Value investing should be about business resilience

Investing style is how investors typically make sense of their portfolios. Emphasis can be on big or small companies, and labelled as “growth” or “value”. Each person’s style preference will fit their longer term goals, or even just match their own personality or attitude to risk. Investors can gain from clear thinking about style. Unfortunately, labels like “value” and “growth” are often misunderstood.

Growth investments have been on a winning streak for several years, against a background of disinflation and low global growth. As economic cycles have flattened, and investors have put a premium on genuine underlying growth – boosting the ratings of businesses that can make steady progress. But, investors should give thought to how far this remarkable trend for growth stocks can run. It might be time for other styles to shine.

What are the alternatives? Value investments – businesses that are more cyclical, troubled or just look cheap – have been laggards in recent years. But is this what value investing should really mean? It may be that the underperforming businesses are cheap for a reason, and there is no economic recovery or inflation to bail them out. What looks like bargain investing, may be a risky approach unless inflation breaks out globally. Even the higher dividend yields that these companies typically offer can come under pressure, with dividend cuts as profits shrink.

For investors concerned that growth shares have had a good run, switching now into deeply discounted businesses may not be the answer. Valuation itself on stockmarket ratios looks like a flawed tool for value investing. It may be that the real alternative to growth is being contrarian. Value driven by a contrarian analysis can actually be a good guide to picking shares in a turbulent world.

A number of notably successful investors approach stockmarkets in a contrarian way. Warren Buffett is the best known example – not picking inherently bad businesses, but seeing potential that others might not fully recognise. These companies may not initially look cheap, and they may not even be particularly cyclical. Finding them takes deeper, more original, thought.

The first rule is to think about longer term risks to a business, rather than today’s valuation or growth estimates. For investors who – like Warren Buffett – rarely sell shares, the long term return to a shareholder will eventually be much like the underlying business performance. This points to favouring a good business, with opportunity to deploy the cash it generates. A contrarian approach can help with identifying good entry points to buy these types of shares.

Investors should recognise that the biggest danger is poor underlying long term returns in a business. This is often created by bad management or governance, or simply by being in an area that is likely to be disrupted by new entrants. Businesses that collapse typically show high levels of borrowing, poor governance, weak business models or questionable accounting. These can be value traps – few are good at pricing inherently risky businesses.

And, in many sectors, there is potential for new entrants to change economics. Think of what is happening on the high street as online sales erode the customer proposition of many. Or banking, where challenger banks are operating without the outdated systems and branches many legacy banks are burdened with. Even the collapse in oil prices has been driven by disruptive new technology in US shale drilling.

The challenge with a contrarian approach is that it requires a long term perspective. Investors need resilience; these investments can look silly for some time. It may also mean largely ignoring sectors such as banking that are ripe for disruption. But these problems may actually give for private investors an advantage. For big institutional investing firms – accountable for performance quarter-by-quarter – patience is in short supply. Explaining contrarian investments to their clients can be difficult.

Low global growth limits the opportunity for bad businesses, but equally growth businesses are currently extremely highly prized. But there are still companies that have genuine growth potential, but are simply misunderstood. Investors need not avoid growth stocks, but can bring a contrarian edge to sourcing opportunities and recognising disruption risk.

A version of this article was published online in Personal Finance in The Herald on 4 June 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.

Image credit: Creative Commons Some rights reserved.

EU Referendum: Investors should be wary of the polls

How should investors prepare for Britain’s referendum on EU membership? Shares were weak ahead of the Scottish referendum and the UK general election, but ultimately it proved right to ignore the opinion polls. Polls can capture a lot of biases and wishful thinking, whereas voting often concentrates the mind. In the polling booth, fear of the unknown can be the strongest emotion.

Investors who ignore polls but track the betting are less likely to be unnerved in the coming weeks. Betting odds were a much better guide to the Scottish referendum and UK general election results. Insofar as betting odds represent a poll of polls – weighting all the information according to the bookies’ assessment of credibility – the numbers are less volatile.

Already, many portfolios have been affected by the fall in the value of the pound. The currency is now at a seven-year low versus the US Dollar and the lowest since 2014 against the Euro. But, there is the potential of worse to come for the stock market if the result is for British exit. Should Brexit happen, there does seem to be agreement on the potential for a few years of weaker growth in the UK. Politics also could be in turmoil, and negotiations will take time.

Even the vagaries of the polls ahead of the vote could unsettle shares. Can investors separate out the risks from their own emotions and voting intentions? For confident investors, the weakness was a buying opportunity – it proved right to ignore the opinion polls. Domestic investors are often better placed to get this right. Typically, international investors are more fearful of being on the wrong side of a nation’s politics, and focus excessively on headlines and polls.

