Thoughts ahead of ISA investment

Wednesday, 5th April 2017 15:17 - by David Harbage

On Thursday we move into a new tax year, which brings the opportunity for qualifying individuals – that is: UK residents of 16 or over for a cash ISA and 18 or over for a stocks & shares or innovative finance ISA - to invest up to £20,000 into the 2017/18 Individual Savings Account (ISA).

Savers will be searching through the ‘Best Buy’ tables of cash interest rates, investors will be racking their brains for new stock exchange investment ideas and many will be trying to decide if their allocation of assets between cash and equity should be finessed via the new ISA allowance. A return of 1% represents the best cash rate on offer for immediate access, and a little more can be procured by ‘locking’ monies away for longer – but ‘mind your eye’, as we say in the market, because many of the advertised cash accounts are not authorised firms and so covered by the UK’s Financial Services Compensation Scheme. As a blog focused on the longer term potential of company shares or collective funds, we will look beyond the cash ISA which currently produces a negative real return – after taking account of domestic inflation – and so erodes true purchasing power.

Amongst the questions posed by potential investors in the stock market, and company shares in particular, the “Is now a good time to buy?” one probably occurs most frequently. The financial advisor may well reply with a whimsical, ”I’d by sunning myself on a Caribbean beach if I knew what share prices were going to do (tomorrow, next week, next month or next year)”, alongside an encouragement to look ever further into an uncertain future. Certainly, in endeavouring to make a judgement, one should take advice as well build up confidence by reading widely in order to make more informed decisions that the investor – rather than any advisor – can ‘own’ for themselves. Try not to be fixated on any one aspect and look at both the ‘pros and cons’ of any argument.

Having said that, a few thoughts on the subject of timing investment into the market, as readers might be considering the commitment of new or additional monies to equity investment:

1. An illustration of the FTSE100 index level would suggest that the UK stock market is towards its peak – and therefore expensive – with an increased likelihood of falling back. However, fund managers will compare share prices to profits or asset backing to determine if company stocks are overvalued by contrast with historical standards.

2. In addition to such a ‘backward looking metric, a view should be taken on whether future earnings are growing, falling or set to be static over the next few years. This will be based on both a ‘top down’ perspective on global or local economic growth, as well as the outlook for a particular business or sector of industry.

3. Beyond profits, the prospective investor will want to consider the most obvious alternatives (like overnight cash and government bonds) for investment in terms of what they are likely to offer. More difficult still, the investor should have a view on any potential geo-political shock or dislocation to the financial economic system (such as Brexit).    

As regular readers of this blog will know, the UK equity market does not appear expensive (based on its price-to-earnings ratio) as compared, for instance, to the last day of the previous millennium. On 31 December 1999, when the FTSE100 index closed at 6,930 the PE multiple (at over 30 times’ prevailing pre-tax profits) was twice as high as today’s market. The fact that the index constituents have changed dramatically, (half of the 100 listed companies have disappeared, via take-overs or relegation) is a sideshow: with the index being only 5% or so higher, and earnings having risen by more than 100% over the 17 years since, it can be seen that the current UK equity market is much more sensibly priced today.

Putting figures on the above, the technology-media-telecom (known then as the TMT, internet-enabled) boom of the late 1990s - featuring many large, but unprofitable, businesses – resulted in the FTSE100 index boasting an earnings yield of 3% (essentially the inverse of a PE ratio of 33x) and a dividend yield of less than 2%. By contrast, Bank or base rate was 5.75% at the end of 1999 (and set to go to 6% in February 2000), while domestic inflation was 1.5%. Looking at analysts’ predictions for profits in the current year, the FTSE100 index offers an earnings yield of 6.6% (the PE ratio is forecast to be 15x) and a dividend yield of 4%, while base rate is at an all-time low of 0.25% and the latest inflation data showed a pickup in CPI to 2.3%.

Financial markets are often described as a barometer, rather than a thermometer, in that they are indicative of future – as opposed to reflecting current – climate. It could be argued that today’s known unknowns (as opposed to ‘black swan’ unknown unknowns) insofar as geo-political and economic matters are rather obvious: a new and rather unpredictable President in the United States and the terms of the UK’s exit from the European Union respectively. Looking at the economic landscape in particular, the stock market’s focus on future earnings can readily be seen when trading results – irrespective of how good or poor the actual numbers - disappoint or exceed expectations. Leaving aside any particular news be it a company-specific event, a major political surprise or natural disaster, there is also the economic cycle to consider. While the pace and magnitude of economic activity (typically measured by GDP which is the total worth of a country’s products & services) may vary – as cycles range from boom to bust – UK equity performance will usually reflect the next stage of the cycle, rather than current experience.  

