UK Equity Commentary - Portfolio Reviewed

Sunday, 7th December 2014 18:44 - by David Harbage

In response to requests for a portfolio of stock exchange investments - following the educational series of considering the merits and shortcomings of different asset types, and the subsequent review of different business activities – the writer constructed an indicative list of collective investments and company stocks on 10 September 2012.

A portfolio of investments should be prepared on the basis of it being suitable to an individual investor. Accordingly, the following investments – by reference to the mix of assets and the selection of individual holdings - will almost certainly be inappropriate to the reader’s circumstances and should therefore be viewed accordingly (for reference and interest only).

The portfolio below was the specimen investment of £100,000 (a sum worthy to consider stock exchange assets), designed to produce growth in income and appreciation in capital value over the long (say minimum 10 years) term, expected to be left untouched (on the presumption that there are other significant liquid assets available to meet known and unforeseen liabilities), requiring relatively low maintenance (expect to ‘Buy & Hold’, rather than regularly trade the individual holdings) but to be reviewed every three months:

1. £40,000 – 40% - i shares Corporate Bond ETF (an exchange traded fund of £-denominated investment grade credit)
2. £20,000 – 20% - Vanguard UK Equity ETF (an exchange traded fund replicating the FTSE100 index)
3. £30,000 – 30% - placing £2,000 (or 2%) into each of 15 individual company share investments: Royal Dutch Shell, Petrofac, Blackrock World Mining investment trust, i share S&P Gold Producers, BAE Systems, Whitbread, Unilever, Tesco, Berkeley Group, GlaxoSmithkline, Vodafone, Scottish Southern Energy, Aviva, RSA Insurance and Standard Chartered Bank. Or more adventurous, growth-oriented investors might wish to incorporate higher risk-reward (because they are smaller, less well-researched businesses) stocks such as Premier Oil, Kentz, Medusa Mining, easyJet, Telford Homes or Monitise
4. £5,000 – 5% - HSBC FTSE250 ETF (an exchange traded fund replicating the FTSE250 index)
5. £5,000 – 5% - Templeton Emerging Markets IT (an investment trust which invests in the equity markets of developing, rather than the more mature, nations’ economies)

Let’s take a look at how the above assets have performed over the past 27 months – albeit a much shorter period than the recommended long term (foreseeable if not indefinite, but minimum ten year) future – showing prices back in  September 2012 and 5 December 2014:

1. iShares Corporate Bond ETF – was £127.37p in 2012, is now £133.69p equates to a capital return +5%, plus income of 10%.
2. Vanguard UK Equity ETF – was £26.71p, is now £30.41p equates to a capital return of +13.9%, plus income of 6.5%
3. Royal Dutch Shell - was £22.56p, is now £22.40p equates to a capital loss of 0.7%, offset by income of 9.5%

Petrofac - was £15.16p, is now £7.76p equates to a capital loss of 48.8%, offset by income of 10%

Blackrock World Mining investment trust – was 538p, is now 330p equates to a capital loss of 38.7%, offset by income of 12.6%

i share S&P Gold Producers – was £11.59p, is now £4.90p equates to a capital loss of 57.7%, offset by income of 6%

BAE Systems – was £3.19p, is now £4.84p equates to capital return of 51.7%, plus income of 8%

Whitbread – was £20.99p, is now £46.70p equates to capital return of 122.5%, plus income of 5.5%

Unilever - was £22.71p, is now £27.20p equates to capital return of 19.8%, plus income of 6%

Tesco- was £3.40p, is now £1.88p equates to a capital loss of 44.7%, offset by income of 6%

Berkeley Group – was £15.05p, is now £26.13p equates to capital return of 73.6%, plus income of 14.5%

GlaxoSmithkline – was £14.17p, is now £14.67p equates to a capital return of 3.5%, plus income of 10.5%

Vodafone - was £1.79p, is now £2.30p equates to a capital return of 28.5%, plus income of 11%

Scottish Southern Energy - was £13.63p, is now £16.75p equates to a capital return of 22.9%, plus income of 10.5%

Aviva - was £3.27p, is now £5.05p equates to a capital return of 54.4%, plus income of 5.5%

RSA Insurance - was £1.14p, is now £4.51p (after capital adjustment) equates to a capital return of 2.1%, plus income of 4.2%

Standard Chartered Bank - was £13.75p, is now £9.73p equates to a capital loss of 29.2%, offset by income of 10.5%

Premier Oil - was £3.69p, is now £1.92p equates to a capital loss of 48%, offset by income of 5%

Kentz - was £3.62p acquired at £9.34p by Canadian peer in August 2014 equates to a capital return of 158.1%, plus 4% income

Medusa Mining - was £3.27p, delisted in London at 98p in May 2014 equates to a capital loss of 70%, offset by income of 1.5%

easyJet - was £5.33p, is now £17.31p equates to a capital return of  224.7%, plus income of 4.5%

Telford Homes - was £1.16p, is now £3.64p equates to a capital return of 213.8%, plus income of 4%

Monitise - was 35p, is now 31p equates to a capital loss of 11.4%, with no compensating income.

