BLOG - What the market forgets
Rob Davies, Fund Manager VT Maven Smart Dividend UK Fund
Equity markets thrive on news flow. Brokers and investors strive to get hard, meaningful data before their competitors and everyone wants to be first. In practice the omniscient nature of the Internet means that all legally available information is known to all interested parties within nanoseconds. There is, it seems, very little the market does not know, but does it appreciate the underlying forces at work?
It is true, for example, that different parties can look at a set of data from quite separate perspectives. As far as the UK market was concerned AstraZeneca was a rather dull drugs company without much of a pipeline of new products but with a prodigious cash flow from mature medicines and hence worth about £40 a share. To Pfizer however, with its unique cash and tax situation, it was worth £55 a share. It can be argued that investors should have known the attractions of the company for a predator and factored a takeover premium into the price. But UK investors chose not to.
The same logic can be applied to pretty much any large or medium sized company on a traded market. There is very little relevant hard data that investors cannot access. However, it is much harder to process these data in a systematic way that focuses on the key underlying business drivers. This is one area where the market is weak, as brokers and managers tend to focus on the very recent news as a pointer for longer term trends.
Companies like Carillion make a great play on new contracts they have won, and understandably so. What is more important to investors though is that earnings fell by over 30% last year, but the Board nevertheless decided that it should increase its dividend by 1.4%. This complacent attitude is becoming more common. According to Bloomberg dividend cover (the ratio of earnings to dividends) for the FTSE 100 has dropped from 2.43 in 2011 to 1.9 in 2013, and is currently standing at 1.3. What it means in practice is that increases in dividends are likely to be more modest in future years. In some cases, it is difficult to envisage any meaningful increases for some time to come. That is not to say these companies will not grow. They almost certainly will, but they won’t be able to distribute cash to shareholders as rapidly as other companies that have higher dividend cover and better prospects. Allocating capital between these various companies is a challenging task and is what fund management is all about.
At the moment the mainstream approach used by index funds would be to allocate in proportion to the size of the company, as determined by its market capitalisation. That has the attraction of being simple and easy to do. Active investors start from this base and then tweak the holding up or down depending on their view of its short term prospects. The temptation is always to be seen to be doing something in response to news. What investors forget, or choose to ignore, is that timing these decisions is virtually impossible to get right on a regular basis.
An alternative approach is to harness the value of the underlying business strength, by focusing on a fundamental measure, such as dividends, and weight the portfolio using that measure. This reduces the inclination to tinker with the portfolio at every bit of news, as dividends do not change as much as sentiment. It is more important to remain invested in the market where dividends contribute 95% of UK equity returns since 1945 according to the Barclays Equity Gilt Study. What the market often doesn’t recognise is that doing nothing, or very, very little, can be by far the cheapest and best investing strategy.