An illustration that I have used to demonstrate this counter intuitive nature of markets is the following circle:

The top or upper quartile of the diagram – think of it as being between 11 and 1 on a clock perhaps - represents the strongest part of an economic cycle. The bottom quartile (5 through to 7 on a clock) is the weakest part of the cycle, which could be a time when an economy is exhibiting negative growth or recession. The segment between 2 and 4 represents slowdown and the final section between 8 and 10 marks a pick-up or the recovery phase of the cycle. The average person might expect company shares to perform best at the top of the cycle (when news will typically be most positive) and worst at the bottom.

However, looking at the returns produced by UK company shares (by reference to the FTSE All Share index, from 1945 to 2015) in the different segments of each domestic economic cycle over those 70 years, the opposite applies. The best total (dividend income plus capital movement) returns – averaging more than 12% per annum - were produced at the bottom of the cycle (when economic activity was lowest, but not necessarily in negative territory), as fund managers looked forward to an improving trend. The worst performance – averaging just 3% per annum (which often reflected dividends allied to depreciation, rather than appreciation, in capital) – occurred when GDP was peaking and institutional investors began to book profits in anticipation of slowing economic growth. To complete the illustration, total average annual returns from listed UK company shares in the recovery phase were slightly better (+7%) than those achieved in the economic slowdown segment (+5%).   

Clearly, as mentioned, economic cycles vary and are far from predictable – with the duration of certain segments seeming to differ dramatically or the usual ‘clockwise’ progression seeming to reverse in direction. As an example, market commentators will refer to a ‘bath’ or ‘V’ shaped recovery sometimes (when considering either a barely obvious or a sharp bounce back in growth) - but it is helpful to know where an economy (UK), trading bloc (Europe) or the wider world might be positioned at any given point in time and the direction in which it appears to be moving. Currently, the UK economic cycle and the immediate outlook suggest a relatively flat scenario with growth in GDP being in the region of 1.5% and 2.0% per annum over the foreseeable future (the next two or three years). 

Another factor to consider, for those investigating where good value may reside, is to look beyond the headline or average PE ratio for the wider market and to consider individual industry or business activity sectors’ equity valuation – based on its earnings multiple. The dispersion or range of such valuations is currently much higher than normal, driven by polarised treatment of company stocks with either overseas or domestic revenue – post the weakness in sterling since last year’s referendum on EU membership. According to one’s view on the future health of the post-Brexit UK economy, this could provide an opportunity (on the basis that this polarisation has been overdone, and a reversion towards the ‘norm’ might occur).  

Knowing that most readers are interested in individual shares, this blog will sign off by highlighting one particular company that recently caught this writer’s attention. Last week, the original Israeli investors in XL Media sold their remaining 32% stake in the digital marketeer, at a price of 110p per share. This action followed the announcement, on 7 March, of impressive final results for 2016 and a number of subsequent post-results presentations to both institutional and private investors. That the £70m disposal was effected with a minimum of fuss bears testament to the market’s appetite, with the likes of Blackrock, Investec, Miton, Oyster and River & Mercantile taking their stakes up to circa 5%. The longstanding CEO, Ory Weihs, owns 1.8% of the equity after this placing – a reduction from the previous 3.5% stake.

What can one conclude from such a major change in the ownership of the company? One can only speculate about the motive of the Israeli venture capitalists and the other early investors in the business. Having seen XL Media shares make good progress in recent months – they were 62p last June, having been floated on London’s Alternative Investment Market three years ago at a similar level – perhaps they decided to take a profit. The vendors may have wanted to raise capital in order to invest into another venture. Although the new owners may choose to hold on to the shares, the free float and liquidity in this AIM stock has been enhanced which can only be a positive. The CEO had no control over the reduction in his stake (effected via his indirect interest in one of the original investors), but Mr Weihs bought another 1m shares within the placing.

The £213m capitalised business possesses interesting digital technology tools (content and search engine optimisation on over 2,000 self-owned websites, digital media buying & campaigns), which enables the group to procure new leads for its corporate customers – 70% of which operate in the gaming or gambling industry - with whom it typically shares revenue on an ongoing basis, rather than taking a one-off introducer fee. Disclosing accounts in US$, pre-tax profit rose 28% to $31m in 2016 on a 16% increase in turnover. A strong balance sheet features $35.2m in cash and short term investments and the company has a policy of distributing a high proportion of earnings. The latter translates into a near 6% dividend yield and brokers, encouraged by guidance of a strong start to the current year’s trading, forecast 9% growth in EPS for each of calendar 2017 & 2018. On a PE multiple of 9.3 times’ next year’s estimated 11.5p EPS, XL Media shares’ apparent undervaluation may be addressed as more investors become acquainted with this little-known stock.