On Target Newsletter
2020.01.31

In this issue:

  • European Union’s troubles
  • International portfolio planning
  • Value stocks
  • Kibbutzim
  • Germany’s car industry
  • Gold
  • US & Iran

Europe Without Britain Faces a Turbulent Future

Britain exits from the European Union today. It leaves what is by far the world’s most important community of sovereign states, with an economy roughly the same size as America’s, to adjust to the loss of one of its key member-nations – one that is both a major economy and a nuclear-armed military power.

How future trade in goods and services is to be conducted, and some sensitive matters such as fishing rights, still have to be resolved. Probably, as the British government argues, this can be done, or largely so, by the end of this year.

But the European Union has a fistful of other huge issues to deal with, many of which whose solutions will require the unanimous approval of all 27 of the remaining member-states…

► A budget for the next seven years deprived of Britain’s contribution. There are major disagreements over how much is to be spent, how it should be spent, and who should pay for it.

► Increasingly divisive internal policy matters such as immigration, addressing climate change, the independence of judges.

► The need to build fiscal union with greater centralized power to manage individual member-states’ finances – their governments and their banks — and provide resources to deal with financial crises. Lurking out of sight is the huge Target 2 build-up of the south’s debts to the north within the Eurozone system.

► Development of an agreed and proactive foreign policy for Europe in a world where the US is disengaging, even turning hostile; the difficult enemy-or-friend relationship with Russia needs to be resolved; and the rising power of China has to be accommodated.

► Research and innovation has been so neglected that Europe is way behind the US, China and Japan in developing and patenting key enabling technologies in industries such as micro- and nano-electronics, weaponry, biotech and artificial intelligence.

► If NATO is, as the French president claims, “brain dead,” Europeans have to face up to the need to reduce their military dependence on the US and replace it with their own centrally-commanded great-power-scale armed forces… a European Army… with conventional, nuclear and cyberwar components. Even outside the EU, the UK has to be a key part of that.

Financial Framework. The plan now ending has pegged spending at 1 per cent of gross national income. The European Parliament wants to boost that to 1.3 per cent in the plan for 2021-27. The European Commission is willing to accept less: an increase of 1.1 per cent. Individual governments favour even less. Germany opposes any increase at all.

Someone has to make up for the loss of Britain’s contributions. The financially weaker countries of the South and East want most of the burden to fall on the wealthier North. Which, understandably, strongly opposes that.

There are major issues over how the money is to be spent under the new plan. France always fights hard and successfully to maintain big subsidies for agriculture, which currently accounts for a massive one-third of all the EU’s outgo. Poland and its allies in the East don’t want cuts to the substantial aid they receive to combat their relative poverty.

The new European Commission president, Ursula von der Leyen, wants to make rapid achievement of zero emissions of carbon gases the hallmark of her time in office. The cost is going to be mind-boggling. One official estimate speaks of the need to invest €260 billion every year to achieve a carbon-free idyll.

A major fight is developing over who is going to pay for this, with countries like Poland, that will be forced to shut down its coal mining industry, demanding massive compensation… passing the cost of carbomania on to other countries. There is also mounting conflict over whether nuclear power should be allowed as an alternative to fossil fuels.

The driving force behind European integration has been the catastrophic history of two world wars. Never again, Europeans say… all European nations must work together to prevent conflicts. But with the passing years, that driving force is losing its impetus. Citizens grow resistant to rule by bureaucrats in Brussels implementing policies they increasingly view as foreign, alien to their cultures, views and priorities.

The EU, says commentator Wolfgang Münchau, “is splitting along three faultlines. One divides the prosperous North from the indebted South. A second separates a eurosceptic fringe from a europhile centre. A third is between a socially liberal West from an increasingly autocratic East.”

It’s becoming harder in Europe to develop and implement policies that require significantly greater integration. Difficult and increasingly turbulent years lie ahead.

Planning Your International Portfolio

If you are an individual investor who would like to diversify internationally, to reduce the risk in your portfolio – and hopefully improve your returns over time – what assets should you select?

Here are some ideas drawn from various sources over my several decades of writing on the subject…

Index tracking: If you believe a return at or close to the market average is the best you can hope for, your best approach to global asset allocation is a passive investment programme replicating market indexes, using exchange-traded funds (ETFs).

The world’s most famous investor, Warren Buffett, argues that index-tracking strategies are fine for ordinary folk who don’t have the knowledge and skills to manage well their equity portfolios.

