Value Traps - open the escape hatch
by Doug Brodie
In this blog:
/1. Capital and income are not correlated
/2. Boringly predictable
/3. Inflation – what goes up must come down
/4. And while we’re here… is this a trigger?
/5. Solicitors look away now
The table above shows the 12-month income for this couple, measured from 1 February to 31 January; it’s not quite a calendar year and the underlying assets do not pay their income on calendar years – trusts have year-ends throughout the year. The jump in this income is high due to the added ISA and SIPP premiums being made, as the clients build their pots in the run up to retirement. The increase in income is created in part by the additional £118,000 invested through the year as you can see in the table below:
/1. Capital and income are not correlated
The capital return has been dire – by way of reference the FTSE was 7876 on 1st February last year and 7625 this year, so a -3.18% loss on the index. This table shows you the effect of fees as well, however importantly it demonstrates that the capital return is not correlated to the income return (the top table).
We do this every day of every month of every year, as we know that over the long term it is very consistent (with all the relevant wealth warnings of no guarantees). In this client’s case the data of their income table over the last five years looks like this:
Within these portfolios, the income is materially better than shown – 32% of the SIPPs are their company office building, and 22% of the ISAs are invested with Terry Smith (Fundsmith), who, like Warren Buffett, grows his funds by seeking dividends to be paid in and then not paying any out.
/2. Boringly predictable
The end result is then mapped out in our planning system, Voyant, and with a simple 3.5% annual income growth produces the simple data behind this chart, showing lifetime income to age 99:
/3. Inflation – what goes up must come down
You’ll remember that the spike in our inflation to 11% was caused by the increase in the cost of energy – the price of oil and gas, triggered by Putin’s war. Every three months Ofgem publishes the level at which an energy supplier can charge. Ofgem has told us that from 1st April the new cap will be £1,690 per year (yes, I know you pay more than that), so the relevant calculation is the change in price between 1 April 2023 and this year. Last year it was £3,280, however, that price was roughly a 50% increase from the beginning of 2022:
January’s cap was £1,928 and that was down 55% from January 2023’s crisis-inducing figure of £4,279. Apply these energy cost reductions across your and my residential costs, across manufacturing and logistics, and the clever bods calculate the resulting 12-month price rise to this month is 3.4% and for April 23 to April 24 will be 1.7%.
We think that’s right – whether it’s + / - 0.2/3% is not material to you or me, so the trend will then have a direct impact on the Bank of England’s rate setting, nicely summarised for us by the team at J O Hambro:
/4. And while we’re here… is this a trigger?
J O Hambro run our preferred income unit trust – we’ve badgered them for a long time to take over / set up an investment trust because that will smooth out the delivery of their income. A unit trust has to pay out all the income it receives, as it receives it, which means they do not have reserves. This in turn means that when the income they receive falls, so does their payment out and we saw this starkly in 2020 when its payment fell by 42% - ouch, not a way to live on pension income.
Specialising in UK listed equities they believe the trigger for a market re-valuation is round about here. We’ve long seen the graphs showing the valuation difference between US and UK equities, and it may be now that starts to reverse. The bods for Wincanton, Currys and Direct Line show the bidders’ faith in the UK and acceptance of those valuations.
What the table is telling us is that you can buy £1 of BP’s profits costs for nearly half the price of £1 of Exxon's profits, for every £10 of shares you get 84p income from Aviva and only 57p from Axa. More on BP, its free cashflow is equal to 15% of the current share price – that means that in c6 years it generates 100% of its whole market value – 6 years is nothing, and remember Nvidia? Its market cap is $1.9 trillion, free cashflow is $27 billion so to earn back what the whole company costs today takes 72 years.
The scenario is the same for our banks:
From an investment perspective, what makes the eyebrows rise is what we call a PE crossover – where the p/e increases ahead of the yield. Plus, if you take off the buybacks (i.e. reduce the number of shares) then the arithmetic means that for Barclays the 8p available dividend now becomes 10.24p – the earnings don’t change, however, the number of shares owning those earnings reduces (by 28%) so on a PER SHARE basis the dividend increases.
More, Legal and General is now on a p/e of 9x and a dividend yield of 9%. Phoenix, the insurer, has a payback period of just 5 years and 10 months.
/5. Solicitors look away now
We recently had someone raising (hmmm) ‘disquiet’ about a bill received from the solicitor arranging / confirming the executor on a will. No meetings, just emails, and yet the bill came to £1,809, including £127 for ‘preparation and reading’, £647 for ‘drafting’ followed by £724 for ‘letter/fax/email out’. We’re not quite sure what the difference is between drafting and writing the emails, however, seven of the emails clearly didn’t need to be drafted.
We only levy a charge on money coming into us (unless a client wants a one-off report). Making end of career financial decisions – lifetime savings – takes time, consideration and then more time. We don’t chase clients, we don’t rush people, as much time as needed for client understanding, consideration and reassurance. Martin, our senior client manager, was handling an application for an older client this week and I had a check back on the document register – this is what the front folder looks like for this client in our server (there are three other background information folders for this client):
The oldest document here is a spreadsheet running tax calculations for the client, you’ll see it’s dated 2022. She has not been billed a red cent over the last eighteen months, she calls and emails when necessary, we research 5 days per week and all that cost is wrapped up into the ad valorem fee. Cost is what is charged, value is what is received, and over the years clients have always preferred not to receive task-billing invoices.