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Alan Miller: Is there light at the end of the investment tunnel?

28th Jun 12 8:43 am

Fear grips the markets but there are reasons to be optimistic, says investment legend Alan Miller

Many investors are nervous at the moment and they have every right to be. Headlines such as Euro Currency Could Collapse and Trigger another Great Depression in the Daily Mail or The Death of Equities? in the Financial Times, do not help. In my view, it best to use the wise advice of two seasoned investment sages, Mr Buffett and Mr Rumsfeld. Mr Buffett advised investors (in 2004) “to be fearful when others are greedy and greedy when others are fearful”, i.e be contrarian and buy when everyone else is desperate to sell.

Mr Rumsfeld said that “There are known knowns…But there are also unknown unknowns. There are things we don’t know we don’t know”, i.e. concentrate on what you do know.

The truth behind the headlines

I would say investors are fearful and in many ways they are justified as the last few years post-credit crunch and financial system bailout have stress-tested and broken financial systems more than at almost any other time in the past century. Unprecedented levels of liquidity combined with low interest rates have been injected into the system and even though financial Armageddon has been avoided, it has not produced much growth. This may be connected with the simultaneous decision in many countries to produce savage austerity measures and insisting on higher bank reserves thereby restricting lending at precisely the wrong time. Two very good fear indicators (and to my mind good contrarian indicators) are:

  1. The latest June Bank of America Merrill Lynch survey of fund managers finding that average cash balances are at their highest level since the depth of the credit crisis in January 2009.

  2. The recent fall in yield on 2 year German bonds fell below zero indicating that those lending the German government would actually be prepared to do this for less than nothing.

What do we know?

We know the valuations in terms of old fashioned fundamentals, for example, price/earnings ratios, dividends and cash flows etc for major markets and how these compare with history. For example, the FTSE 100 is rated on just 10x these years’ earnings with a yield of 4.3 per cent. This is low by historical standards – the last 10 years have witnessed underlying earnings and dividends growing strongly whilst prices have changed little – i.e, you now own more for less.

Therefore even if you assume no dividend growth whatsoever over the next five years, you would earn 23 per cent in compounded dividends alone – add on just 3 per cent per annum profits growth and no change in valuation, and investors can earn a further 16 per cent in capital, i.e a total return of 39 per cent. Of course you might prefer the ‘safe’ home of UK government bonds – currently the average 5 year UK bond yield is about 0.7 per cent a year, i.e. over 5 years a return of 3.5 per cent.

This is good in theory but there are two fundamental problems. Firstly, are you actually investing in the average equity or fund. And secondly, how much are the costs associated with investing taking away from this return? In my view, lower growth is likely to produce more individual company ‘shocks’: who expected Tesco to fall so dramatically in one day? Investors need to try to insulate and isolate such shocks and be as well diversified as possible. This does not remove fully the ‘unknown unknowns’ but can mitigate the losses from such events e.g. the Japanese nuclear meltdown last year.

The other issue is costs. Recent research by the academics Elroy Dimson, Paul Marsh and Mike Staunton estimated that the real return on equities going forward was likely to be 3 to 3.5 per cent a year. If you pay high costs and fees, say 2 to 3 per cent (or more) a year, and inflation is running at around 2 per cent, what is the point of investing? This is why the investment industry dinosaurs are so reluctant to be honest, as the true and cost and under-performance may put many investors off; for some this is absolutely the right decision.

In my view we are in uncertain times, but there are investment opportunities if you choose to invest in a disciplined, diversified and cost-efficient manner, investors can actually benefit from the “fearful” and worry less about the “unknown unknowns”.

Alan Miller is the Chief Investment Officer and founder of SCM Private. He was the founding shareholder and Chief Investment Officer of New Star Asset Management 2001 to 2007.

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