In the early stages, whether longer term prospects are better or not, will not be what matters for the stock market. Those who believe exit will happen are likely to be repositioning their assets more cautiously.

What even the politicians and economists do not know, is whether a British exit would trigger a crisis. British exit could be a catalyst for change within the EU itself, which is a work in progress. Currently, political union, banking union and monetary union are in their early stages. Opposition politicians in Europe’s periphery could see exit as an easier option.

For some, Europe is a straight-jacket forcing austerity, with the euro a modern-day gold standard restricting growth.

And, any break-up within the UK itself would become an internal matter for Britain rather than a direct concern for the EU. The question of Scottish independence would move from the potential to impact on an EU member, to one of considering Scotland as a new admission. While the UK is in the EU, any secession could encourage other splinter groups. The question of re-admitting Scotland would not create the same risk.

Irrespective of whether another “once-in-a-lifetime” Scottish referendum could be held, Brexit would be likely to trigger speculation on the future of the UK.

Investors need robust strategies and diversification of assets in order to avoid short -term panic. Assets overseas would be revalued in sterling terms, providing some offset in internationally diversified portfolios.

A devaluation often boosts growth and inflation, and so could improve UK growth. Many British companies – particularly the largest ones – have a broad spread of global interests. And even cash might do better, if Britain’s drift into negative deposit rates is deferred. A broadly-spread portfolio will have winners and losers.

Politicians will play on fears in the coming weeks. Investors should try to stop this disrupting their long-term strategy. In the lead-up to June 23, there will be opportunities as well as risks.

A version of this article was published in Personal Finance in The Herald on April 2nd 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.

The disappointing EU record on financial services

Could financial services take centre stage in the British referendum on EU membership? One of the UK’s strongest sectors now seems to be questioning what EU membership has delivered. A tide of legislation since the financial crisis has hit UK asset managers and banks hard. Asset managers, in particular, are not sure why. A working EU capital markets union still seems years away. Without fundamental reform in the legislative process, the City could swing to supporting Brexit.

The UK economy emphasises services, an area where EU benefits to exporters are less visible. And, for the part of the financial services sector that operates entirely domestically, EU legislation seems more about pain than gain. Investment firms find they must constantly adapt to new rules, often with insufficient timescales for consultation and implementation. Not all of this seems geared towards either protecting the consumer or improving competition.

An EU action plan on building a capital markets union by 2019 looks too late, and unconvincing. It offers a commendable wish list and talks vaguely of removing barriers. But, a recent European consultation side-stepped the big issues, such as whether EU regulation is actually capable of making use of modern technology? Submitting information on paper to each member state still seems the norm, without standardisation on format. And, where technology has been accepted, little thought seems to be given to practicality. Best execution reporting, for example, involves the collation of billions of data fields.

The European Commission has just completed collecting evidence on the EU regulatory framework for financial services. That aimed to identify unnecessary regulatory burdens and bad legislation. But, given its desire to investigate detailed evidence, improvements may take time. Prescriptive EU regulation may not sit easily with a UK principles-based regulatory approach.

The biggest challenge for the UK appears to be the proposal for a financial transaction tax (FTT). This is expected to push up costs for all users of financial markets and reduce liquidity. Few expect the tax to raise much revenue. Instead, the proposed implementation of this new tax in only a few member states seems likely to introduce distortions in the operation of capital markets across the EU. And it runs directly counter to capital markets union objectives to maximise growth and job creation. FTT looks like a gift to campaigners for Britich exit in the Referendum debate.

Some legislation is creating unforeseen consequences. Many more asset managers will soon be caught by legislation on remuneration, through the interaction of conflicting rules. This seems to work against individual risk mitigation in smaller firms. One set of legislation recognised proportionality, only for new rules to cast a wider net and remove hard-won exemptions.

Other EU legislation has hit UCITS managers. It is still hard to market UCITS across borders. One major problem is that individual states can set their own rules for the paying agent requirement. This third-party structure creates extra costs, and appears not to recognise technological developments since the original UCITS directive 30 years’ ago. It is particularly challenging for alternative investment funds such as hedge funds and investment trusts.

Reporting requirements, too, can be onerous. These are a combination of EU-level obligations and national ones. Gold-plating – additional national requirements – of performance and cost disclosures, prevent firms from developing EU-harmonised marketing materials. Some member states still insist that asset management companies file marketing documents in hard copy with national regulators, rather than permitting electronic filing. For firms with dozens of UCITS, often with many separate share classes, submitting these across 28 countries is a nightmare.

