TB Wise Income Newsletter August 2017
This is a letter for investors and potential investors in TB Wise Income. Its aim is to give you an overview of what has been happening in the fund over the last year or so, and how we have managed it – what has worked, and what hasn’t. I will begin by describing the backdrop to the markets in which we invest in some detail, before going on to discuss the fund, and how we have set it up to make the best of the environment in which we find ourselves.
Part 1 – economic and market background
Central bank policy in the aftermath of the Global Financial Crisis
The world’s four main central banks all work independently of the governments of the countries in which they operate. They are the Federal Reserve or ‘Fed’, in the US, the Bank of England, the European Central Bank (ECB) and the Bank of Japan (BOJ). Their co-ordinated actions created the extraordinary monetary conditions in which we live today. Faced with the failure of the world’s banking system, the central banks cut interest rates to nothing, and began a vast programme to purchase government debt. The effects of these policies were far-reaching, and include :-
Very low interest rates allowed highly indebted governments, companies and individuals to pay the interest on their debt, and so not become insolvent, but at the same time destroyed the returns on deposit accounts, forcing income-seeking savers to look for returns in riskier assets.
Huge purchases of government debt (known as Quantitative Easing, or QE) forced up the price of the asset, and like zero interest rates, pushed investors into other, riskier asset classes, which they might otherwise have avoided.
The actions of central banks allowed governments and companies to borrow new money at very low rates.
The general raising of asset prices was supposed to create a ‘wealth effect’ which would encourage businesses to invest, creating jobs for the benefit of the wider economy, rather than just the financial markets - though many believe that this outcome has been minimal at best.
These monetary policies have had negative effects as well as positive ones. As well as destroying the returns on deposit accounts, QE has ensured the demise of final-salary pension schemes. Ultra-low interest rates on government bonds artificially inflate the liabilities of these schemes, and have forced nearly all large companies to pay many £millions into their schemes to reduce the deficits. These payments divert cash away from business investment – the very opposite of what was intended.
‘Unconventional monetary policy’ has favoured the rich, as owners of most assets have seen their values inflated in the period since the crisis. These policies have run alongside Austerity, a cutting of government spending which has fallen most heavily on the poorest in society. The reason for the recent fall in life expectancy appears to be related to the reduction of social welfare spending on the elderly since 2010. Taken together, these policies have increased the inequality in society, leading to the rise of populism, and making the tone of political debate more fractious and confrontational generally.
Things are changing
There is nothing at all new in the above analysis. We have all become used to a financial world which is in many ways distorted and unlike anything anyone alive today had experienced before 2009. But things have started to change. This is for several reasons. One is that the negative effects of the zero interest-rate policy (ZIRP) and QE are becoming increasingly obvious. Policymakers have started looking for economic stimulus through the tax system rather than from monetary policy.
Also, there is little more that central banks can do. Their balance sheets are distended by the huge quantities of government debt which they have bought, and need to be brought back into balance - otherwise the banks will be helpless to intervene in future crises. Realistically, interest rates can’t be any lower than slightly below zero, and then only for short periods. There is no better way to stimulate economies than by lowering interest rates, but in the next recession, as things stand, that tool won’t be available, as rates are already as low as they can be.
Of the four major central banks, the Fed has advanced furthest in the ‘normalisation’ process. Four years ago, Ben Bernanke, then its Chairman, announced that the Fed would begin to taper its QE programme, which subsequently ended. The US has since begun tentatively to raise interest rates, and has begun talking about the third step in the normalisation process, selling the bonds it has bought back into the market. Other central banks are lagging behind the Fed. The Bank of England, for example, has probably finished QE, but hasn’t started raising interest rates from their unnaturally low rate of 0.25% (with inflation at its current rate of 2.6%, well above the BOE’s 2% target, you might reasonably expect the base rate to be around 2.5 – 3.0%, or even a little higher.) And the BOE has announced no plans to return its £425bn of QE assets to the market.
However, the overall direction is clear. We are seeing the beginning of the end of unconventional policy, and as it is gradually withdrawn, it is hard to escape the conclusion that interest rates will gradually rise, regardless of what happens to inflation. This conclusion affects everything we do as income fund managers.
