issues as performance.  In the stockmarket, liquidity and pricing are closely linked; the right price to sell a large position may be a much lower price than mid-market.  And, overall the focus on cost has side-lined risk management, stewardship and long term performance.  A new approach should recognise all these factors.

 

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice. I am a manager of actively invested equity funds. 

Image credit: Wiki Commons : Aral Sea. Creative Commons Attribution-ShareAlike 3.0 IGO license. Published on behavioural-investing.org June 7 2019

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Finding true growth – how some businesses fake it

April 9, 2018 by colinwmclean 0 Comments

Is it really so easy to separate growth and value investment styles? Growth in particular is a challenging concept this year.  Investors should think harder about what it means.  Genuine cash generative growth is valuable, but rare. Investors need to know how to spot it and what they should pay for it.

Often, analysts need look no further than earnings per share to estimate growth rates, but this has become a risky approach. It is not just that accounting treatments, profits adjustments and share buy-backs flatter earnings per share. Some so-called ‘growth’ stocks are actually businesses whose customer base is shrinking physically. Investors need to look deeper into organic growth comparisons, and separate out pricing and volume effects.

Longer term performance means finding companies with true growth; weeding out the imposters. If companies have been exaggerating their growth, any shock to that can hit the share price hard. Not only are immediate profits forecasts cut, but future growth rates are revised down and  a greater risk factor might be applied to discount longer term prospects. And for some, more capital might be needed to address the problems or restructure. Changing prospects may even suddenly make bank debt look like a bigger problem if goodwill has to be impaired. Managements typically have a bias to optimism, and are reluctant to address asset valuations until they are forced to. All this even seems to surprise lenders, who set covenants that can overly rely on intangible assets. If investors want to keep one step ahead of share price collapses, they need to think of growth in down to earth physical terms.

Printing money has boosted consumer and business confidence, and restored economic growth. But that growth in western economies is now much lower than historic levels, and disguises a lot of business disruption. Many traditional businesses face challenges from new business models but are responding with cosmetic changes that only temporarily flatter reported growth. These can include rolling-up a business by buying smaller competitors, or pruning lower margin areas. Accounting treatment can flatter these moves. And many retail businesses have continued to expand their floor space or units, even as their business model has been called into question. This roll-out usually distracts management and investors alike from the problems at the core of the business proposition.

It seems that investors do not look closely enough to see if activity in older units is slipping back. Management may be incentivised to focus on keeping up appearances in the short term.  Should we be surprised, in a world where ‘shrinkflation’ cuts the size of consumer products to preserve prices and margins? Investors should be no more convinced than consumers that this disappearing act does not compromise brands and business value.

Sadly, many businesses have simply raised prices, misunderstanding their power and believing that they are in a semi-monopoly position. The failure of these strategies often comes as a total surprise to investors. It is an area where analysts need to do some work themselves. They should start by questioning some of the metrics that company managements put out. There are accounting standards for earnings per share, but not for some of the earnings per share adjustments, or for the ‘organic growth’ metrics put out by managements.

Extracting more profit from a declining base of customers or shrinking product hardly merits a growth rating. These challenges are not just about technology and consumers moving online. Many tobacco and branded food businesses are being hit, alongside high street retailers.

The psychological impact of priming is powerful – we are typically influenced unconsciously by context and framing. A ‘growth stock’ label, combined with rising earnings per share and management excitement, influences subsequent analysis. The halo effect, as management claim credit for share price performance, is added to the social endorsement of seeing other investors pile into the shares. A powerful cocktail of biases spares many growth companies from close scrutiny.

In a world where true growth is scarce, it should be prized. Superior returns on capital can persist for several years, meriting a premium rating. Indeed, some new strategies may merit a very forward-looking approach; digital businesses can scale rapidly. And, even older economy businesses, such as Fever-Tree Drinks, have developed capital-lite business models. But even for those businesses, the cost of customer acquisition and unit costs matter.