It should be possible for the EU to keep up better with the pace of change in technology and in developments in other financial markets. For example, the US makes better use of the ability to rescind outmoded rules via no-action letters. The EU could, for example, mandate the use by regulators of a standard on data such as ISO 20022, which allows fully electronic filings on a standardised basis. It is hard to see how the EU can encourage new online and mobile business models for financial services, when the existing regime involves so much paperwork.

Simply dealing in shares can be a minefield for institutional investors. Confusion is created by the threshold for the notification of major holdings set at 5%. Individual states can, and do, set different levels, such as 3%. Time periods for notifications and penalties also vary widely. Obligations and fines can arise even where voting rights have changed simply because a company has reduced its issued share capital, forcing a passive and minimal crossing of a notification threshold.

Will the next few months see the European Securities and Markets Authority (ESMA) recognise its contribution to the Brexit debate? The MiFID II delay – with apparent friction between ESMA and the European Parliament committee, ECON – is not a good advert for the EU regulatory process. Financial services may be intangible, and therefore not the stuff of headlines, but it is a big sector for the UK.

Part of the problem may be the way the European Commission develops legislation. More time should be made for consultation, and there is a need for practical implementation deadlines. The various Commission services could be more closely co-ordinated. And, although the Commission talks about “better regulation” it needs to look more carefully at the impact of new legislation. The Commission’s preference for lifting old definitions into new legislation can have unintended consequences. It could even take action against states that are creating additional or even illegal burdens on participants. The time and cost of recovery of the withholding taxes can be a real deterrent to cross border investment by funds.

The challenge to European regulators is co-ordination, practicality, proportionality and use of technology. Getting this right could help to keep Britain in the EU. But, the bigger prize for Europe could be finally improving the flow of savings to boost economic growth.

A version of this article was published as an Op-Ed in Financial News on February 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. 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
.

Image credit; Creative Commons, some rights reserved.

Mixed signals for 2016; deflation still the global risk

Investors enter 2016 divided on outlook: economic signals are mixed. The global economy is out of sync; with growth in the UK and US, but a slowdown in the developing world. How should investors position for the year ahead?

Investors who were under-weight in oil, mining and industrials in 2015 might be forgiven for feeling smug as they enter the new year. Away from the index heavyweights – which typically capture more of the global problems – there has been good progress over the last 12 months. UK medium-sized companies, in particular, have delivered some strong performances.

Many once believed that demand for metals would grow for decades to come. But faith in the commodity supercycle has finally been shattered. The new hope is that 2016 might bring some supply cuts in copper, iron ore and oil, to help pricing. Yet, the state of the Chinese economy is far from clear, with limited scope to borrow to build more unproductive infrastructure. The global economy is still growing, but also de-industrialising. Global trade in manufactured goods is weak, and even in the UK, growth is almost entirely based on services.

The US economy leads the rest of the world currently. But in the US stockmarket, the re-rating of online businesses such as Facebook, Amazon, Netflix and Alphabet (Google) has disguised weak performance elsewhere. In 2015 to date, the 10 largest US listed companies have had share price gains; the average of the next 490 has been negative. The major US consumer technology businesses are not only grabbing a bigger share of investor interest, but are disrupting conventional businesses and tax revenues around the world. Investors must think harder in the year ahead about changing business models. There is real uncertainty about the future of some major businesses and brands.

Investors who had faith in the Eurozone recovery – refusing to be unsettled by Greece – have had a good year. The Euro represents a straightjacket for the Eurozone that limits policy options. The currency will break if Germany does not reflate. Fortunately, the latest data shows signs that this process is now underway.

Globally, the disinflationary pattern seems likely to persist. It is triggered by weak productivity growth, resulting from a lack of opportunity for productive investment around the world. There is no sign that capital goods demand is suddenly going to pick-up, making it likely that the global pattern of anaemic growth and low inflation will continue. Investors should focus on shares of businesses with genuine underlying growth and some potential for self-help.

Emerging market currencies remain weak, with the US Dollar moving near 13 year highs. US Dollar strength is linked to the issues of whether inflation will return, and if emerging economies will face credit problems. With low oil and commodity prices, growth in the supply of Dollars globally has slowed. This impacts emerging market borrowing, which has in the past been helped by an easy supply of cheap Dollars. Rising US interest rates may exacerbate global disinflation.

Despite the Bank of England talking of a rate rise, there is little sign that UK inflation is progressing towards its 2% target. There are some hot spots in the British economy such as buy-to-let properties, but overall insufficient to merit Bank intervention in the near future. Returns on cash deposits and bonds are likely to remain very low, increasing the attraction of equities that offer growth and growing dividends. Defensive sectors such as healthcare and tobacco, could find a bigger role in portfolios – particularly if there are dividend cuts in cyclical sectors. The UK market may also get a boost from bids and mergers in the coming year.

