Take Cover and Look for the Dividends


One odd thing about this nasty market is how little it seems to bother most investors. Global equity markets are down 15% so far this year – and many parts of the market are much lower – yes, I’m looking at you, US tech stocks.

But while platform data shows investors are considering more conservative investments than in the past (a good thing), Scottish Mortgage is still the most popular investment trust on buy lists (a strange thing given that it is at the epicenter of the market collapse).

However, the absence of obvious stress among private investors makes some sense. After all, most of us have still made quite a bit of money in nominal terms over the past two years and a lot more over five years.

The latest figures from Interactive Investor show that while their average DIY investor is down 11% this year, it’s up 13.2% over the past two years and 2.6% over the past two years. and a half, i.e. since just before the lockdown-induced crash of March 2020.

The past two years have been so unreal in many ways that having the same amount of money as you then somehow feels good. A lucky break even.

The problem is that we can’t be sure we’ve escaped yet. Valuations aren’t as bad as they used to be – the US market‘s cyclically-adjusted price-to-earnings ratio is down to 28x from a high of 38, for example – that’s only about 15% higher than the 15-year average.

The UK market is on a cyclically-adjusted price-earnings ratio (CAPE) of 14.6x according to Cambria Investment Management figures, which is just a few percent of its long-term average.

All of this may seem reassuring, comforting even. It probably shouldn’t. The truth is, in markets like these, it’s not enough to go back to long-term averages. According to Matt Kadnar, portfolio manager at GMO, an asset manager, it makes sense for price-earnings ratios to be above their long-term averages when things are looking good. If earnings are high, economic growth is good and inflation is low, investors feel comfortable and “they are more likely to pay a higher market multiple”.

So it makes sense that in the pre-Covid years, when all of this was true, valuations were “significantly higher” than their long-term averages. Things are clearly less comfortable now – very uncomfortable, in fact.

Valuations should therefore no longer be at their long-term averages, but rather below. How much below? GMOs have a model for this – a model that Kadnar says has historically shown “incredibly high” explanatory power. Unfortunately, this model — the Comfort Model — does not tell us anything reassuring: the CAPE should strike about 19 times, rather than 28 times as is currently the case. To get back to the mean would require a drop of 15% – more if the income part of the equation gets bad. If investors end up reacting to the current circumstances as they have to similar events in the past, that 15% might just be the start. Do you feel less comfortable? You should be.

You should also now consider getting a little insurance against valuations falling not, but well below, their long-term averages.

One place is in the investment trust industry. Most analysts keep a close eye on the discount their stocks are trading at to their net asset value (NAV) to get an idea of ​​when it might be time to buy. In June, the average discount across the industry widened to 9.5%, says Winterflood. This means that you can buy the shares of the average trust for 9.5% less than the actual value of the assets it holds. This figure was 2.2% at the beginning of the year, which should have been a signal of danger elsewhere. That’s up from an average of 4.4% over the past year and 4.7% over the past decade.

There is of course a huge range here – huge discounts in sectors such as real estate, private equity and technology, reflecting the expectation that the prices of the underlying assets they hold will soon to drop further, and not so huge as in the UK. equity income.

But the key is that the discount is wider than usual, which is good, but probably not wide enough to be a strong buy signal. This is clearly not the case if we think of it in terms of a comfort model – there have been times in the past when the average discount in the industry was 20%.

That said, any discount greater than a few percent gives you some reassurance, as the expectation of lower prices for the underlying holdings is already in the price. And some trusts seem to offer very high levels of long-term insurance.

Look to the private equity sector, says Nick Greenwood, manager of MIGO Opportunities Trust, a trust of investment trusts.

Many trusts in the industry deserve huge discounts, with the average currently well over 30%. The value of a large number of holdings will soon be depreciated according to price declines on the listed markets.

But not all private equity trusts invest in the kind of early-stage growth companies that plummet in value. Some have long focused on mature businesses and focused on earnings and cash flow. They won’t see the same depreciations – so they could be really cheap and provide you with built-in insurance. Look at Oakley Capital Investments — with a 30% discount — and NB Private Equity Partners with 36%, Greenwood says.

The other place to look for insurance in the UK at least is in dividends. Those who invested in the FTSE 100 this year will have lost around 3%. But that will for now at least be offset by the dividends they will receive along the way – the UK market yield is expected to be 4.2% this year – a total payout of £85bn, down from £78 .5 billion pounds sterling in 2021 .

This is not unique: the payouts are well covered by corporate earnings, notes AJ Bell, and while there is some concentration risk here, as more than half of the total payout comes from just 10 shares, more companies are paying dividends this year than last. year.

These dividend payments are significant. The FTSE 100 could drop 20% from here – who knows? But if it drops and stays low, dividend investors will at least know that they have an excellent chance of being par in nominal terms at least five years from now, thanks to dividends being paid out over 4% each year. .

You could even opt for dual coverage and buy one of the UK’s income trusts. They don’t offer a lot of discounts these days, but you can get 2% off the NAV at Murray International (4.5% yield) and JPMorgan Claverhouse (4.7%). And 10% to the Lowland Investment Company (5.4%). There must be comfort in that.

Merryn Somerset Webb is editor of Money Week. She owns shares in investment trusts, but none in the named companies. The opinions expressed are personal. [email protected]


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