My Small Cap Dilemma

I have something in common with the England football team. I may have been made to look better than I really am by a favourable context only to be found out in the most testing conditions.

I’m referring to my until recently successful use of a variety of UK small and mid-cap funds since my accelerated journey to early retirement began in 2012. For the next three years progress was largely serene, indeed the Numis Smaller Companies Index reached an all-time high in June 2015. The diagram below from the 2016 Numis Annual Review  captures the long-term outperformance of UK smaller companies over sixty years:

However look carefully and you can see the down-squiggle of 2007-9 which was far more severe at the time than the graph’s scale expresses (many UK smaller company funds and shares fell 40-60% between late 2007 and spring 2009).

  

Could we be on the brink of another sharp decline in UK small cap fortunes?

Even before the EU referendum vote on June 23^rd there’d been some signs of a pull-back before the severe and sudden mark-down. The partial recovery in some funds and stock prices since early July 2016 still leaves many several percent down, as the prospect of more difficult times for UK-focused smaller firms and funds looms.

So what to do? 

About 10% of my hoped for retirement fund is in non-income bearing UK smaller company funds (e.g. Marlborough Special Situations, Fidelity UK Smaller Companies, River and Mercantile UK Smaller Companies) from which I’d been intending to switch into dividend-generating vehicles (possibly adding to existing holdings in Acorn Income and Small Companies Dividend Trust) either side of the April 5^th 2017 tax deadline (I aim to leave full-time work in late 2017).

One of the many lessons of June 2016 is the importance of geographical/currency diversification and the avoidance of excessive home bias. 

I’d begun to address this in my 2016/7 ISA and the improvement in a number of previously lagging overseas holdings in Newton Emerging Income, Guinness Asian Equity Income, Aberdeen Latin American, and the strong performance of Fidelity Global Dividend, provide some indication of the worldwide array of income-generating options at my disposal.

However, one strategy is becoming more appealing, particularly given the likelihood of my breaching the £5000 dividend taxation threshold in future years. Rather than switching all my capital into dividend paying instruments I will reserve a portion for pure growth investments, selling a small portion of the capital if and when required to supplement the core natural yield of the bulk of my holdings. 

In this vein I am likely to add to what has so far been a highly successful position in Fidelity Asian Smaller Companies. The fund manager Nitin Bajaj has an admirably candid approach as he outlines in this 15 minute Charles Stanley video and this fund (and the very similar Fidelity Asian Values investment trust) provide access to companies I’d be highly unlikely to have found myself.

With (hopefully) thirty years or more ahead of me (perhaps even more according to this book about The 100 Year Life) there has to be a place for growth in my portfolio, and given the rhetoric of the new UK Prime Minister we can’t assume that dividend tax rates and thresholds will be left untouched in the years ahead.

In this possibly higher-tax lower UK dividend environment the ability to realise up to £11,100 per annum free of capital gains tax, as well as natural yield, from globally diverse sources should not be overlooked.

 

Books that Changed How I Invest

As a soon to be ex-academic reading has been my life. As I head towards early retirement I’ve radically altered my book-buying habits to provide a rapid self-taught course in investing. Here are five works that have changed not just how I think but how I’ve invested.

1. Benjamin Graham The Intelligent Investor

There’s a reason why most investing reading lists include Benjamin Graham’s classic text. Chapter 8’s famous personification of ‘Mr Market’ has once again proved prescient in the wake of the EU referendum result: “Often […] Mr Market lets his enthusiasm or his fears run away with him and the value he proposes seems to you a little short of silly”.

The 2003 edition with Jason Zweig’s helpful chapter summaries could do with an update. There is no shortage of recent material to work into the commentaries.

2. Lee Freeman-Shor (2015) The Art of Execution

Manager of the Old Mutual European Best Ideas fund, Lee Freeman-Shor draws on analysis of nearly 2000 investments made for his fund by some leading fund managers. Most of their decisions lost money, but the best managers made up for this with big winners. The key to success is knowing what to do with an initial winning or losing position to maximize gains and minimize losses.

Freeman-Shor provides a helpful typology of investor decision styles:

Rabbits: frozen into inaction, they hold onto losing investments for too long.

Assassins: ruthless with losing investments, they follow stop-loss rules and materially adapt when they are losing.

Hunters: buy more of an investment after an initial entry starts to lose in the conviction of its long-term recovery. Following this strategy emboldened me to add to a losing position in Aberdeen Latin American Income. The incremental addition is up over 20% in three months, bringing the total of three investments to near break-even.

Raiders: grab a small profit, but can sell out completely of winning positions too soon.

Connoisseurs:  sell a small portion of stakes in winning investments, but hold on to the bulk of their successful holdings.

3. Ben Carlson (2015) A Wealth of Common Sense

Ben Carlson’s book takes its title from his invaluable blog.

The text distills several years of wisdom:

- The necessity of articulating a clear investment policy statement: Why are you investing? What is your risk appetite? What is your time horizon?

