Each month I like to review what I was thinking and doing two years ago so that I can spot holes in my approach, with the benefit of hindsight.
There won’t always be any dazzling insights to be gleaned from the past, but often there will be so it’s a useful activity.
You can download the December 2013 issue of UK Value Investor here (as a PDF) to get the full picture.
Having reviewed that issue again I would say there are three main lessons, or at least reminders of important points:
- Mean reversion can take a long time
- Temper your enthusiasm, even if your portfolio gains 25% in a year
- Be flexible in your holding period and don’t always expect to hold “forever”.
Mean reversion can take a long time
Back in December 2013 things were looking up. The FTSE 100 was up over 12% during the year and was close to its record highs at 6,651. The FTSE All-Share tracker which I use as a benchmark had done even better, gaining 17% (with dividends included) year-to-date.
The FTSE 100’s CAPE (Cyclically Adjusted PE) ratio was still some way below average though, suggesting that the “fair value” of the market was higher still.
You can see the range of different market values which relate to various CAPE ratios in the table below (as at Dec ’13):
As we now know, the market essentially went sideways for the next two years, although a near-4% annual dividend has been paid out, so it’s not all bad. But capital gains have certainly been lacking.
However, this does not imply that the CAPE ratio is not a good indicator of future returns, but instead merely that CAPE mean reversion is something that typically happens over seven to ten years or longer, rather than two.
Temper your enthusiasm
In December 2013, my defensive value model portfolio was showing a one year total return of 25.1%. That is, of course, fantastic, especially for a primarily large-cap, high yield, low risk portfolio.
Even the FTSE All-Share tracker which I use as a benchmark had gained 19.5% over the same period.
Aah, those were the days! Back then we were still seeing massive gains as the market rebounded from low valuations which were a consequence of the financial crisis.
But such reboundings, or re-ratings, do not last forever. Once the gap between market value and intrinsic value has largely closed, those sorts of spectacular gains are unlikely to continue.
So when you portfolio does well, rejoice, but also remember that it is unlikely to last much longer (and if it does then you should start to worry that the market value of your portfolio might be far above its intrinsic value).
You can see the results of the model portfolio and its benchmark up to December 2013 in the table below.
Be flexible in your holding period
In the December 2013 issue I decided to buy Royal Dutch Shell when the share price was 2,145p. Having reviewed the company I thought it looked like a good medium to long-term investment, as long as my time horizon didn’t stretch out much past the middle of the century.
Unfortunately it probably doesn’t, but by that point carbon emission regulation may be having a serious impact on Shell’s core business.
Over a shorter decade or two timespan I thought its 5.1% dividend yield and good record of above inflation dividend growth, along with many other business factors, made it an attractive choice.
However, having bought the shares I ended up being a Shell shareholder for only eight months. In August 2014 the share price hit 2,556p and for a variety of reasons I ended up selling Shell.
There was a nice capital gain of 16.3% which, combined with a dividend income of 2.5%, gave the investment an annualised return of 31%.
However, the company still had a 4.4% dividend yield and still looked like a good investment at that higher price (the oil price collapse was still in the future at that point and almost totally unexpected).
So why did I sell?
When I bought the shares they had a rank of 27 out of 220 stocks on my stock screen, which is actually somewhat low for a new investment.
This put the shares somewhere near the middle of my model portfolio’s existing holdings, based on the combination of a range of defensive and value-based factors (such as growth rate, growth quality, profitability, PE10 ratio and so on).
By August 2014 the company’s fundamentals hadn’t improved (revenues and profits were down, although the dividend had increased by 3%), but the share price had increased by more than 16%.
That isn’t much of a gain in the big scheme of things, but while Shell’s share price had gone up the share price of many other high quality and relatively defensive companies had gone down.
This made the relative change in attractiveness between Shell and these other companies larger, and so Shell fell down the stock screen ranks to 60th place. That isn’t particularly low, or even expensive, but it did mean there were quite a few more attractively valued stocks on offer.
So even though most investors should go into each investment with the intention of holding for several years at least, they should also realise that circumstances can change, and that sometimes it can make sense to lock in a quick capital gain in order to invest in even better companies at lower prices.
Kaizen for investors
If you don’t currently perform a review of your past opinions and decisions, perhaps you might want to slot one into your monthly investment routine.
It can be unsettling to see just how wrong you sometimes are with the benefit of hindsight, but if a culture of continuous improvement can work for Toyota (of which I currently own two!) then perhaps it can work for us small-time investors as well.
You can download the December 2013 issue of UK Value Investor here (in PDF).
Nice article. My family also owns two Toyotas – an Avensis and a Yaris. Unfortunately we’ve just heard from them and the DVLA that both need a recall! C’est la vie I guess.
John Kingham says
Thanks Andrew. We have a Prius and an Aygo and no recalls… yet.
Hi John, Just scan read your notes here and will read back over your sample pdf, looks interesting. Always a good thing to check and check again.
Often there is an old symptom to only spend time renewing the new stuff you want to buy and forget to review the old stuff and heh presto, one day something hits you in the face.
Incidentally, and off topic a little, have you ever considered or indeed invested in infrastructure assets (things like 3i Infrastructure or HICL)?
One of my reviews, just this day in fact was the performance of a chunky holding here. Not that it is in anyway a measure of the good bad or indifference of the companies, but I became uncomfortable with a couple of aspects of 3In, which has returned a really great return over 3 years.
The two things that concerned me resulting in a complete disposal, was the stock value trading at a significant premium to underlying assets and the amount of money pouring into infrastructure projects — some many multiples of the amount only 5 years ago. The upshot is that buying into these assets involves a bidding war and hence the premium.
I may be over worrying, or I may have had a lucky escape. I worried in a similar manner regarding Gold and Silver in 2013 and late last year about bonds and in particular high yield bonds and got a really lucky escape on all three.
End result is I’m just in stocks and cash now and feel more comfortable despite some being under water, as is the case for many right now I suspect.
Sorry for the rather long ramble but would welcome your views on infrastructure and something for feedback and general interest for other readers.
John Kingham says
Hi LR, no I haven’t ever invested in infrastructure funds or even considered it. I stopped investing in funds back in 2007/8 when I switched over to company shares and haven’t looked back.
I know from some of my insurance company investments in recent years that they have massively stepped up their infrastructure investments as they search for yield on their insurance float, but beyond that I don’t have any special insight into infrastructure.
As for your ability to get out at the top, perhaps you have an intuitively good feel for when an asset class is becoming overvalued. I’m sure there’s an element of luck to it too, but you have to look for your edge wherever you can find it, so if you have this ability then that’s good, although I would be wary of making any dramatic or high risk “calls” using it. But so far it seems to have served you well.
Personally I am only ever in stocks and cash as that’s what I know best, so I sticking to my knitting. And yes, there are lots of stocks underwater at the moment, but that’s inevitable, and these falling prices are likely to be a short window of opportunity for long-term investors.
As always, your comments are much appreciated,