We have seen a string of extraordinary events over the last year, including the UK referendum, the election of President Trump, and the increasing belligerence of North Korea. Some of these events are closely linked to the economic conditions described above. For example, the election of Donald Trump appears to be the reaction of the ‘have-nots’ against increasing inequality and an establishment that has failed them, though there are other elements such as globalisation and the march of technology as well. What is happening in North Korea is the culmination of events over at least the last 20 years, and would have happened anyway.
The crisis of 2007-9 left investors deeply traumatised and risk-averse, and explains much of what we are seeing in today’s financial markets. During the crisis, share and commercial property prices fell by around 50% on average, but the prices of some assets, such as Northern Rock, became worthless. We now know that asset prices were going to recover, but that wasn’t known at the time. People remain terrified of losing money. Investors today have an insatiable appetite for investments which pay a high rate of interest and appear not to be financially risky. Current favourites include infrastructure, clean energy, and peer-to-peer lending funds, and more recently, social housing and warehouse trusts, all offering income in the region of 5-6% per annum, more or less inflation-proofed, over the medium to long term. What could possibly go wrong?
While it is always futile to try and predict the future, it seems to us that what might spoil this particular party is gradually rising interest rates. Once cash begins to give a meaningful return again, if it ever does, a lot of money invested elsewhere is likely to find its way back into deposit accounts. Where will that money come from? Two areas that look particularly vulnerable to us are corporate bonds (company debt), apparently safe but expensive and low-yielding, and the various ‘alternatives’ referred to above. Peer-to-peer lending began in its current form in 2009, and has never been tested under adverse conditions. The other assets, including social housing and clean energy are investable, but demand has pushed up the prices of the assets to uncomfortable levels, and the investment trusts through which people invest are all at premiums, making the underlying assets another 10-20% more expensive than they were already, and are potentially very illiquid – you can only sell them if you can find someone who wants to buy. It is not hard to imagine a stampede for the exits, in which there would be many sellers, and no buyers.
The asset bubble
If you read the financial press, or the financial pages of any broadsheet paper, it won’t be long before you come across the asset bubble. The experts ware warning that shares are more expensive now than at almost any other time in history - dangerously overvalued, and only maintained at current levels by central bank policies which appear to be ending.
This view is partly correct. Shares are on average expensive, but the average is deceptive. Expensive shares are so expensive that they conceal the cheapness of the cheap shares. The valuation disparity between cheap and expensive shares is unusually high at present. For example, the US tech. giants known as the FAANGs (Facebook, Amazon, Apple, Netflix and Google, renamed Alphabet) which are in aggregate worth $3 trillion, are all on elevated ratings, reflecting their rapid growth and prospects. They dominate their indices to such an extent as to make entire indices look expensive.
The valuation gulf between the ‘growth’ ‘momentum’ and ‘quality’ companies which investors favour, and the rest of the market, can be explained by the more cautious, risk-averse mindset of the post-crisis investment community. Investors like to own assets which make them feel safe, and avoid ones that make them feel uncomfortable. Companies whose share prices have been rising for a long time, companies which have been raising their dividends for decades, and companies with exciting growth prospects are favoured, but a piece of negative news, such as a profits warning, can cause the share price of a former darling to collapse, as we have seen recently with Next and Provident Financial.
Part of the ‘asset bubble’ narrative is the protracted length of the current bull market in shares. Bull markets tend to last four or five years, whereas the current one is already in its ninth. But, like much else about today’s financial environment, the current bull market is hardly a normal one. It has been unusually slow, and punctuated by major setbacks. The first Greek debt crisis in April 2010 caused a significant sell-off, and a much worse one ensued in July 2011, when it looked as if the Euro might implode. Concerns over world growth caused a significant drop in all emerging market and Asian assets in 2015-16. Alongside this bull market was a five-year decline in mining assets, causing Rio Tinto’s share price to fall from £72 to £16, from which recovery is still only in its early stages. Mr. Bernanke’s announcement of QE tapering in May 2013 led to a sell-off in the bond markets and emerging market assets, known today as the ‘Taper Tantrum’, from which these assets haven’t fully recovered. After the referendum last June, the prices of all companies serving the UK economy fell sharply, and most recently the markets have fallen on concerns about a nuclear exchange between the US and North Korea.