Investors are nervous, and underestimate the determination of politicians to stimulate growth, resolve international frictions and stabilise the global economy. Investors should structure their assets to ensure that headlines and short term anxiety do not trigger panic. Upside could come from good use of policy tools in Europe, combined with continued US growth. The boost to global stockmarkets from supportive central bank policies could have much further to run.
A version of this article was published in Personal Finance in The Herald on January 2 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, SVM clients had holdings in Alphabet (Google).
Image credit: Some rights reserved. Published on behavioural-investing.org January 4 2016

3 key psychological challenges for investors

What are the main challenges to achieving good long term returns? Investors focus mainly on what the stockmarket might do; less so on their own behaviour. Some of the human behaviour that confers advantage in everyday life can drive poor investment decisions. The big challenges include; how we search for patterns and trends, the desire to conform to social norms, and how we value the future.

The two main patterns behind poor decisions can be categorised as emotional biases and analysis errors. But these are often entwined, and emotion can even be part of very useful “gut feelings”. Fortunately, behavioural finance accepts the role of emotion in decision-making and does not simply demand that people just think harder. It offers some simple rules that can guide good investment practice.

One challenge stems from the natural human bias to see patterns in everything. It is a trait that typically gets worse as people age and they build up more experience. But, it is a shortcut that does not always work – sometimes patterns are perceived where none exist. Even where an underlying process is random, humans are naturally drawn to imposing order. We create stories and linkages that reassure us we can interpret events. It can encourage investors to jump aboard trends, and buy into shares too late. It is closely linked to the belief that we can understand complex matters by over-simplifying. That may give the illusion of controlling events that are actually more random than we think. Having an investment checklist or other analysis discipline can help to reduce the emotional appeal of patterns.

A recent survey of investment professionals highlighted social conformity – following the herd – as the biggest challenge. May professionals work in teams, which helps to explain this concern. This behaviour is often seen in committees or other small groups, where agreement is the easy option. But, what other people do can sometimes be a good guide when we do not understand what is going on. We tend to do this more when economic or company information seems to be changing rapidly, as in 2008. It can be a good guide in life – for example, picking the brand that gets most votes online, when they otherwise all seem the same.

But, that drive for conformity can make us slow to reappraise information, to think originally or even to take sufficient portfolio risk. Crowds can give false comfort. Investors should set rules on what might drive any change in their investments. It is important to clearly understand why an investment is held, and not be swayed by headlines. Similarly, jargon that often describes big companies or their chief executives may add little to investment judgement. How often do analysts tell us that a CEO is respected, the company is quality, and they have conviction in the share as a long term core holding based on fundamental analysis. It sounds good, but investors need to dig deeper.

There is also growing evidence that investors struggle to balance short and long term decisions. While we rely on the benefits of long term compounding of returns, it can be hard to evaluate what that really means in future. The short term wisdom of saving, or keeping costs and portfolio changes to a minimum, may not be recognised, because the results appear so far in the future. The real value of gaining big long term results from small decisions today is as much of a challenge in investing, as it is with diet and exercise.

Behavioural finance is changing the way that investment professionals think about their daily work. More financial advisers and wealth managers are now incorporating psychology into their advice. A good starting point is an investment plan that reduces stress, helping to avoid panic amidst stockmarket turmoil. And all investors should review their past investment decisions.

A version of this article was published in Personal Finance in The Herald on November 7 2015.

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: Creative Commons Some rights reserved.

PwC Survey shows slow progress on UK executive pay and bonuses.

The latest PwC survey on executive pay and rewards in the FTSE 100 is presented as an improving trend. Yet it is remarkable that just 36% make full disclosure of bonus benchmarks. There is little sign of realism in incentives; many rewards remain detached from sustainable value creation. Too many do not disclose numbers to evidence the payouts, typical claiming “commercial sensitivity”. Others rely on a single target indicator. Some of high profile FTSE problem companies such as Tesco and Glencore have shown just how well paid strategic failure can be. In many companies, rewards remain focused on the short term, with opaque metrics. There is little sign that boards are willing to build in the potential for claw backs of bonus that subsequent events call into question. Change is slow; shareholders and boards need to raise their game.

Despite the potential now for shareholders to register dissent, only the largest institutional investors can hope to have any impact on the remuneration setting process itself. The problem may even be the composition of boards; it seems too many non-executive directors come themselves from a culture of high pay. The Department for Business Innovation and Skills (DBIS) consultation in September 2011 aimed to establish a “clear line of sight” between the levels and structure of remuneration and directors’ performance in meeting strategic objectives. But targets are often opaque, irrelevant or too short term. Goalposts shift, as companies redefine earnings per share or return on invested capital. The volatility in year to year rewards points to short-termism. In FTSE 100 companies, three year vesting periods remain the most common and there is little sign of real long-term alignment with the timescale on which strategy might succeed or fail.

