Stats and facts
How to get rich slowly and avoid the puddles
by Doug Brodie
I'm leaving this question in for you - it's rhetorical, but it is very important in setting the right frame of mind for income investing.
A quick question to ponder on: are you more anxious about what your income will be in the next 12 months, or in 10 years time?
No better visual lesson about the pitfalls in trying to time the market.
The market’s off, you’ve got cash waiting to be phased in, you suspend the phase; we wonder if the investor is waiting for the shares to become more expensive before continuing the phase?
I have a client we’ll call Oz – we run his SIPP and he runs his ISA on a well known direct platform (owned by two people who have both made more than £2 billion from it). Over the past few years Oz was very proud of pointing out how hugely successful his ISA was being invested in Scottish Mortgage. I was responsible for client money across the dotcom boom so I am exceedingly sceptical about vertical rises in the shares of tech co’s that are cashflow negative.
If I had been twenty years younger I would probably have capitulated to Oz, but not now, and we offer all our clients our experience from those times. Sure enough, we haven’t heard from Oz for a while. Timing the market for investing returns depends on two decisions being right – when to buy and when to sell.
This is Scottish Mortgage for the last two years, when would you have sold? Most retail investors don’t, they hold on like moths stuck to a lightbulb, glued by irrational optimism. Baillie Gifford – the manager of Scottish Mortgage - bailed out of Tesla in 20/21; those who piled into the trust on the back of its 2019 gains have not made a single sou. (apart from dividends – Ed.)
Why this market is falling
The average interest rate in your adult lifetime has been around 7%, the average for the last 100 years was around 4%, so when the BoE cut rates to (virtually) nil, it became very simple to borrow money to gear up. Buy to let took off, so did borrowing money for structured investment (cost of borrowing next to nil, average equity returns 7% per annum).
What’s just happened is the cost of borrowing has (very) suddenly leapt, meaning the capital value of gilts and fixed interest has crashed (another thing we’ve been warning about for years). This means those who borrowed money secured on (say) gilts, have now had a margin call – ie the value of the gilt collateral is not enough to cover the cost of the money they borrowed. That means they need to find cash to give back to the bank, so they have to sell any investments they can to raise cash. So the markets get trashed because institutional investors are raising cash, final salary pension schemes being included. This market fall is showing us who’s been swimming naked.
This raise in rates … creating a bond sell off … creating a further sell off to repay borrowings that were drawn to invest in the first place …. coincided with excessive valuations in US stocks, and then an unfunded, 'sixth form economics class – style' mini budget from an untried government promising nothing other than higher debt.
They don't teach this in school, and they really should.
When the BoE raises rates, all other interest bearing assets adjust their yields to stay (roughly) in line with the Bank. After all, if the BoE is the safest depositary of all, no one will accept a lower yield from any other asset, which is necessarily more risky.
That means that if the Bank increases its rates by 1%, then assets which are already issued have to match that increase in yield as well. As they are (almost) always 'Fixed Interest' the only way to increase the yield is to reduce the price of the asset - that means if you own it already, the price falls.
Worse still ... if your asset has a multi year return via income, all those future years of income also have to increase, so your investment price has to be reduced to do that; the future income yields in this sum are known as the discount rate (ie 'discounting' the value of future income not yet received), and this is what is happening right now to assets valued this way. (This is not a technical description so please don't email me!).
This example is of what has happened to infrastructure trusts in falling in line with the new raised interest rates:
It is very important to note: the income from these trusts has not changed, the annual income remains the same, all that has happened is that each £1 received is now deemed to worth less per share than before - the income can't fall, so the share price falls. In this way the yield from each trust remains in line with the new, increased BoE base rate.
It means that £1 of income is now cheaper to buy than it was three months ago, and that's good for income investors.
Supermarket Income REIT
This is a listed trust that does just one thing: it owns the buildings that our major supermarkets run their business from, the physical stores and fulfilment centres, covering both physical and online shopping. It's clients are Tesco, M&S, Sainsbury's, Aldi, Morrisons, Asda etc.
Its last twelve months dividend totals 5.955p, its share price today is £1.035, meaning a (historical) yield of 5.75%.
In June it's price was £1.33 so that same 5.955p dividend was a yield of 4.48%
That's why this is a buying opportunity for the right investor with the right objective - we don't think the trust's income is at risk, we can see quite clearly that the share price has been clobbered by an amendment to the discount rate calculation.