The UK stock market’s most-quoted index continues to be the UK stock market, which tracks the largest 100 companies listed on the London stock exchange. From May 28th 2013, just before the ‘taper tantrum’ sell-off, to the time of writing, the UK stock market index has risen from 6,762 to 7,310, or by 8.1% - around 2% a year. And since its peak in May 2015, theUK stock market has advanced by just 2.0%.
Far from a rip-roaring bull market, UK stock market has barely kept pace with inflation these last four years.
In today’s markets, while we can see plenty of overvalued assets, we can see plenty of bargains as well.
Part 2 – TB Wise Income, the fund
What we are trying to do
When we set up TB Wise Income in 2005, our idea was to provide an attractive level of income. At the time, good deposit accounts paid around 4-5%. We wanted people who chose TB Wise Income as an alternative to a deposit account to be able to transfer across without seeing a significant drop in their income. Since then, interest rates have fallen, but we remain committed to providing an income which is as high as possible without taking undue risk, and today’s yield is 4.7%, of which more in a moment. Our other aims at launch were to grow the fund’s income in line with inflation or better, and to grow the capital value in line with inflation or better. In fact, the two aims are linked – if the income rises, the capital value will tend to follow, though probably not in a straight line.
How we do it
The income we’re looking for can be obtained from a wide range of assets, and in the 12 years since we started, the range of choice has grown. We can invest in shares, commercial property and fixed interest, together with alternatives including private equity, infrastructure and clean energy, anywhere in the world. We list TB Wise Income in the IA Flexible sector, which is the only sector that places no restrictions at all on where we can invest, or in what proportions. We couldn’t possibly have known in 2005 that UK gilts would become un-investable because of QE, nor could we have known then that we would soon be able to invest for income in solar and wind power. We don’t know how the market will evolve in future, so we need the maximum flexibility to respond to the opportunities, and to avoid the threats, that will inevitably arise.
We really care about income
Producing robust, sustainable income is at the heart of our process. We approach each new asset from that point of view. Where does its income come from? How well is it covered? How important is producing sustainable income to the managers of the asset? How likely is the income to increase?
TB Wise Income’s charges are all taken from capital so as not to be a drag on the income.
Holders of the fund who invested at launch paid £1.00 per share. Those who take dividends have received 60p so far. We are pleased with this income return, and proud that we have achieved our target, so far, of increasing the fund’s dividend yield by more than the rate of inflation.
We regularly monitor the fund’s income, and model it for the year ahead. You might imagine that all income fund managers do this, but it seems they don’t. We regularly meet the managers of income funds who can’t tell us even roughly what the dividend yield of their fund is, and income fund managers will often go through an entire meeting without mentioning the income which their fund has been set up to provide.
TB Wise Income’s dividend yield
There are two ways of calculating the fund’s yield. One is backward-looking and the other forward-looking.
If you had bought the B Income shares of TB Wise Income a year ago, on August 18th 2016, you would have paid £1.136 per share. In the last year, the fund has paid four dividends totalling 6.03p, so, dividing the income by what you paid for it, your income yield in the first year would have been 5.3%.
Looking forward, we calculate the yield by looking at what we expect each of the fund’s holdings to pay in the year ahead. We assume that they will pay the same as they have in the past year, unless we know otherwise. Using this method, we forecast that the income yield on an investment made today will be approximately 4.7% in the coming year. This number is subject to change as dividends are increased and lowered, and as the underlying holdings in the portfolio change.
Over the last year, TB Wise Income has made a total return after charges of 23.16%, and in 2017 to date, the fund has made 13.36%. Risk warning - past performance is not an indication of future returns. The value of investments and any income you receive from them can fall as well as rise. You may get back less than you invest.