Undoubtedly, this year will see many established businesses fall from their growth pedestal. Portfolio performance may depend on side-stepping these disasters. It can be hard to overcome some psychological biases, and those linked to growth are harder than most.  But, looking at the trends in physical like-for-like customer demand is a good start

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice. I am a manager of actively invested equity funds. Clients own shares in Fever-Tree

Image credit: rights reserved; source Bloomberg. Published on behavioural-investing.org April 9 2018

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Will the UK Election result unnerve investors?

June 9, 2017 by colinwmclean 0 Comments

– Falls of 2 to 3% likely in UK domestic sectors like property, media, retail and challenger banks

– FTSE 100 sectors with international earnings – pharma, oils, mining, exporters – should gain on the weaker Pound

– Domestically-oriented sectors such as housebuilding and building products can benefit in coming months

– A barely workable Conservative majority will weaken Britain’s hand in Brexit negotiations and may delay the start of talks

– The weak result for the SNP in Scotland undermines the momentum for another independence vote

– May’s position is untenable

– Avoiding nationalisation risk and higher corporate tax risk are positives from a UK equity market

– The global background may matter more to investors than the election result

– There are many businesses that will prosper independently of governments

Ahead of the vote, there was little selling of UK risk: 10 year gilt yields are near their lowest since October. The FTSE Mid 250, which emphasises domestically oriented UK businesses, has been strong recently. But I expect selling of domestics today, with falls of 2 to 3% in sectors like property, media, retail and challenger banks. However FTSE 100 sectors with international earnings – pharma, oils, mining, exporters – should gain on the weaker Pound. The majority of FTSE 100 earnings are overseas. But some domestically-oriented sectors such as housebuilding and building products can benefit in the coming months as there is cross party agreement on the need to boost these, although with differences in implementation.

 A barely workable Conservative majority will certainly weaken Britain’s hand in Brexit negotiations and may delay the start of talks this month. But recently investors seemed to think that a reduced Conservative majority might increase prospects for flexibility in negotiations and a soft Brexit. If anything can be taken from a confused election result, it is that the electorate does not want a hard Brexit. This may already be reflected in the calmness with which investors approached the election. Business and consumer confidence has been resilient. The Pound has sold off overnight and could see a further modest fall, giving up its rally this year. The weak result for the SNP in Scotland undermines the momentum for another independence vote. Avoiding nationalisation risk and higher corporate tax risk are also positives from a UK equity market perspective.

The path to a more generous transition agreement is now less clear. This adds uncertainty and volatility. Theresa May would have hoped for a cabinet reshuffle, selecting the cabinet that will help her most in the Brexit negotiations, after beginning with a compromise team. Markets would have been reassured if one or two hard Brexiteers are dropped. Instead it is now more likely that one of the hard Brexiteers will replace her in party leadership. Her own position is untenable.

The global background may matter more to investors than the election result. Growth in the economies that were hit by the financial crisis is still sub-par, and the ratio of global debt to GDP is now at a record high. Indeed, many major economies have higher debt levels today than they had at the start of the crisis. In the periphery of the Eurozone, non-performing loans remain high.

 Investors usually pay too much attention to politics – elections reinforce the notion that governments can control the direction of the economy. In practice, business confidence is not so easily directed, and interlinking with the global economy is a straightjacket. Markets quickly rein in any unrealistic ideas of government borrowing. There are many businesses that will prosper independently of governments, with a specialisation or competitive edge. untenable.

The global background may matter more to investors than the election result. Growth in the economies that were hit by the financial crisis still sub-par, and the ratio of global debt to GDP is now at a record high. Indeed, many major economies have higher debt levels today than they had at the start of the crisis. In the periphery of the Eurozone, non-performing loans remain high.

Investors usually pay too much attention to politics – elections reinforce the notion that governments can control the direction of the economy. In practice, business confidence is not so easily directed, and interlinking with the global economy is a straightjacket. Markets quickly rein in any unrealistic ideas of government borrowing. There are many businesses that will prosper independently of governments, with a specialisation or competitive edge.