Others argue that the sensible way to invest in shares is “stock picking,” or selecting the companies or funds that can gain in value against the trend. The trouble with that is that it’s hard to do. Either you have to have the knowledge, skills and time to do it yourself. Or you accept the “fund manager risk” – the risk of selecting managers who get it wrong. Usually their track record turns sour just after you commit your money to them!

As an alternative to the handful of investment funds that truly mirror a global index, you can construct your own portfolio out of a selection of regional funds, or those that track single country indexes, using ETFs (exchange traded funds), investment trusts (closed end funds, also listed on stock exchanges) or mutual funds (unit trusts).

What’s better, passive or active management?

The most important argument against trackers is that they channel your investment towards overvalued shares – those unlikely to have most upside potential — rather than undervalued ones.

The most powerful objection to the alternative, actively-managed funds, is that in practice they are rarely able to match — let alone beat — the performance of trackers over the long term, and identifying the few exceptions in advance is very difficult.

Past performance is of little value: For smaller investors, collective funds are the only practicable way to go global. But how do you select ones for your portfolio?

With international, as with domestic, funds, investors have come to realize that past performance is no reliable guide to future returns.

A fund may look good over periods such as one, three or even five years just because it had one sensational year. It may have done well in recent years only because market fundamentals or fashions have favoured its particular investment style… which is on the verge of going out of favour.

But one kind of past performance does seem to foreshadow the future – poor performance tends to continue.

By choosing a particular category, benchmark and/or time period, managers of a fund may be able to present its performance as having been excellent. That’s why it’s important to look at consistency of returns.

Questions to ask: If a fund looks good on that basis, discover how the consistently high returns were obtained. Was it luck or judgement? Is the performance repeatable? Has the strategy been high- or low-risk?

Experts suggest you should also ask: “What is the most money I could have lost in this fund if I had bought and sold it at the worst time?” That gives you a measure of downside risk.

Does the fund you have in mind really do what it claims to do?

Some of the funds investing in shares in China, for example, were discovered to be very high risk venture capital providers. Others, more reputable, actually had much of their funds invested in Hong Kong and/or Taiwan, which is not quite what most investors had in mind when they went into a “China” fund.

An American study showed that some funds were able to improve their benchmark-adjusted returns by nearly 1 per cent by switching categories at the end of the year, so they could be measured by benchmarks that showed them in the best light.

So take a look at the detailed composition of a fund’s portfolio and see how it compared to its claimed investment approach.

Evaluating managers: How much did the past performance of the fund depend on one person rather than a cohesive team of clever investors? There is a surprisingly high turnover of managers, so the one who racked up the impressive gains may have been poached by a rival firm.

Finding out who will really decide where your money goes can be difficult, especially as some fund groups don’t want their managers to become too well known. But if you can, discover who’s The Man, how long he’s been with the fund, what his overall track record has been, and whether his style matches your investment objectives – or whether it has changed recently.

Letters to shareholders often help as they tend to be written by the managers themselves, rather than by PR hacks. Such letters generally offer a fairly candid view of what has gone right with the fund and what has not.

Ask the fund management company for copies of published interviews with the manager.

How much is luck, how much is skill?

The aim of all this detective work is to differentiate between luck and skill, to discover which part of a fund’s returns is due to markets, which to investment style, and which to stock-picking skills.

Do managers really matter that much? An American study by CDA/Wiesenberger of 40 equity funds found that the top performers fell to 10 per cent below the norm in the five-year period after their managers left. Conversely, the study showed that returns from poor performers soared from 69 per cent below the norm to 27 per cent above average in the five years after a new investment manager was hired.

Find the local hero: A simple way to find the right manager for a country fund is to go with the best of the indigenous funds, some experts suggest.

One study by a firm of performance measurement experts showed that the best returns among funds investing in a single country will generally be scored by local, rather than foreign, managers. Not surprising, I suppose.

So you’re likely to do best by picking a local team – if there’s one you can invest in – to manage a single-country fund.

Group style: Don’t just look at the fund – look at the group as a whole. If it’s posted solid performances in its other funds, that’s a plus.

Individual funds can have a great run for a while because they’re invested in a particular country that’s currently top of the pops.

But for the long haul, your best chance of achieving decent returns is to invest in several country or regional funds run by one, two or three management companies with the best all-round and consistent performance. There is the added advantage of reduced costs should you decide to switch funds within a group.

Keep down expenses: Given equal risk-adjusted performance, a fund with a low expense ratio stacks the odds to your advantage.