We have benefitted from two significant opportunities. The first of these was the extremely low prices seen across Asia, the emerging markets and the commodity sector following the five-year sell-off which ended in February 2016. Adding to our holdings during the winter of 2015-6, as prices fell ever lower, was a somewhat unnerving experience, but we have been well rewarded for making those investments, in the likes of Rio Tinto, Blackrock World Mining, Middlefield Canadian Income Trust, and Aberdeen Asian Income. We have taken some profits in this area, but believe that the recovery has further to go.
Then, following the referendum, the pound fell sharply. Investors reacted by buying the shares of international earners such as Glaxo and Unilever, while the shares of domestically-focussed companies, which were expected to suffer the double blow of higher import prices and a weakening UK economy, slumped. We were presented with the opportunity to invest in a range of excellent companies, including Morgan Sindall and Savills, at bargain-basement prices. We have been surprised by the speed and extent of their recovery.
Our UK smaller companies have served us extremely well over the last year, but some have become fully-valued, and we have trimmed some holdings and exited from others entirely.
Over the eight-and-a-half years since the end of the financial crisis in March 2009, TB Wise Income has made a total return, with income reinvested, and net of all fees, of almost exactly 300%. In other words, £1 invested in March 2009, and with the income left to roll up would be worth almost exactly £4 today, a return of just under 18% per annum compound. During this period, we have made particularly good gains in UK smaller companies, private equity, and UK commercial property. However, at this stage of the cycle, the opportunities in all these sectors are not as compelling as they were, and we have reduced exposure accordingly. Private equity is now just 8.2% of the fund, from a high point around 13.5% less than a year ago.
Recently, the performance of TB Wise Income has been flat, to slightly down, with the current share price around 1% below its high point at the end of May. Some of our assets are pausing to consolidate after making large gains in the last few months, while two of our smaller positions have gone wrong.
Quarto is a publisher of coffee-table books (things like ‘1001 Movies to see Before You Die’). We bought the shares three years ago in the belief that the dynamic new Chief Executive was uniquely suited to a business of this type, working with large numbers of creative talents, and would breathe new life into the business, increase profits and use them to pay down debt. However, the company has become acquisitive, and failed to sell a non-core division, which they ended up more or less giving to its management, with a big write-off. Quarto has recently been affected by the slowing retail environment. We sold over half the holding a few months ago at roughly twice what we paid for it, but the shares have since fallen 60%. We are waiting for a meeting with the company before deciding how to proceed.
Carillion is a construction company which is increasingly focussed on services, an example of which is the recently-awarded contract for maintaining buildings for the Ministry of Defence in the north of England and Northern Ireland. The company recently announced a profits warning relating to three construction contracts, with an £850m write-off, and has cancelled its dividend. A new Chief Executive will announce the results of a strategic review in early September.
These two blow-ups have cost TB Wise Income around 2.0% of its value, with most of the loss coming from Carillion. A common feature of the two companies was a weak balance sheet, which we – mistakenly in both cases – thought was improving, together with a management which had not concentrated enough on improving the financial position.
The opportunities that have caught our attention recently have been in larger companies, especially in two sectors.
We have been building exposure to utility companies in the UK, suppliers of gas, electricity, water and telecoms. The shares have performed poorly over the last couple of years, look cheap, and pay attractive dividends which the companies are committed to increasing. Warren Buffett once said that the ideal investment would be an unregulated water company. Its product is an everyday necessity, and being unregulated, it can make more or less as much profit as it likes. However, water companies are too important to be unregulated. In the UK they, like other utility companies, are monitored with great care by their regulator, and fined if they fail to hit demanding quality targets. However, being regulated has its positive aspects. One is that it makes the regulated company much harder to compete with, and another is that the regulator has to let the regulated company make profits. Centrica for example has, at the behest of its regulator, installed four million domestic smart meters, at a cost of £70 each. This expense has to come from net profit. The regulator can’t let the regulated company fail, so it must look to the interests of all stakeholders, including the company’s shareholders as well as the users of the service.
Utilities are seen by many investors as boring, indebted, ex-growth, badly-managed and over-regulated behemoths. We look at them and see companies which we can understand, which we expect still to be around in ten or twenty years’ time, paying attractive dividends which they expect to grow. There are worse places to park the bus, we think.