 

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

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Crisis 10 years on – what’s changed

June 5, 2017 by colinwmclean 0 Comments

This month marks the 10th anniversary of the opening rounds of the great financial crisis. Though years in the making, it was finally in June 2007, that two Bear Stearns hedge funds created to invest in sub-prime mortgages, collapsed. This triggered an attempt by many banks, such as RBS, to shore up their own capital and de-lever. What has the ensuing decade taught us? Certainly, that banks need to be brought under control and that high debt is unsustainable. But, also that it was right to stay in stockmarkets after policy eased in 2009.

Today, economic growth in the crisis-hit economies is still sub-par, and the ratio of global debt to GDP is now at a record high. Indeed, many major economies have higher debt levels today than they had at the start of the crisis. The US Federal Reserve has a $4.5 trillion balance sheet. In the Eurozone, an equivalent of the US Troubled Assets Relief Program (TARP) is still needed to address non-performing loans in the peripheral countries. Without the ability to devalue, or even apply internal devaluation via more austerity, Greece and Italy will find it hard to reflate and repay creditors. And, despite the enthusiasm with which many investors jumped into last year’s “inflation trade”, long bond yields point to subdued inflation expectations. The US Treasuries 5 year/ 5 year forward breakeven rate of implied inflation is back down to 1.9%, its lowest level in 7 months. The performances of Europe’s banking and mining sectors are closely following this unwinding of inflation expectations. The disinflationary forces of technology and low productivity of capital investment are not easily shifted by monetary policy or tax cuts.

Unfortunately, easy monetary policy has encouraged the leveraging of inherently low returns on assets in what are inherently capital-intensive sectors. Many European banks are still not earning their cost of capital. It may take another decade or two before the banking sector resolves its fundamental problems. The lesson may be to avoid leveraged low-growth businesses, with better prospects in companies that have core strengths to protect margins. Meanwhile, new growth businesses are emerging across a range of sectors which can use capital-lite strategies to grow.

Technology has now overtaken banking as the best performing sector in the US and Europe, although Europe’s technology exposure is much lower than the USA. Indices have significant weightings in legacy businesses that are challenged by low inflation and business disruption. This makes a strong case for active management to focus on sound business structures.  For the bank sector as a whole, risks remain elevated.

 
Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

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What does disruption mean for investing?

June 1, 2017 by colinwmclean 0 Comments

Can a disciplined investment process deal with rapid change? Rigorous analysis of historic numbers seems at odds with disruption and a radically different future. Economic revolution seems to question the very concept of consistent growth. The process of investing may now need to adapt to involve informed guesswork on innovation and adoption of technology. Investors who are most comfortable with numbers face a psychological challenge. Is prediction fact-free?

Certainly, company lifespans are getting shorter. Although we all want to be long term investors, companies may not outlive the average pension plan. Of 81 companies that joined the Fortune 500 between 1955 and 1960, just 7 are left today. Disruption has not only hit industrials and media, but is now accelerating in retail, consumer services and finance. The impact on retailers is being felt in most western nations and has moved from hitting city centres to affect the shopping centres and malls that were once seen as the future. The challenge is not just delivery technology, but an evolving change in consumer tastes that favours services over goods.

Technology is the best performing sector this year in the US, and joint top with financial services in Europe. This is despite technology’s high rating, suggesting that investors now place greater value on future earnings and growth prospects. Some of these are enabling or B2B businesses that may not be dependent on the outlook for a single customer sector. For example, the technology underlying self-driving vehicles may have wider applicability and greater value than car manufacturers themselves. And, a number of young disruptive companies are coming to the stockmarket, often with innovative business models, radically different from the incumbents they are attacking. Active investors may be able to move faster than passive funds to bring these IPOs into portfolios with a meaningful weighting.

Investors may need to incorporate some emerging businesses into their portfolios, ideally trying to capture these at an earlier stage. They also need to understand what are likely to be successful strategies, based on proven disruptive approaches. Some of this will be out of investors’ comfort zone. Factors in success may include managers and directors with experience of experiment and failure. But at least that failure should be in the rear view mirror, in contrast with traditional businesses where the real problems have yet to come.