The new binding votes on company pay policies every three years have not had a major impact on pay practices. Indeed shareholder activist seems to have waned since 2012. Why is progress so slow? It seems that the response to each new wave of pressure on boards and management is to employ external consultants. This facilitates engagement with the biggest shareholders and ensures a process. But the end result is lengthy remuneration reports, often fudging what actually has been paid and whether targets have actually been hit. Much still looks like an option on stockmarket progress, or even just an incentive to talk up the shares. Many of the bonus metrics are changed so often, it is unsurprising that pay has uncoupled from longer term corporate performance.

Chief executives can collect for behaviour that might be assumed to be in base pay, such as “engagement with colleagues”. Many of the incentives that feature in remuneration reports look like they should be simply part of what an effective CEO should do to keep his or her job.

The CEO bonus culture contrasts with lower pay grades; many mid-managers and other employees are expected to perform primarily for base pay, and progress in that. Indeed, academic research points to the limits of motivation by extrinsic financial reward. It can even be counter-productive in areas where quality or ethics really matter. Some incentive arrangements appear so complex that the consultants and executives involved must have diverted a great deal of time and effort in design and negotiation.

Surprisingly, despite the importance of effective pay design, remarkably little independent research has been conducted. Measures are simply plucked out of the air with little hard evidence that they work over the longer term. Despite this, EPS and TSR still remain common, and the measurement and retention periods are relatively short. Companies still hide behind their consultants and claims of commercial confidentiality. Boards should be required to say exactly what they expect an incentive to deliver.

Many large company boards seem unable to challenge these trends, fearful they will lose a star CEO. Would UK business really be hampered in global competition by making a change in setting pay? Strategic failure in some of Britain’s biggest companies seems related more to the structure of pay and the wrong metrics, rather than the total sums. Surely the best executives would still be attracted by a package that paid for what they could really influence. What is missing is an evidence-based understanding of the role of executive bonuses in long term corporate success. A more radical review of bonus structures is now needed.


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.

Image credit; Wiki, rights reserved.

Why are commodities over-represented in indices?

Do investors have an outdate view of commodities? Far from helping to diversify portfolios, or representing a tangible way to benefit from economic growth, commodities have become volatile financial plays. A misguided view of the nature of these assets has resulted in them being over-represented in indices. Indeed, many passive investors may be surprised to find how much commodities matter for their portfolios.

With the recent collapse in the shares of many mining companies, investment reports for the third quarter may not be happy reading for many. Far from offering protection against weak stockmarkets, metals and mining businesses now seem at the core of stockmarket problems. How should investors view this sector?

The appeal of physical commodities is in their seeming permanence and core role. Copper, iron and other metals have been used for millennia, with steadily rising use. Expected growth in China and emerging economies seemed to promise even greater demand. And, for many years the commodities cycle did behave differently than stockmarkets. This was the basis for some of the portfolio diversification claims. Commodities were promoted as an element of stability for long term planning by investors; an asset class that deserved a place in portfolios. How different is today’s reality.

As with most good things, extremes set in. Advocates for commodities grew firm in their belief in a commodities super-cycle that would last for decades. Investment banks and other financial vehicles entered commodity trading and production, with borrowing becoming a bigger part of mining finance. This boosted production of key metals, such as copper. Mega-mergers between mining giants, and huge new projects, became commonplace. The result has been a sector that now behaves more like the banking sector.

The mining sector created wealth not just by extracting and refining, but by trading, stockpiling and even lending metals to secure bank loans. As mining moved from its roots, its fortune became more closely intertwined with banking. Recent stockmarket behaviour points to the close links between the sectors.

Many investors might be uninterested in this, were it not for the disproportionate representation of mining businesses in the London stockmarket. This feeds in to indices and index funds, such as Exchange Traded Funds, that are based on these averages. And, given how closely many conventional actively-managed funds follow indices, the impact on most institutional and private portfolios has been significant.

This use of indices to guide risk assessment is encouraged by regulation, but in this case has not helped investors. Twelve months ago, the most broadly based index of UK shares, the FTSE All-Share Index, had 15% in oil and oil-related businesses, with 11% in mining. That weighting distorted perceptions of risk, and bore little relation to wealth creation in the British economy. Investors need a real-world understanding of risk, rather than simply relying on indices.