(I might add though, the above is not a simple 'all you need to know so fill your boots' - that would be how execution only retail investors can come severely unstuck (Woodford anyone?) - an investor also has to take into account that £309m of its £793m borrowings are due for renewal next year, clearly at a higher rate than previously costed in.)
That’s why the markets have tanked. Plus, history tells us that on average it happens every eight years or so, so its quite important not to follow a market-dependent strategy for retirement income if you want your third age to be stress free, and worrying is not a hobby you want to follow. Volatility is (pretty much) guaranteed to happen, investors decide if they want to participate, it’s easy to avoid it. It's your choice.
If you don’t want to get eaten by the market, just stand back from the edge.
How to treat this falling market
Where to find a financial umbrella
Since you’ve been able to read newspapers, the market collapsed in 1974 (oil), 1987 (US crash and the hurricane), 2001 (dotcom), 2008 (bankers getting exposed) and 2020 (covid-19). In every case the market bottomed, turned round, and returned back to where it started and back into profit.
This time is no different. We have commented for the last several years of the extreme share prices in US FAANGs - an area we don’t support because it doesn’t produce income (yet), and low and behold, the old economists’ adage of ‘reversion to mean’ is now doing precisely that. This is good news. This means that the embedded understanding of the cyclical nature of markets is correct. If the markets didn’t do this, that is when to be fearful because then we don’t recognise what is happening.
Income and capital are not correlated
(this is not an optical illusion)
Our investment strategy was defined in 2007-08 in the midst of the economic disaster created by those running the banking industry (under the *cough* watchful eye of the FSA). It is specifically designed to protect you, our clients, income-dependent investors, from the vagaries of market volatility.
It is not rocket science: we don’t use covered calls, margin trades, paired currencies, barbells, put/call spreads or any other synthetic items manufactured by the banking industry; we simply looked at fifty years of financial records to calculate if there was indeed any reliable income in investments. There is, and we refer to it as the Russian space pencil method of investing.
If you follow the unresearched commentary of total return and low cost investing strategies you are right to panic now. Your income is being cut – if you sell more of your investments now you have less available when prices recover. Don't get us wrong, we are fans of Vanguard, we run millions of GBP in their funds, but they are not a good solution for retirement income. In the current year its low cost UK tracker has fallen in five of the nine months so far, and it is down -7% in total. If an investor takes 4% income from this fund by selling capital, then the loss is -11%, and that requires a return of 12.4% in the next three months just to get back to where he/she was in January. That is no way to create a stress-free retirement.
Yes, I’ll repeat it again, income is not correlated to capital movements, and dividend income from the ‘mom and pop’ trusts we use has not fallen. That’s the whole point.
Your car will depreciate each year more than the cost of a 1974 Morris Marina but that cost doesn’t matter to you – it’s the value you need, cost being only one factor of value. (Plus of 807,000 Marina’s produced only 120 remain on UK roads). The depreciation of your car is good value for your purposes.
Institutional funds, designed to run £100’s of millions of pounds/dollars/euros for decades past your lifespan, need to take simple exposure to the markets so Vanguard type funds and ETFs are designed for them, not for you and me. And for them, slivers of cost is an issue as they have their own administrators etc, unlike retail investors.
Trust dividend income is paid from revenue reserves the trust has accrued over decades, and is further underwritten by billions more in capital reserves; the income in our simple portfolios did not fall in the covid crash or the credit crunch or dotcom era .. or.. or...which is why we do this.
If you look at your pension portfolio when the market has fallen, such as now, it will show you that your valuation has fallen, so unless you’re a fan of self-flagellation its best not to keep checking. When you see a fall in value you have two options: a) sell and crystallise a loss, or b) do nothing. Your income will only change if you do ‘a’, you will develop deep anxiety, you will worry about your future retirement and you won’t sleep. We know this because we’ve seen individuals do just that in past crises, all for emotional, irrational reasons that have ended up creating deep, deep anxieties and embedded worries. Don’t follow ‘a’ – remember, reduced share prices are a buying opportunity, you only sell if you don’t have the money to meet a margin call.
The difference between price and value:
A year ago one share in Murray Income trust cost £8.18 and the prior year dividend was 34.5p
Today one share costs £7.18 and the prior year dividend was 36p.
It is now 12% cheaper to buy that 34.5p Murray Income dividend than it was a year ago.
Doug
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