Winning disruptors may also share common ground in how they operate; focusing on customer experience, delivery, brand value and scalability. Surprisingly, not all are digital or online models – London-listed Fevertree Drinks, for example, has rapidly built scale and competitive advantage simply selling mixers on a capital-lite model. Despite a £2bn capitalisation, like ASOS, it remains on the London Alternative Investment Market, AIM. Investors waiting for a full listing or capital-raise from these types of businesses may need to be very patient.

Investors also need to think harder about incumbent businesses that may be seeing new entrants steadily poach their customers. Initially the disruption may still be under the radar, and the headwinds faced by established groups might not be clearly understood. Some of the attrition in market share could be lost amidst macro and seasonal noise – dismissed as weather, temporary margin pressure or just a soft quarter. Sectors under attack may reclaim some value via consolidation, yet without providing a long term fix. Investors are only likely to win in this scenario if they correctly pick the last man standing in a sector, or find a business which manages an orderly run-down and exit to deliver a cash return. Worse case is when challenged businesses desperately acquire or market to recover lost business – HMV showed what can happen.

Investors can use traditional DCF approaches if they can estimate eventual market share, margins and the investment required. But the picture might be cloudy and a spread of investments may be wiser. Incorporating new sources of information could help to understand trends, and diverse teams may bring more flexible thinking. Investors also need to consider whether they can tolerate shares without dividends, or whether pay-outs from some older businesses might actually be at risk.

The upheaval in business methods and technology has much further to run. Disruption needs to be considered in asset allocation and company analysis.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

Client funds hold positions in Fevertree Drinks

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The Problems with MiFID

April 4, 2017 by colinwmclean 0 Comments

Years in planning and one year late, the European Union’s wide-ranging new MiFID II regulation is still going to catch-out much of the industry. Although European, it will impact global asset managers, and may herald change across the industry. No-one yet quite knows how it will work in practice. The aim – to fully and transparently align the industry with the end client – is worthy, but the challenge is in implementation. Some areas remain unclear, including what would represent best practice under the new regime. And, there is a real risk of regulatory arbitrage, with the Directive applied differently in each EU member state. For now at least, the rest of the world will remain on a traditional commissions and research bundled model.

The new legislation aims to address MiFID I shortcomings, by delivering fair, effective and safe operation of financial markets. The focus of regulation will expand to include non-equity products, such as OTC derivatives, and will enforce conduct and client suitability rules on intermediaries. It recognises new types of trading facilities, codifies product governance, and will require unprecedented levels of data recording. Whether end clients will really benefit is uncertain.

MiFID I similarly had high hopes, but failed to demonstrably assist the integration of European financial markets. Its successor looks like it will tear up existing business models, but possibly just shift conflicts from one area to another. Costs may simply move from commissions onto wider dealing spreads and issuer payments. Financial markets are a complex global system, and remodelling one sector in one region may have unintended consequences. London could lose business to countries with a lighter touch regime, and the EU as a whole could see activity migrate to New York or Asian centres. Adjusting to all this will be a challenge for global investment banks and asset managers.

Certainly, clients deserve control of research costs. MiFID will shed some light on the workings of the asset management process, but many clients are more interested in outcomes; in terms of returns, control of style and risk management. Discussing the new system and reporting on research must carve out attention in the relationship that managers have with clients. This may be at the expense of more important issues. Clients are becoming more interested in governance and sustainability, and would rather have extra data on that. Can the bandwidth in client relationships really be stretched to take all this in?

In the EU, the industry does not currently expect that research budgets will fall, but a shift away from the largest investment banks seems likely. Many smaller brokers will fight to keep some sort of relationship with investment firms. While this cannot be free under MiFID, low charges for research would still offer brokers the opportunity to provide fund raising, institutional access and IPO services to corporate clients.

The research from these smaller brokers often already appears conflicted, perceived as reflecting obligations to corporate clients. The value to the buy side is less clear, so brokers’ revenue may come from spreads, or possibly as part of fees on corporate transactions. These trades and transactions are infrequent, and so true cost discovery will be a challenge, if possible at all. MiFID II can control the buy side, but creative new sell side business models may emerge.