Added to the challenge of mining and energy, has been weakness in many “soft commodities” such as foods. Prices of coffee, orange juice and sugar in world markets have collapsed. All this builds a picture of deflation globally, rather than the inflation that central bankers seem to fear. Rising interest rates seem a long time away, despite the continued warnings of the Governor of the Bank of England.

It is the emerging economies that typically are the losers from this, with many nations having little except commodities to export. While the US Dollar itself has strengthened, making Dollar prices for goods worth more in local currency, it threatens a crisis in the developing world. It is not just miners that have borrowed at little cost in recent years, but many businesses in emerging economies have been helped by previously-cheap Dollars. That boost has ended, and re-payment of this debt could now prove difficult.

Turmoil in the commodity sector will trigger problems in many banks and emerging economies. Deflationary pressures are likely to persist, delaying a rise in US or UK interest rates. Instead, Europe and China are likely to stimulate further. It is clear that not even the mining giants or their bankers, are good forecasters of commodity or energy prices. Nor is it something that investors should attempt. Instead, investors should consider how their portfolios are positioned for this deflationary world, and reflect on whether commodities balance risk or increase it.

A version of this article was published in Personal Finance in The Herald on October 10 2015.

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: Lars Lentz ; licensed under the Creative Commons Attribution-Share Alike 1.0 Generic license. Some rights reserved.

Why was Volkswagen in ESG and Sustainable Investing Funds?

Responsible investing must come clean about Volkswagen. Too many funds rated it highly on Environmental, Social and Governance (ESG). Collateral damage will run well beyond the car sector. Already, the scandal has tarnished the brands of Volkswagen and Germany, with their reputations for trust and engineering excellence. But it is not just about mis-selling cars. Investors should be asking questions too.

The focus should now be on Environmental, Social and Governance Investing (ESG), along with funds and index products that use these criteria.

Volkswagen was rated as one of the best ESG companies, included in key products that claim to offer investors portfolios of the best-behaved companies. Now confidence has been shaken in the notion that being a “good” company must mean an outperforming investment. Terms like “responsible investing” and “sustainable” may need to be re-defined.

Can ESG even be measured accurately? There is a danger of relying on company reports that can be self-serving or misrepresent. The desire to promote ESG has run well ahead of the investment industry’s ability to measure it. The Volkswagen scandal should drive an opportunity for the ESG movement to reassess its claims and improve its practices. It is a broad church that now needs to get more specific, particularly on governance.

ESG is meant to deliver long-term investment benefits, as well as improving society. The claims go beyond simply making asset owners feel good. The spin suggests that companies scoring well on ESG face less strategic risk, and should perform better. The appeal is not to investors’ altruism, but their pockets.

There is now a lot of money backing ESG as the future of investment. Not only have indices and ETFs been set up that buy only these “good companies” and package them for investors. Increasingly many conventional active investors are trying to integrate the concept within their investment analysis and decision-making. A recent CFA Institute survey of investment professionals worldwide showed that 73% of them take ESG into account in their investment analysis and decisions. But the same poll highlights the need for third-party verification, given the dangers of relying on company reporting and promises.

The movement is entering the mainstream with more research now being done to create a robust methodology. Academic evidence to date is mixed, although studies may not fairly capture the long timescale in which ESG might make its biggest impact. There is an understandable lack of detailed historic data, as some of the concepts are new.

Recently advocates have claimed evidence that there is some relationship of shorter-term performance to the direction of improvement in ESG. But for something that is argued so strongly, it is surprising that the evidence is not overwhelmingly in favour.

Perhaps it is a concept that many investors simply want to believe in. It seems beyond debate the companies should be sustainable and everyone should invest responsibly. It seems growth in ESG has been based largely on the argument of what should be, rather than hard historic evidence. But the role each factor plays in the ESG case is complex.

The simplicity of just three letters is persuasive, but we may not yet have found how to identify the companies that in the long term do the most social good. Getting the right measures for ESG matters.

Simply scoring companies on a box-ticking exercise for diversity, disclosure and environmental impact may not get to the root of the problem. It is too easy for the companies that make the most noise about caring for the environment to get favourable treatment. Volkswagen’s annual report stated its intention to become the global economic and environmental leader in cars, and talked of its focus on setting new ecological standards.

The biggest companies are typically more skilled at the sort of expensive reporting that scores on ESG, but they may actually have the greater risk. Volkswagen is not the only major company where rhetoric has run ahead of reality.

Volkswagen scored in ESG as the cheerleader for environmentally-conscious car owners. Yet its undemocratic voting structure seemed not to penalise it. Four controlling groups have over 70% of the votes, yet own less than half the equity. Effectively, the free-float of 37% was entitled to less than 10% of the votes. That looks like a recipe for an unquestioning and complacent board.