This factor favours, in order of priority: no-load funds (generally only available in the US), exchange traded funds and investment trusts whose shares are listed on a stock exchange, then load funds such as unit trusts. Load funds are those that take an up-front charge, so don’t invest the full amount of your capital.

A study by the US financial magazine Forbes showed that on average there was no difference in performance between load and no-load funds.

Go “offshore”: Funds based in tax-exempt locations offer advantages over onshore funds in that they don’t deduct tax for any revenue authority before distributing income or gains to you, have greater freedom in the ways they invest, and offer greater client confidentiality. The downsides are that their charges are usually higher, they often lack sufficient transparency, and you enjoy less investor protection if things go wrong.

The term “offshore” applies to funds based on islands, such as Jersey, the Isle of Man, Bermuda, but also to funds in landlocked countries such as Luxembourg and Switzerland that are marketed to non-residents.

Fund managers, bankers and trust companies based “offshore” do not normally disclose an investor’s holdings to any third party. However, because of increasingly aggressive activity by governments to combat tax evasion, money laundering and financing of terrorism, they will usually do so to investigative agencies that produce the correct paperwork.

Keep it simple: Using one fund family makes for trouble-free management, which encourages you to do your periodic portfolio reviews. It also “brings you many conveniences, such as toll-free telephone switching, consolidated monthly statements and an annual consolidated tax statement,” says one adviser.

Firms such as Vanguard (US-based) and Robeco (Europe-based) “have all the tools needed to build a first-class, globally-diversified, low-cost asset allocation plan within their fund families. They’ll even show you how their funds can help you index nearly the whole world’s tradeable economies.”

How to achieve cost savings

If you wish to diversify beyond one group, you can keep things simple by using one discount brokerage house that gives you access to hundreds of funds with the convenience of a single account. You can avoid initial purchase charges on existing funds or stocks you wish to keep by transferring title to your discount brokerage account. The transfer may take weeks to clear, but should mean tidy cost savings.

Be careful to avoid funds with frequent turnover of their holdings, steep expenses and high minimum investments or yearly charges. Money taken in charges is loss of capital that would otherwise be invested in growth.

New funds: Don’t be dazzled by new funds. Most of them are just virtual clones of existing ones, or currently fashionable ideas that are almost certain to disappoint. However, occasionally something new and really useful becomes available, such as the ETFs offering direct investment in gold, oil and uranium, or single-country funds providing a convenient way to invest in a smaller emerging market or business sector.

Investing directly in shares: Exactly the same principles apply internationally as they do in your home market. You need to do a lot of homework before committing your money. Unless you value the advice and research you get from stockbrokers, use discount brokerages.

Earnings expectations are an important determinant of share prices. You can track analysts’ forecasts and how they are changing for thousands of companies worldwide by subscribing to the IBES system, but it’s far too expensive for individual investors.

Avoid heavy brokerage costs by opening an account within any country in which you want to invest directly and substantially in its shares. Deal with the biggest bank, so there’s no risk it will go bankrupt. They’ll keep your certificates, collect your dividends, and reinvest if you wish.

Underperformance by Value Stocks

We are currently in one of the longest-ever stretches of underperformance by value relative to growth stocks in the US equity markets says NTAsset’s Kenneth Ng. But investors should remember that value stocks always reverse, leading to long stretches of outperformance by value.

The current premium of value over growth is a negative 6 per cent. Historical evidence suggests that such sizeable underperformance by value stocks would be followed by outperformance averaging 19 per cent a year over five. This “rosy future” for value stocks suggests that the current situation offers a “lucrative opportunity to purchase value stocks,” Ng says.

Although identically comparable data isn’t available for emerging markets, the past period of underperformance looks similar to that of 1994 to 1999. When the dotcom bubble burst and the US went into recession, it was followed by one of the best periods for emerging markets.

For a quite different view on value-based investing, here’s what the outstanding British fund manager Terry Smith has to say about it in his latest annual letter to shareholders (including me) of his Fundsmith Equity fund…

He is not a value investor. His strategy is similar to that of the world’s most successful investor, Warren Buffett, which he describes as: Buy good companies; don’t overpay; then do nothing. Buffett’s rule is that “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

Smith says value investing “has its flaws as a strategy. Markets are not perfect, but they are not totally inefficient either. Most of the stocks which have valuations which attract value investors have them for good reason – they are not good investments.

“This means that the value investor who buys one of these companies which are indeed lowly rated, but which rarely or never make an adequate return on capital, is facing a headwind. The intrinsic value of the company does not grow (except for any new capital that its hapless investors allow it to retain or subscribe for in some form of share issue), or even erodes over time, while the value investor is waiting for the lowly valuation to be recognized and the share price to rise to reflect this.