Asset managers might even see some benefit from this forced process and additional cost. Data collection around investment decisions – capturing internal conversations as well as detail on trade implementation – will reveal much about how value is created. Managers will be able to monitor research inputs and leverage the new data into better decisions. Unfortunately, to date, many of the new services, such as research aggregators, present the services as regulatory solutions rather than tools that will benefit managers. These providers may need to align themselves better with the business models of buy-side clients.

Regulators cannot get inside the business models of all the firms on each side, and so it will be difficult to tell whether profitability is being recaptured in dealing spreads or corporate transactions. Many of the new specialist research providers that present their work as “independent” research, will actually continue to be paid by corporate clients. Most smaller or mid-cap listed companies will likely need to pay for the research that is provided to investors. In the same way, research from brokers with corporate advisory relationships is already questioned. Will we be any nearer finding a true market value for this “information”, or will anyone really care if its buried within the budgets of corporate clients?

The concept of stripping out inducements to establish underlying true execution costs is appealing. But many shares and derivatives will have insufficient liquidity to establish an execution-only price. And the nature of an investing institution’s order flow will be a complicating factor. The system will need some wriggle-room, if the new regime is not simply to drive a huge incentive for scale on both the buy side and sell side. There could be a further tilt towards passive funds, which essentially benefit from the price formation created by other research. Does this really help market integrity?

MiFID II might herald a new world of alignment and transparency, but the challenge is whether investment banks and brokers providing research will be willing to break out their research bundle. They will aim to preserve broadly based subscription services. Price discovery for this research depends on granularity, but that may represent too big a move from the current business model. The value is not primarily in the printed reports. The buy side recognises that analyst calls are expensive, but wants to maintain low touch access to sell side analysts.

In theory, the new regime will bring return on investment into research, but in practice, there will remain work-arounds and fudge. Ideally, innovative dynamic pricing models should develop – where the price of research varies as it is disseminated. Major buy side firms using research will potentially have much more price impact than boutique asset managers, quickly exhausting the value of the insight. The value of a specific research piece or analyst team, might be better captured by selling to smaller asset managers and minimising impact.

Regulators could be tempted early in 2018 to make some high profile examples to highlight best practice. But the industry will be in turmoil for months and any intervention should be taken with care. Instead, it is more important that regulators should be alert to any emerging systemic risks encouraged by the new regime. MiFID’s problems may surface more quickly than the benefits. North American and Asian regulators are unlikely to follow the EU until the results become clear.

A version of this article was published as the Op-Ed in Financial News on March 28 2017

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. I have no business relationship with any company mentioned in this article. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice. A  client fund of my employer owns shares in Alphabet (Google)
Image credit: Some rights reserved.

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Investors must recognise disruption risks

April 3, 2017 by colinwmclean 0 Comments

Not all recent UK company results have made pleasant reading for shareholders. Some highly regarded retailers – such as Next and Kingfisher – have disappointed, and not just because of the recognised headwinds of Brexit and currency. Something bigger seems to be happening. Across the whole of Europe, the retail sector has lagged the main share indices. And in the US, retail malls are noticeably quieter. The internet is rapidly eating into brick-and-mortar sales. But retail may not be the only sector being disrupted. What are the risks to investors?

The warning signs for the retail sector have been in the online growth of Amazon and Alibaba, with record sales in last November’s Black Friday and Singles Day. UK High Street activity is shrinking, with speciality shops and restaurants that depend on footfall also seeing weakness in retail parks and shopping centres. Many units in these locations depend on the major branded retailers to attract customers, and everyone loses when shopper numbers fall. The only stores that appear to be coping with this onslaught are businesses such as John Lewis that have a strong online offering.

The process of shrinking-down the retail estate could be a challenge spanning many years, with a high cost to exit units that are trading poorly. And, technological development will compound these pressures. New services such as Google Home and Amazon Dash simplify direct ordering of home supplies on an “as needed” basis. The intelligence brought in to homes and everyday objects – the Internet of Things – will see even more products circumvent bricks and mortar retailers. And the growth of mobile services on our streets – such as Deliveroo, Just Eat and Uber – should make us think how that impacts other investments.