Worryingly, the concept of favourable voting rights for longer term investors appears a core belief of those who seek better company stewardship, and could be enshrined in EU legislation. The EU’s Shareholder Rights Directive may reward long-term shareholders with additional voting rights or other enhanced benefits. When opinion on what constitutes good governance is divided, how can stewardship be rated? Disproportionate voting rights might either reward long-term holders, or just lead to cosy long-term relationships. Which of these is more likely matters a lot for implementing ESG.

Governance may prove to be the key to getting other sustainability factors right. Shareholders need bold sceptics in the boardroom. Those directors can ask questions and drive change in a way that is not possible for shareholders. Repeatedly, lack of accountability of boards has been linked to nasty surprises. The Co-Op, Tesco and Glencore are just perhaps the highest profile examples of this.

Volkswagen and other recent scandals should be a warning bell for sustainable investing. To be truly effective, hard evidence is needed to relate scoring on good governance with real world results. And much better verification is needed of company ESG claims. ESG has arrived in the mainstream. But it must now explain how it will prevent the Volkswagens of the future from gate-crashing ESG funds and indices.

A version of this article was published as a Financial News Op-Ed on October 5th 2015.

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.

Image credit;Volkswagen, fair use, all rights reserved.

Investors love stories, but no happy ending for Emerging Markets

Investors love a good story, but the latest chapter of the emerging markets growth story has come as a nasty surprise to many. There may be much worse to come. Narratives can help to make sense of facts and figures. Stories can convey meaning, by joining up often unrelated information, and they offer hope. But not all stories have happy endings.

Narratives have intrinsic appeal, and are told by companies to their shareholders, by investors to clients and even politicians to voters. People want to believe. Growth always sounds good, and the concept of lifting poorer parts of the globe into better living standards seems like impact investing. Advocates of BRICS and emerging markets talk much more of belief, and a brighter future, than they do hard numbers. Their faith is not so easily unsettled by mere facts.

Unfortunately, studies suggest there is little link between stockmarket returns and economic growth – at least not any relationship of investment value. Psychology comes into play, where the representativeness bias encourages the belief that a growing economy must mean rising stockmarkets. Yet, even the idea that revenue gains must translate into profits growth is questionable. Developing economies are turbulent environments, with some unique risks to businesses. And that is before political instability, currencies and credit are taken into account.

Even though forecasts are fraught with uncertainty, investors could learn from history. The long term economic record in China, Argentina and India, shows that development is not a straight line exercise. Emerging economies can spend decades dropping down the rankings, often wiping out equity investors.

The record shows previous regional crises – in Asia and Latin America – but rarely a broadly-based pattern hitting all emerging economies. The current crisis has developed slowly, catching many investors unawares. No single economy is overheated, nor is there any clear external shock. A sharp fall might have jolted investors’ faith in emerging markets, and created a fresh narrative about panic and rebound. Instead, economic growth has gradually deflated, along with a slowing of world trade and a fall in commodity prices.

Were it simply a bubble being pricked – an asset overvaluation – investors might have a better understanding of where the floor lay. Instead, it is a creeping crisis of anaemic growth with no clear solution. Should BRICS defend currencies that may really be overvalued? And, does competitive devaluation offer any real solution to failures of productivity or infrastructure investment? Many of these developing nations have failed to create sustainable value-added – a problem highlighted, but not caused, by falling commodity prices.

The one continuing competitive strength that emerging markets had in common was the ability of their governments and corporates to borrow cheap US Dollars. Indeed, this has arguably been the biggest single factor driving the dream. In recent years there has been little limit to leverage and almost no cost. Now, the world is no longer awash with Dollar liquidity, and those Dollars look increasingly expensive to re-pay.

Few BRICS or emerging economies have any policy tools left in their chest. This opens up the possibility of political risk in countries as far afield as Brazil, Mexico, Turkey and South Africa. Even India, with its renewed confidence, has weak credit growth, excessive regulation and outdated infrastructure.

Investors need a new narrative on emerging markets – preferably non-fiction. Their economies have potential for future growth, but investors need to analyse the hard facts of what this means for equities. More thought must be given to politics, deregulation, productivity and realistic infrastructure investments. The emotion of wishing a rise in living standards around the world is laudable, but equity investors must combine this with objective analysis.

A version of this article was published as in the Behavioural Finance Series in Citywire on September 24 2015.

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.