“Over the long term the returns of any portfolio which has such an approach will tend to gravitate to the returns generated by the companies themselves, which are low for most value stocks.”

The biggest flaw in value investing, whose very nature does not lend itself to buy-and-hold but requires switching from shares that are perceived to be expensive to those seen to be cheap, “is that it does not seek to take advantage of the unique characteristic of equities.”

They are “the only asset in which a portion of your return is automatically reinvested for you. The retained earnings (or free cash flow if you prefer that measure, which we do), after payments of the dividend, are reinvested in the business. This does not happen with real estate (you receive rent, not a further investment in buildings), or with bonds (you get paid interest, but no more bonds).”

Buffett explained his switch from being a traditional value investor to one who selects “quality” companies focused on growth because the defect in value strategies is that the original price that looks like a bargain “probably will not turn out to be such a steal after all. In a difficult business no sooner is one problem solved than another surfaces. Never is there just one cockroach in the kitchen. Any initial advantage you secure will be quickly eroded by the low return that the business earns.

Smith says investors, rather than spreading bets across several strategies and seeking safety through diversification should rather follow people such as Warren Buffett and Charlie Munger (Berkshire Hathaway), Bill Gates (Microsoft), the Bettincourt family (L’Oréal), the Brown family (Brown-Forman), and Bernard Arnault (LVMH), who “all seem to have become extraordinarily rich by concentrating their resources in a single high-quality business and not trading regardless of valuation.”

Israel’s Socialist Model Falls Out of Favour

For decades many young people around the world have looked to Kibbutzim, the unique communes as a model of an ideal way of life of hundreds living together, working the land together, raising children together, as one huge single family, from each according to ability, to each according to his or her needs. Some have even travelled to Israel for the experience of living in one.

But in Israel itself, they’ve fallen out of favour. Only a handful of the settlements still exist that conform to their traditional socialist ideals.

They haven’t worked as well in practice. One reason is that individual ownership – of clothes for example – was discouraged. When clothes were sent for laundering, no tabs were kept on whose were whose. “Women hated it,” Johan Norberg reports in The Spectator. “When everything was shared, people left lights on day and night and invited acquaintances – even their dogs and cats – to eat in the communal hall for free.”

Depending on communal land cultivation didn’t work out the way it was supposed to, either. Kibbutzim began hiring outside labour.  They also began employing outside managers and assigning wages according to skill levels.

“Eventually most kibbutzim privatized themselves by giving each member entitlement to their dwellings and an individual share to their factory or land.”

So socialism rarely works the way it’s supposed to. In practice societies revert to a system based on incentives and disincentives for individuals, with nuclear families. It’s what is generally called… capitalism.

Germany’s Ruling Class Chooses Self-Harm

Although Germany’s biggest manufacturing industry, motor vehicles, is being hurt by a cyclical weakness in global demand, the serious damage is being done by what Jefferies’ Christopher Wood calls self-harm.

Under threat from penalties that could cost as much as $25 billion, it’s being forced to make electric vehicles its principal product. That means having to build radically different production lines at great expense. And buying batteries, the major component, few of which are even made in Europe – they mainly come from plants in China, Japan or Korea.

As from January the automotive industry has to cut average CO2 emissions of the cars it sells to 95 grams per kilometre.

The biggest problem with electric cars it’s being forced to make its major product is that most motorists don’t want to buy them. Last year they accounted for only about 3½ per cent of sales of new cars in Europe despite governments’ huge subsidies.

What makes things even worse is that political hostility to diesel engines is driving motorists to convert to petrol motors despite the fact that the latter are roughly a quarter more polluting than diesel in CO2 terms. And that about two-fifths of buyers now prefer the bigger, more polluting, American-style SUV models.

A recent study concluded that in the German industry alone the European Union’s enforced transition to electrics is going to destroy more than 400,000 jobs.

Converts to the Merits of Gold

Credit Suisse expects gold prices to “perform well” this year, but its forecasts are very moderate – an average of only $1,540 an ounce. Supportive factors for the metal are expected to be a continuation of major central banks’ extreme easy-money policies, negative interest rates, and gold buying by many central banks.

The world’s biggest hedge fund, Bridgewater Associates, is much more optimistic because central banks are no longer hostile to inflation and there are mounting political uncertainties. Chief investment officer Greg Jensen says gold could easily surge to $2,000 an ounce and should be a cornerstone of investors’ portfolios. “When you look at geopolitical strife, how many foreign entities really want to hold dollars? What are they going to hold? Gold stands out.”