- Making money in the long-term requires a willingness to endure losses over several short-terms in an investing life-time: “Plan on experiencing uneven results, frustrating periods, volatility, and the occasional crash”.

4. Tobias Carlisle (2014) Deep Value 

A challenging read in the best sense that mixes business biography and back-testing of deep value valuation metrics, ultimately to highlight the power of mean reversion: “investors aren’t rewarded for picking winners; they’re rewarded for uncovering mispricings – divergences between the price of a security and its intrinsic value […] And the place to look for mispricings is in disaster, among the unloved, the ignored, the neglected…”

5. S. Horan, R. Johnson, T. Robinson (2014) Strategic Value Investing

Another data-laden text, with chapters on different methods of estimating the intrinsic value of potential investments and thereby what both Benjamin Graham and latterly Seth Klarman term “the margin of safety”: the potential difference between current stock market price and the underlying value of the business.

As with Carlisle’s book this volume’s historic data illustrate the long-term advantages of small-cap value, together with the attendant short-term volatility -  an important lesson given what’s happened to my overweight in UK small and mid-caps since late June.

Introducing 'The Uncertain Investor'

“Restless and incalculable, the speculative market reflects the wild ambitions, the reckless imagination, the haunted mind and the ever-mutable outlook of the business world and of humanity at large” (G.L.S. Shackle (1982) Means and Meaning in Economic Theory).

Those characteristically prescient words of the English economist George Shackle are an apt opening for 'The Uncertain Investor' amidst the ongoing turmoil of post-Brexit politics and economics.

Who am I?

Inspired by the emerging Financial Independence movement, particularly the writings of Monevator, Simple Living in Suffolk, and fuelled a few years ago by a combination of a sudden inheritance and growing discomfort with full-time employment I plan to ‘retire’ in 2017 but thereafter work on refining the raw thoughts and ideas I will lay out here as a bridge between now and then.

My investment journey

From an unhealthily young age I’ve been intermittently engaged with the stock market. My father set up a Barclays Unicorn financial plan to part fund my university life in pre-student loan days and I gradually became aware of his portfolio: Grand Metropolitan, Smithkline Beecham, Ash and Lacy, Ault and Wiborg, Ocean Wilsons.

As I studied A-level Economics the privatisation of British utilities introduced my mother to the stock market and I became her informal financial ‘adviser’ [no commission…]. I bought my first share in 1984 (12 shares in Applied Computer Techniques, makers of the Apricot PC) adding a rather random collection of unit trusts and individual equities in the following years (e.g. Hays, National Express). The 1990s and early 2000s was dominated by career-building and deposit-saving until the ill-timed purchase of a flat in the mid-2000s, coupled with lack of time and at that point relative financial ignorance, meant I could do little other than watch my savings decline through the late 2000s financial crisis.

The death of both parents, becoming an executor twice, inheritance, and the discovery that extreme early retirement was possible find me here. Since becoming mortgage-free in 2012 I’ve targeted 2017 as the year I walk away from my office for the last time and have been rapidly accumulating capital and knowledge to reshape a still growing portfolio to that end.

What can I add to the many wise words already posted by others on these themes?

However sophisticated I might feel my investment philosophy is, in practice it’s less Warren Buffett or Benjamin Graham, more as Eric Morecambe might put it: ‘I make all the right investments, but not necessarily at the right time’...

So I will use 'The Uncertain Investor' to highlight my mistakes (currently too overweight in UK small caps, too many UK equity income funds, too many investments, why no passives, why no bonds?...I could go on…) and the occasional success (Caledonia Mining, dividend up 22% today!) I will document my dilemmas, share links, resources, reflections and hopefully contribute thoughts to help us all navigate through treacherous times.

Why ‘The Uncertain Investor’?

The reference to, and contrast with, Benjamin Graham’s classic The Intelligent Investor is deliberate. Instructive though Graham and many other investment texts are, I've been revisiting the economic thought I briefly encountered as part of my degree in the 1980s. Keynes's General Theory, particularly Chapter 12, is always worth re-reading, perhaps even more so his 1937 article in the Quarterly Journal of Economics.

Yet as the opening quotation suggests one of Keynes’s lesser-known interpreters, G.L.S. Shackle, is the thinker I’ve found most probing.

Shackle’s distinctive approach to the human condition, “a theory of intelligent conduct in a flowing, enigmatic and elusive world”, regards choice not as a cool calculation of cost and benefit but as an anticipation of an imagined future and a commitment to a course of action in a time-to-come: 

“Choice is a resolve, a moral and not merely an intellectual act […] In the act of choice, the chooser in some degree stakes his own self-esteem”. (G. L. S. Shackle (1979) Imagination and the Nature of Choice).

In choosing where to invest, more is at stake than our money.

My current reading/listening list

You Have to Invest (A Wealth of Common Sense)

How Real are those post-Brexit Gains? (Simple Living in Suffolk) which reminds me of Harold Wilson, 1967, 'The Pound in Your Pocket'

Aswath Damadoran's Musings on Brexit

Where are the Best Global Values? (Meb Faber podcast)