Other sectors are being disrupted, too. For banks, branch closures are just one tangible sign of a change in customer demand. Many customers are now comfortable with handling their bank accounts entirely online, needing only ATMs on the high street. New challengers are using big data to catch up quickly with traditional banks in understanding all the nuances of consumer credit risk. Decades of experience in judging lending risks are quickly giving way to direct lending methods that target niches of profitable customers, using technology to monitor changes to risk. Credit scoring used by traditional banks has evolved little in recent years, but new entrants have found surprising indicators. For example, measures of social media influence can be effective in assessing lending risk.

Financial technology such as blockchain, best known as the infrastructure behind Bitcoin – could accelerate demonetisation and bring in competitors that are currently not even in the finance sector. The potential to use new data analysis could also disrupt insurance. Phones are not just a way of attracting customers and servicing them, but can also gather useful data on lifestyle, preferences and risks.

While western investors are focused on the disruption potential of Facebook, Amazon, Neflix and Google, in Asia there are bigger threats. Alibaba and Tencent Holdings have already moved into digital banking, scooping up financial customers with astonishing ease. Alibaba’s finance business is now worth $60bn, and has 450m active users. Once customer trust is gained, it may prove easy to move from e-commerce into consumer loans and online payments.

A combination of widening broadband availability with higher capacity, cloud and mobile computing, big data and wise use of smartphones will hit many industries. Many of the new entrants are using unconventional streams of data and applying innovative business models.

Investors should consider the risks this creates for blue-chip investments. The gaps in the high street, such as HMV and Blockbuster, are testimony to this. Annual reports should be examined closely for information on how companies are dealing with these challenges. And portfolios might also include some investments or funds that will be part of the new business landscape.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice. I am a manager of actively invested equity funds. At the time of publication, clients of my employer held long and short positions in bank stocks. A client fund of my employer holds a position in Alphabet (Google).

Image credit: Some rights reserved.

A version of this article was published in The Herald on March15 2017

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Change in the World Order

November 9, 2016 by colinwmclean 0 Comments

Trump is an immediate negative for markets around the world, as seen already in Asia. Immediate winners are gold, Treasuries and the Yen; but losers include the US Dollar, Mexican Peso, oil, climate change and equities. Since 1948, the Dow has typically fallen under a Republican. But if Trump’s presidency echoes Reagan’s leadership, markets may come to respect the new leader and his policies. What they fear is a Berlusconi. As Brexit showed, fear of the unknown can be overdone by markets. The Republicans have a clear mandate so uncertainty should fade.

The corporate earnings background is favourable, with an earnings season that is beating expectations. Indeed, S&P 500 EPS growth should accelerate next year. But with the election over, US investors should more at individual company results. This would see the market favour sectors such as banks and technology that have been beating earnings expectations.

Trump’s presidency will break from the traditional Republican commitment to free trade, imposing a set of protectionist policies to close America’s economic borders. Despite Trump’s slogan, much of his comment on change he plans for military commitments represents a sea change in America’s global role. This is less supportive for global trade and emerging economies. In campaigning he has said he will immediately announce his intention to “renegotiate” the North American Free Trade agreement with Canada and Mexico. He would also cancel participation in the Tran-Pacific Partnership. That may ease some of the competitive forces that have restricted real wage growth per capita.

One sector that feared Clinton and should nowrally is healthcare. The major UK pharmaceuticals are exposed to the US market which was threatened by Clinton’s proposed pricing reforms. His year the sector has de-rated, losing its premium rating of 20-30%. But Trump has said he will repeal Obamacare, and the sector may be helped by his new plans. Clinton would also have brought the prospect of either a higher marginal tax rate or higher taxes on capital gains, or both – a risk that has been removed.

Both candidates favoured increased infrastructure spending, promising to inject hundreds of billions of dollars in fiscal stimulus. This could raise US economic growth over the longer term, but the benefit may depend on how the work is financed. Trump has indicated that the cost will be met from reduced climate change spending. There are London-listed businesses that could benefit from US infrastructure and construction, such as CRH, Ashtead and Wolseley.