The FT’s Rana Foroohar says looming threats such as unfunded pension and healthcare entitlement in the US, and the willingness of central bankers and policymakers to try to deal with them by printing money, “could make gold the hottest new asset class of the next few years.”

Gold mining companies are currently more interested in buying up existing producers than in the higher-risk business of borrowing capital to invest in exploration and development. That’s good news for investors as it allows miners to accrue profits so they can pay down debt, raise dividends and buy back shares.

Geopolitical Risks

Although the chances of a full-scale war between America and Iran are unlikely – “no more than 20 per cent” — tensions are likely to mount, predicts the well-known commentator Nouriel Roubini.

“The conflict will continue to feature aggression by regional proxies (including attacks against Israel)), direct military confrontations that fall short of all-out war, efforts to sabotage Saudi and other Gulf oil facilities, impeded Gulf navigation, international terrorism, cyber attacks, nuclear proliferation, and more. Any of these could lead to an unintentional escalation of the conflict.”

Iran badly desires “regime change” in the US – failure by Trump to secure re-election in November. It can make that more likely to escalating tensions. It can afford to do so as hostile initiatives or reactions by the US such as the assassination of Quds Force commander Qassem Suleimani drives Iranians to rally around the regime. It has all the incentives to do so, initially through proxies and asymmetric warfare.

Investment markets’ current complacency is not just naïve, but “utterly delusional,” Roubini says. The risk of further softening in world economic growth, or even a global recession, is now much higher and rising.

Tailpieces

Negative interest rates: Despite very low — sometimes even negative — interest rates, Germans continue to save strongly. Last year their holdings in cash and current account deposits rose 8½ per cent to a record €1.8 trillion.

Most of the nation’s big retail banks have started to pass on to customers the negative interest rates forced on them by the European Central Bank – but only to companies and wealthy individuals; those with deposits of more than €300,000.

The authorities are clearly worried that the negative rates will drive savers into gold. To discourage them the limit above which names and details of buyers of gold must be reported has been reduced to only €2,000. At that level you can’t even buy a wafer of as little as 50 grams without having your identity registered.

China: It’s pursuing a long-term strategy of reducing its reliance on trade with the US and in its currency. Examples of three major deals that have been part of that strategy are a long-term agricultural agreement with Brazil, a long-term bargain to buy oil from Iran, and a long-term pact with Russia to buy gas from Siberia.

Despite its trade war with America over tariffs and the rising costs of operating in China, it has been able to hang on to its huge share of global trade. In the 12 months to September it accounted for 13.2 per cent of world exports, compared to 8.7 per cent by the US, 7.8 per cent by Germany.

Top engineers in demand: About 10 per cent of all semiconductor engineers on Taiwan – some 3,000 of them — have left the island to go work in China, where the government has launched huge state-funded initiatives, including attracting experts from abroad, to develop production of advanced electronic components. China knows that to compete with and then overtake the US it must achieve this. To become a military superpower it must have the best chips for advanced armaments such as hypersonic missiles, fifth-generation fighters and laser weapons.

Four risks: Goldman Sachs’ chief equity strategist David Kostin says that “the combination of accommodative monetary policy, low interest rates, range-bound oil prices and continued economic expansion is constructive for US equities.” However there are four major risks, any of which could derail the optimistic scenario… A prolonged conflict over Iran that raises oil prices; a rapid rise in interest rates; the dollar’s trend reverses from weakness into strength; economic growth turns out to be much weaker than expected.

Capital flight: Bank of America says that 2019 was one of the worst years on record for performance by active fund managers, with less than a third of the stock-pickers ending ahead of their benchmarks. That’s why those with billions to invest are increasingly switching to low-cost passive strategies. The huge California Public Employees Retirement System, for example, last month cut the number of its external equity fund managers from 17 to three and slashed their combined allocations from $33½ billion to $5½ billion.

Money bubble: Here’s a surprising… shocking… fact from Eoin Treacy of FullerTreacyMoney: “The aggregate of central bank balance sheets has increased by $750 billion since early OCTOBER” (my stress). Have the money printers gone nuts? Or are they acting out of fright of the danger of some major crisis lurking in the global financial system?

Money & wealth: “Gold is the money of kings, silver is the money of gentlemen, barter is the money of peasants – but debt is the money of slaves.” American author and commentator Norm Franz.

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