Friday 26 October 2012

Investors Chronicle Comments

As stated in my last post, I thought the comments received from the guys at the Investors Chronicle were largely positive, and I'm very grateful for their input. They did pose a few interesting questions concerning my strategy, and I hope I can answer them sensibly here.

Firstly I'll list the points Chris Dillow makes, and try to answer them in turn.

Q. Why are you so attracted to defensives? There's a bad reason and a good one. The bad one is that defensives are 'safe'. But they are not. Take BAT, your biggest holding, and one of the most defensive stocks on the market..... (he goes on to talk about volatility and says if you want real safety you should be in cash).

A. I disagree with his statement that Defensives are not 'safe'. They are volatile of course, but as Warren Buffet says 'In the short run, the market is a voting machine. In the long run, it's a weighing machine.' The share price of BAT (his case in point) may fluctuate wildly with the rest of the market in the short run, this is in part because the prevalence of index trackers means that the market moves in lock step as the computer controlled funds are forced to sell across the board when people pull their money out forcing all shares down regardless of underlying value.
However, the underlying business in BAT's case is rock solid; they generate massive amounts of cash and are selling a product with a very inelastic demand curve which means they are well placed to pass on any inflationary effects incurred to the consumers of their product. They are also expanding into emerging markets which is more than offsetting the decline in smoking in the West. Their long term share price graph says it all really.

Furthermore I disagree with the notion that being in cash would be any safer. In an environment where inflation is running higher than the average return in a cash ISA I think cash would be a very destructive place to hold your money, especially for a young(ish) investor like me who has plenty of time to ride out any short/mid term dips in equities.

The good reason he talked about was that defensive shares are - 'very often under priced. Investors' pursuit of exciting shares means they ignore dull ones, giving these above-average returns to those smart enough to buy them.'

This is a good point that I totally agree with. While studying for my degree in Economics we covered the subject of the 'favourite-long shot bias', which is where bettors /investors tend to overvalue long shots (tech firms, knee deep in debt and making no money) and undervalue favourites (tobacco firms etc). The topic we were studying at the time was horse racing odds but I think this theory equally applies to the equity markets and many other similar situations where human psychology is involved in betting on outcomes.

Q. There are two things that worry me about your approach. One is that you say you'll trim your tobacco holdings if they rise more....... the old advice to 'run your winners is good'.  My second concern is your preference for good dividends (goes on to say some dividends are high for good reasons etc)

A. I do agree with both these points. As a rule I do let my winners run. However if one company or sector grows so much that it is dominating your portfolio, the portfolio is then subjected to more company/sector specific risk. So it's a balancing act really, and as a loose rule I don't want any one company or sector to represent more than 25%-30% of my portfolio. This gives the tobacco firms some way to run before I would start to sell.
The second point is also a good one, you have to be sceptical about why a company's yield is high. When I look for defensive companies to invest in I like to see a good history of steadily growing dividends and also good dividend cover ( the ratio of company's net income over the dividend paid to shareholders ). This generally sorts the good from the chaff.

Helel Miah says that now I have matched the liability on my mortgage I should aim to preserve my capital and structure my portfolio so that it doesn't suffer too much should market conditions turn sour.... 'The best option may be to pay off the mortgage.'

This is sound advice and would certainly achieve my initial objective, however as a relatively young investor with a long mortgage term, I think the best option is to remain invested in equities. I have considered however paying my mortgage down a bit so that I have 40% equity in the property and can benefit from better mortgage deals. If I were to do this the ROCE (return on capital employed) would be about 6% which I think is very attractive in the current environment.

A few people have asked me what performance I've achieved over the last 7 years. I've invested approximately 60k so have effectively almost doubled my money over the timeframe. This includes dividends being re-invested. It is hard to calculate an annualised gain as I've been drip feeding money in randomly, as and when I could afford to. But I think I've easily averaged over 10% a year which is quite pleasing in a market which has barely moved over the period.




  1. They really raised good questions. Thank you for sharing all with us.

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    1. Thanks, they did raise good questions, what did you think of the answers I gave?