Trump stood between an accelerating US economy and Fed intervention. It seems unlikely even so that the Fed will delay beyond December. At the start of 2016, four ¼ percentage point hikes were expected, but to date none of those increases has taken place. The Fed saw a risk that a Trump presidency might have cooled the economy and inflation trend. Headline PCE increased 1.2% in September YoY, with non-core PCE – often a leading trend – running at 1.7%. Average hourly earnings for private-sector employees were up 2.8% YoY in October, the fastest pace since in seven years. 10 year Treasuries are also pointing to sharply rising inflation expectations, with the yield curve steepening. Next year US output is forecast by the Atlanta Fed to grow 3.1%, the fastest pace in more than two years. Unemployment is low, at 4.9%. But the elephant in the room is that, since 2008, the US has added significantly to its national debt, an extra US$ 15 trillion. Trump is seen as being comfortable with borrowing.mony.

After the US, investors may focus on the Italian Referendum, where polls currently point to a NO vote. Trump looks like part of an ongoing change in politics. In Europe it is clear that the social and political consensus that has prevailed in the West for 60 years is under attack. Markets may take a few months to assess winners and losers in the new world order, but the US and world economy start from a position of growth.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice. I am a manager of actively invested equity funds.

Markets
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New bubbles from misguided monetary policy

September 22, 2016 by colinwmclean 1 Comment

Have any lessons been learned following the Great Financial Crisis? Around the world, it looks like new bubbles are growing. Certainly, the crisis showed that central banks and politicians can move decisively on the threat of economic collapse. But the sequel has been years of bad policy; propping up banks, bad loans and unsustainable growth. Between 2007 and the end of 2014, the combined world-wide debt of households, governments, corporations and the financial sector actually grew. Adding in unfunded pensions liabilities of governments around the world, overall indebtedness in the world’s economy is today over 400% of global GDP. London house prices are now 50% above pre-crash levels. Should investors be worried?

Bubbles tend to creep up on investors; one of the worst credit crunches in history has changed behaviour little. It seems easier to carry on as before. Politicians need growth for re-election; investors like rising stockmarkets. Complacency rarely drives change, even as the world moves further down the slippery slope to negative interest rates. This may not end well.

There is little sign that negative bank deposit rates are flushing out a wave of new capital investment or even consumer spending. Instead, the inability to earn returns on low risk assets are threatening the business models of banks, insurers and pension funds. To date, few companies have linked rising pension deficits to dividend cuts, but more can be expected. Banks themselves are now unable to make the profits needed to rebuild capital. They enter the next economic downturn largely unprepared. And, in the weird world of government debt, even the challenged Republic of Latvia, with a bond rating of A -, now has bonds that yield almost zero.

Clearly, with such bonds the maximum upside is preservation of capital. It would be a bleak world in which that represented a win. But it may look smart relative to some negative yielding bank deposits where bail-in risks remain. It is not just Italian banks and a few European mutuals that need to re-capitalise, but some of Europe’s major banks. A thin sliver of genuine loss-absorbing equity supports these banks, with little known about how derivatives would behave in a new crisis. Already, this year we have seen how some of the exotic capital – CoCos – might be viewed when the chips are down. And remorselessly, bank balance sheets are becoming more entangled with Eurozone sovereign risk. This is not just because of ECB bond purchases, but subtler issues such as deferred tax assets. The latest European Banking Authority stress tests did little to reassure.

Investors often seek safety in the crowd. Regulation encourages this; the index or consensus is typically used as a risk benchmark. It explains current market buoyancy and low volatility. Equities seem to offer dividend yield, with an upside bet on moderate inflation returning. Meanwhile, the driving forces of long term globalisation seem weakened. Trade harmonisation was meant to boost growth, but the new proposed agreements of TTP and TTIP look dead in the water. It may take the US presidential election to finally kill these trade deals off, but it is hard to see where the next boost to global growth will come from. Instead, we can expect continuing squabbles over trade, and currency wars.