Average return on the above mentioned 21 companies was 29.8%, plus income of 7.9%.

1. HSBC FTSE250 ETF - was £11.46p, is now £15.75p equates to a capital return of 37.4%, plus income of 5.5%.
2. Templeton Emerging Markets investment trust - was £5.43p, now £5.77p equates to a capital return of 6.3%, plus income of 2%.

In practice, the above portfolio may have been altered – if only by reference to the individual company shares (for example reinvesting the proceeds of the take-over of Kentz) – but, based on the proportions to be invested in each of the five categories detailed above, the portfolio would have produced a capital return of 15.9%, plus income of 7.9 % over the 27 month period to date. (This is calculated by applying: 40% of portfolio in i shares Corporate Bond ETF produced 2% capital return plus 4% income for the whole portfolio, 20% in Vanguard UK Equity ETF produced 2.8% capital return plus 1.3% income for the whole portfolio, 30% in individual company shares produced 8.9% capital return plus 2.3% income for the portfolio, 5% in HSBC FTSE250 ETF produced 1.9% capital return plus 0.2%% income for the portfolio and finally 5% in Templeton Emerging Markets investment trust  produced 0.3% capital return plus 0.1% income for the portfolio).

The following explanation of why each investment might have had appeal was published by the writer and is now replicated below, verbatim from the original blog of September 2012:

iShares Corporate Bond ETF

Forty per cent of the portfolio has been placed into this investment, with two particular purposes in mind. The first is to own corporate bonds (rather than British Government stocks) as a diversifying non-equity asset, but also to be viewed as a quasi-cash reserve potentially to be invested into other higher risk-reward investment (such as equity, property or commodities) when economic and stock market conditions appear more conducive. Interest rates are unlikely to rise in the immediate future, and so the 4.95% annual flat yield (3.5% gross yield to maturity) - distributed on a quarterly basis - available on this ISA-able investment appeals. However, it is inevitable that both overnight and longer term rates must rise eventually and such a move will indicate a return to a more normal economic environment – which would almost certainly prompt a reduction in this relatively cautious investment.  

Although a pickup in gilt yields along the curve will be a headwind for corporate bonds, the current spread over the ‘risk-free’ rate is particularly generous. As corporate health proves to be more robust than is currently anticipated (the current premium over gilt yields implies an improbably high level of company liquidations), we expect corporate bonds to hold up relatively well compared to conventional British Government stocks - which appear expensive. As such, retaining a reasonable weight in this relatively low cost (total expense ratio of 0.2%) asset is likely, with a likely longer term bond exposure of approximately 10-15% of the portfolio worth - which might also accommodate inflation protection via index-linked government stocks.

Vanguard UK Equity ETF

This provides exposure to the equity of the hundred largest fully listed companies on the London stock exchange, by purchasing the physical underlying stock investments within the FTSE100 index. This is effected at particularly low cost; the managers expect a total expense ratio of 0.1% per annum, with all running costs coming out of the annual management fee of just 10 basis points. Although entitled UK Equity, such an investment is essentially global as most of the businesses are multinational: earning their profits overseas rather than being dependent on the local economy. Given the difficulty of outperforming the FTSE100 index, whose constituents are followed by a large number of analysts (both in the UK and beyond), owning a tracker makes eminent sense to ensure that returns on the full range of the underlying businesses is captured.   

This investment is particularly appropriate for the less experienced investor, who may lack the knowledge or confidence to choose individual company businesses. In such circumstances the potential investor would be wise to rely upon the exchange traded fund for his or her exposure to UK equity and, as capability and courage grows, perhaps choose to introduce individual company stocks in due course. Meantime this £ denominated exchange traded fund, which distributes its income (of almost 4% per annum) on a quarterly basis, will provide the desired exposure to leading well-known blue chip businesses which feature in the FTSE100 - in very reliable fashion.

Individual company share investments

Taken overall, the following (as mentioned in the first list, above) companies provide a broad range of business activities, including both essential and discretionary spend product and services, are not wholly dependent on the domestic economy, represent leaders in their respective industries, have robust balance sheets, are profitable and pay dividends (which are forecast to rise in the current year), enjoy the favour of equity analysts and possess well regarded management teams. By industry, they include Oil & Gas (Royal Dutch Shell, and services company Petrofac), Mining (Blackrock World Mining investment trust, and the i share S&P Gold Producers), Defence (BAE Systems), Leisure (Whitbread), Household Goods (Unilever), Retailing (Tesco), House Building (Berkeley Group), Pharmaceuticals (GlaxoSmithKline), Mobile Telecommunications (Vodafone), Utilities (Scottish Southern Energy), Insurance (life-biased Aviva, and the more general RSA Insurance) and Banking (Standard Chartered).