Another area of interest is the UK retailers. These face challenges. In the short term, wages are rising at less than the rate of inflation, which has risen since the pound fell after the referendum. This means that the average wage earner’s real spending power is shrinking, putting pressure on retailers’ revenues. Meanwhile the impending Brexit is making everyone feel cautious. Longer term, retailers are under attack from discounters, including Amazon, and from the internet, which threatens the demise of physical retailing.
The stock market’s revulsion towards retailers is extreme. Next, once a paragon of the sector, is languishing at around half its recent valuation, and most brokers have it as a ‘sell’. There are many other examples, some well-known, others less so. We are not in a hurry to increase our exposure to the sector, but are researching it carefully.
Change of Fund name – no significant change of objectives
On September 1st, TB Wise Income will change its name to TB Wise Multi-Asset Income, in order to emphasise the fact that the fund can invest in any and all asset classes. This change needed to be submitted to the FCA, who have required us to make some changes to the fund’s stated aims.
For example, when we first launched the fund, the first of our three aims was to ‘provide an income roughly equal to what you would receive in a good deposit account’. Our idea was to allow building-society investors to switch to an asset-based fund with no significant loss of income. However, when interest rates fell to near zero early in 2009, that objective no longer made sense, so in time we altered it to ‘provide an attractive starting yield’. As you may imagine, the FCA felt that ‘an attractive starting yield’ was too imprecise, so we have had to substitute an alternative phrase, ‘a yield in excess of the BATS UK All-Companies Index’, which refers to one of our two benchmarks. We would like to emphasise that though the published aims of the fund have changed, the way we run it has not, and will not. My personal definition of the yield TB Wise Multi-Asset Income provides would be something like ‘the highest amount we can find in any given market conditions, subject to not taking risks that we believe our investors wouldn’t be happy to take if they were in our position’.
At the time of writing, the fund size is around £101m, roughly double the size it was a year ago.
There is no initial charge, no performance fee, and no redemption charge. The current all-inclusive annual charge, the Overall Charges Figure (OCF) on the B shares is 0.93%. This figure has come down every year for the last few years, mainly reflecting economies of scale as the fund has grown.
TB Wise Income is managed by the Wise Funds team, together with its sister fund, TB Wise Investment, which targets long-term capital growth. Our team at present has five full-time members – myself, Tony Yarrow, as lead manager of both funds, my co-manager Vincent Ropers, formerly of Standard Life Investments, who joined us in April, Manasa Patil, who mainly researches companies on behalf of TB Wise Income, our business development executive John Newton, and our PA Debbie Long, who looks after us all.
Wise Funds is a limited company within the Wise group.
TB Wise Income will be 12 years old in October. It was launched as a one-stop shop for investors who wanted to invest in the best assets we could find across a broad spectrum of sectors and geographies, who needed a reliable income, and wanted to outsource the management of their hard-earned savings to a trusted manager, who would look after it with a view to the long term. We believe that the need is if anything greater today than it was in 2005. We hope that our investors continue to see us as that trusted manager, and above all else, we wish to retain their trust. Looking ahead, we can see many challenges. Without doubt, large areas of the financial markets are expensive, and don’t reward us properly for the risks of investing in them. But we believe that we have adapted, and are continuing to adapt, the fund to that environment. We have de-risked the portfolio, and expect to continue doing so over the course of the next few months. This process has involved holding more un-correlated assets, selling our more fully-valued holdings, replacing smaller companies with larger ones, and investing where possible in companies which cater for our most basic needs, and without which the economy would cease to function.
We invest in the TB Wise Income ourselves. Our interests are in every way aligned with those of our co-investors. We will continue to do everything in our power to give you the best returns we can, in whatever conditions we find ourselves.
The figures quoted above have been taken from Financial Express. The income forecast figure is based on historical dividend information and is regularly updated by Manasa.
Further questions and comments
I am always happy to respond to questions and comments. Please contact me at firstname.lastname@example.org
Please note – the above article contains the personal opinions of Tony Yarrow as at August 21st 2017, and should not be interpreted as financial or investment advice.