Image credit; Wiki Creative Commons; some rights reserved

Tougher regulation needed for UK listed company directors

A gap has opened up in UK regulation, leaving investors exposed to Companies Act and accounting issues without a clear remedy. Despite all the focus on governance and stewardship, investors are still getting nasty surprises. Tesco and Quindell are perhaps just the highest profile of those involved in further investigations. Making the stockmarket safer should be the responsibility of boards, regulators, investors and analysts. Recent events suggest each could be doing a much better job.

Accounting and governance issues are triggering some sharp share price moves. In some cases company updates seem to question all the previous analyst forecasts and board reassurance. Others have seen share prices trashed by short selling “research”, often from online blogs. Regulation seems focused on cutting costs for investors, rather than price formation, but risks may be rising. The stockmarket does not look a safe enough place for savers and index funds that rely on share prices being right.

This year has seen many AIM stocks crash, with the light touch regulatory approach called into question. But few investors are unscathed by these overnight surprises. Some other major companies, such as Rolls Royce, have delivered continuing disappointment, with a series of profit warnings. Even where there is no suggestion of accounting fault, a share price collapse points to a failure of communication or analysis. Oil and gas explorer, Afren plc, rapidly moved into administration last month, despite previous coverage by 27 analysts and reported revenues of almost $1 billion. None seemed willing to publish a critical view when it might have helped.

The FRC Stewardship Code envisages shareholder voting and communication with the board as a key tool to resolving problems. But shareholders in Afren did tackle its chair wi. th governance concerns, only to find out the limits to stewardship. Most shareholders, with small percentage holdings, can make little impact. Selling is still the easier course.

Instead, it has been left to the much-derided short sellers and more aggressive activist investors to drive change in the worst-governed companies. But, the last 9 months have been challenging for short sellers, too, with price corrections punctuated by sharp squeezes and often misinformation. After a long rise in the market, and losses on short positions, overall short interest is now low. Yet, viewed from the perspective of less sophisticated investors and index funds, short sellers may actually make the market safer. The quicker a share price bubble is punctured, the better. There is little value for continuing investors in excessively over-valued shares or unrealistic expectations.

Unfortunately, there can be powerful incentives for troubled companies to reassure, often supported by their Nominated Adviser or broker. Primary capital raising is what drives profitability in cash equities for all but the largest companies. If business problems trigger a need to re-finance, boards and their advisers are incentivised to avoid a share price collapse. This does not support good price formation.

What is needed are strong sanctions on those offering unrealistic and superficial reassurance. The focus should be on encouraging healthy debate on share prices, not on preserving unrealistic share valuations. Regulators operate in a political world, where there are repercussions for company failure, but the regime seems too generous to boards and advisers in bad businesses. Unfortunately, the current regulatory focus is typically on those who trade around the time of sharp share falls, and not on the previous pattern of company reporting.

Technology group, Blinkx plc, has fallen almost 90% in less than 2 years, yet initially the company’s response to online criticism was largely an attack on the professionalism and motives of the blogger. It seems that some of the new analysis is actually helping the market understand prospects better, and set the right share price.

At a time of increased regulatory concern about sell-side research, and who pays for it, accounting or governance problems have often been best highlighted by independent analysts or short sellers. They are usually criticised by boards and management for inaccuracy. But for some of the problem companies the truth has been nearer the independent assessment than the board assurances trotted out to comfort shareholders. There may be a role for encouraging more independent critique. There should be more scrutiny of use of shareholder funds in litigation against analysts and critics who question a business valuation or prospects.

Belated price formation may be painful for existing shareholders, but ETFs and passive funds are often ongoing buyers of shares, whatever the rating. Investors in these funds benefit from low costs, they but in major sell-offs such as resources this year or banks in 2008, they can take on more risk than they plan.

Perhaps regulators could make it easier for bloggers to enter the mainstream, provided conflicts are disclosed. There is a case for worrying less about the price of research than its quality, and whether there is enough publicly available analysis to make markets safe.

One indication that the market has become less efficient is in the outperformance by many active managers. The Investment Association statistics on its UK All Companies sector suggests active managers are winning on average over 5 years. It seems to have become easier for them to do the job they are paid to do; finding mispriced shares. That is good news for those who can pay up for that management – provided it persists – but does suggest there are new losers from mispricing. What is healthy for the active industry may in fact be a warning signal on market quality. Buy-side analysts may not have become suddenly much better at research, but instead are benefiting from the combined effect of index fund dominance, mis-reporting and low sanctions on those involved in that.

The odds appear stacked in favour of distressed companies raising more capital at high share prices. But big share price falls point to a risky market for the average investor. The regulatory stance should be tilted back in favour of good consistent price formation.

SVM Asset Management has positions in Tesco at the time of writing.

A version of this article was published as an Op-Ed September 2015.

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.

Image credit; SFO, fair use, rights reserved.