How should investors react to bubbles? For most asset managers, sitting out a rising market is not a viable business model. Those owning financial assets – whether equities, bonds or property – are the current winners from misguided monetary policy. Why worry, when the alternative is not clear?

In current conditions, portfolio protection is particularly difficult. Low volatility reduces the value of premiums that can be written on an equity portfolio. Negative interest rates limit the options that can be bought on upside whilst sitting in cash. Instead, investors may need to think carefully about diversification of assets.

Behavioural finance is often accused of simply asking people to think sensibly. But individuals typically do not believe they are behaving irrationally during bubbles. Instead, the problem posed by bubbles needs re-framed. Rather than make a simple risk-on or risk-off bet on the market, investors should assess where the biggest risks lie, and take selective action. The bank sector, for example, may be a loser whatever happens. And, given the risks in banks and derivatives, investors should monitor those areas for warning signals.

A version of this article was published in Citywire on September 19 2016

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice. I am a manager of actively invested equity funds. At the time of publication, clients of my employer held long and short positions in bank stocks.

Image credit: “Bubble Rain”, 2005, Steve Jurvetson, http://www.flickr.com/photos/jurvetson/10525957/. Licensed under the terms of the cc-by-2.0. Some rights reserved. Published on behavioural-investing.org September 22 2016

Articles, Behavioural Finance
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8 years on, has Lehman cut global bank risks?

September 15, 2016 by colinwmclean 0 Comments

The Great Financial Crisis still casts a shadow in the industry, eight years on. The fear remains that it might not be the main event, but simply advance warning of something bigger. After two decades of accumulated bank leverage and a few years of irresponsible lending, the remedy has mainly been sticking plasters. Regulation has hit asset managers hardest, but in many cases, failed to deleverage the worst banks.

In the Eurozone, failure to write-off bad debts where sovereign risk is involved condemns the world to low growth and disinflation. While governments were congratulated for a rapid response in 2008 and 2009, more recent policy looks wrong.

The rebound in stockmarkets, and desire of politicians to reassure all that the banks are safe – has downplayed ongoing problems. In 2008 a handful of banks in the US, UK and Eurozone had astonishing levels of leverage; bad loans and derivatives propped up by a sliver of genuine loss absorbing capital. Just as regulatory capital was flattered in the run up to the Crisis with artificial forms of hybrid capital, now we have contingent convertible bonds and questionable deferred tax reserves. The ability of banks to raise equity capital can disappear very quickly. Events this year with Deutsche Bank have shown how little is understood of the new CoCo bonds.

Gradually, the ECB has intermingled its sovereign risk with bank balance sheets. The problems are not just Italian banks and mutuals, but some of the largest banking names even in Germany. To date, bank bail-ins have been in peripheral areas such as Cyprus, but depositors in some more mainstream banks may be at risk. The UK’s Co-op bank is just one example of the sort of problem that continued after Lehman, and has only been dealt with recently. In general, deleveraging in the UK is ahead of that in the Eurozone, albeit far short of action taken in the US.

The years since Lehman have not brought true wisdom about banks. Not just the public, but even sophisticated corporates, seem unable to discriminate between banks on the basis of bail-in risks. And, negative rates are leaving banks struggling to rebuild capital through profit. Investment banking, which could generate prodigious profits in boom times is now dominated by the biggest US banks. European banks are struggling to compete.

The bank sector needs to see genuine stress tests that more robustly question sovereign assets and loan provisioning. Meaningful bank capital buffers are needed. This will likely force more debt write-downs and encourage mergers. Without that, the sector will remain broken as a channel for new lending and economic growth. Deleveraging might slow short term growth, but seems the only way to give public reassurance on the sector. If the Lehman legacy is to be a healthy bank sector globally, more work must be done.

A version of this article was published in Investment Week on September 15 2016

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice. I am a manager of actively invested equity funds. At the time of publication, clients of my employer held long and short positions in bank stocks.

Image credit: CC Attributioon 2.0. This image was originally posted to Flickr by Robert Scoble at http://flickr.com/photos/35034363287@N01/2861707320 Published on behavioural-investing.org September 15 2016

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