As previously indicated, the more adventurous, growth-oriented or higher value portfolio investor might wish to incorporate higher risk-reward smaller company stocks such as oil explorer Premier Oil, oil & gas service group Kentz, gold miner Medusa Mining, budget airline easyJet, house builder Telford Homes or mobile telecomm business Monitise. In addition, the extent to which an investor would prefer to exclude cyclical, economically-sensitive businesses or might take comfort in an above average dividend will necessarily influence stock selection.

More critically, where there is low or no interest in the individual business of companies, exchange traded funds will probably offer greater appeal. In that universe, if higher dividend income is a priority, the i shares UK Dividend Plus ETF could have appeal. This exchange traded fund, which offers exposure to the 50 highest yielding shares in the FTSE350 index, should not be perceived as lower risk than the FTSE100 ETF because of its higher yield. Rather, the writer would caution that its underlying investments will include companies that would not be large enough to qualify for the FTSE100 index, that are necessarily higher risk-reward, and could feature less reliable (and sustainable) dividend income.

HSBC FTSE250 ETF

Very similar to the previous selection, except that this exchange traded fund aims to replicate the performance of the FTSE250 index – which represents the 250 largest company shares, with a full listing on the London stock exchange, outside of the 100 largest found in the FTSE100 index. Essentially medium sized businesses with a market capitalisation of between £300 million and £3 billion, these are frequently referred to as ‘mid cap’ but can often represent industry leaders or possess strong international franchises. Unlike the above mentioned FTSE100 selection, this ETF rarely owns all 250 constituents of the index it tracks, but rather manages to deliver close replication by holding the largest 200 company stocks. Reflecting its more demanding objective and higher workload, this fund’s total expense ratio is higher than the FTSE100 ETF - at 0.35% per annum. As an alternative, the i shares’ FTSE250 ETF charges 0.4% and invariably owns all the constituents of the FTSE250 index.

By contrast with the FTSE100 exchange traded fund, this equity investment vehicle should be viewed as higher risk-reward as – while ostensibly more diversified, by reference to the number of constituent companies – these smaller businesses are less well researched, by industry analysts or the financial media, their revenue and earnings tend to be less defensive or resilient and, finally but not least important, share price valuations tend to be more demanding (reflected in the current 2.6% annual income yield). As such, more cautious investors should be aware and will no doubt increase a bias to the higher dividend paying FTSE100 ETF, and perhaps leave the FTSE250 exposure to more growth-oriented investors.

Templeton Emerging Markets IT

The FTSE350 index (a combination of the FTSE100 and the FTSE250 indices) can be viewed as providing exposure to successful leading multinational businesses around the world – to the point of rendering the need to seek separate investments in stocks listed on the other prime stock markets of the United States, Europe and Japan unnecessary. This may be viewed as an inflammable or debateable point, but is made in the context of wishing to present a simple solution within a limited value portfolio - in the knowledge that the UK equity market’s valuation is less demanding (notably by reference to historic earnings) than almost any other leading bourse. However, a more robust argument can be presented for investing in the local companies of emerging economies - where truly different business models and dynamics reside.

Biased towards higher growth economies of Asia, Latin America and Eastern Europe, investors must be mindful that such nascent investment represents a further step up the risk-reward ‘ladder’. In the opinion of this writer, primarily based on the existence of less rigorous corporate governance in such countries as China, accompanied by less supportive equity valuation metrics (in earnings and balance sheet terms), the risk profile of this asset class is higher than that of the previous selection of medium sized UK companies.

The Templeton trust represents one of the largest fund managers of emerging market equity with £1.9 billion of assets under management, endorsed by Morningstar amongst other fund rating agencies. Boasting a strong track record over 3, 5, 10 & 20 years, the current fund manager, Singapore-located Mark Mobius’ prime country exposures (as at 31 July 2012) were: Hong Kong/China 24.5%, Brazil 15.5%, Thailand 14.3%, Indonesia 10.4%, India 9.6%, Turkey 6.0%, South Korea 4.5% and Russia 4.3%. The shares currently yield just 1.1% and stand on a discount of 5.4% to their net asset value.

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In conclusion, dear reader, a reminder that the above commentary can only represent a starting point – and an indicator only – of what a portfolio of stock market assets might look like. For further information surrounding the different asset classes, please see the earlier ‘educational’ blogs (published in May, June & July 2012) on this website.                            

David Harbage