Good reads from around the Web.

Once about as exciting as an ice bucket challenge for a polar bear, in recent years bonds have provoked some fierce debate.

In fact, for years it’s been a near-consensus opinion that bonds have been in a bubble.

Yet it’s a bubble that’s staunchly refused to burst.

The uncertainty has even grabbed the attention of sleepy passive investors, who have caught the whiff of the fear about bonds and wondered if they should really hold them in their supposedly speculation-proof portfolios.

We’ve tried to do our bit to steady the nerves, pointing out that bonds are in your portfolio for stability, not the expectation of great returns.

And also that passive investing works because you let the maths do the work, not speculation.

Gilts do the business in 2014

For my part as a legendary speculator in my own spare bedroom, I’ll admit I’ve thought bonds over-priced for ages – and far too early.

But having been humbled many times by the markets, I’ve urged the more vehement posters in the comments of this website to curb their expressions of certainty.

Any time we typed the word ‘bonds’ in 2013 – even in a simple ETF portfolio update – it felt like everyone and their dog stopped by to tell us that bonds were set to crash in 2014, and if you must hold fixed interest, hold cash.

Yet as I write the Vanguard UK government bond fund has returned 6.79% so far in 2014, beating the 2.74% return from UK shares!

Oh Mr. Market, how you love to put egg on the faces of the overconfident.

Bonds, bonds, everywhere, and barely any income to drink

Of course the year is not done, and even a year is a small time period over which to judge an asset class.

Yet government bonds – and the co-incident swelling of public debt around the world – have been defying investors for years, as Elaine Moore explains in her summary of the situation for the FT this week (note: link is a search result):

…bond markets have flourished, forcing investors to reconsider the level of risk they are willing to take in credit markets to find respectable yields. Debt sold by European countries that once faced a forced exit from the Eurozone has attracted levels of interest that would have seemed incredible two or three years ago. […]

The switch into riskier bonds isn’t confined to Europe, either. Flows of money into emerging markets have also swung up, with the “taper tantrum” swiftly forgotten.

Countries such as Ecuador, Ivory Coast and Pakistan have returned to markets – after years of civil war, political turbulence or debt defaults – to find investors more than willing to lend at rates of just 6 or 7 per cent. Those are the sorts of yields that prime borrowers such as the UK or US had to pay before the financial crisis.

Surprising stuff.

Now, I don’t think the demand for bonds this year is a reason not to be cautious about the asset class.

You can’t escape the mathematics of bond returns, and with yields already so low there’s really no way we could have very strong nominal returns for many future years. (Well, unless we saw deflation. Even a 1% return from a bond might be attractive if inflation was negative by 2%, for example.)

And personally, as a reckless and ill-advised active investor, I’m holding cash and selected obscure fixed income securities like preference shares to diversify my largely equity-focused portfolio for now.

But if I was a pure passive investor, I’d still have the chunk of my money in UK government bonds that’s suggested for my risk profile, perhaps split between bonds and cash.

My word, bonds

Meanwhile if I was an investing enthusiast prone to sharing my certain opinions on investing websites and bulletin boards, I’d try to have just a little more humility when it comes to bonds.

This is for two reasons.

Firstly, it’s clear something has to give someday with bonds. But just like with stock market corrections, as 2014 has proven in spades the timing is at least difficult, and likely impossible.

Secondly, many private investors weaned on shares don’t understand the mechanics of fixed interest investments.

The reality is that rates can slowly rise, bond prices can go down, and you can still end up with a positive total return – because you’re getting income, and you’re reinvesting it at progressively higher yields.

As a Vanguard white paper quoted on FE Trustnet put it earlier this month:

“A simple duration analysis can give a rough estimate of the price return, but this ignores the income that an investor earns over time,” said Vanguard.

“As the graph [below] shows, despite realising a -10.4 per cent price return over the next 10 years, the investor’s cumulative total return is actually positive at 31.4 %.”

“On an annualised basis, this is 2.8 per cent per year, roughly equal to the current yield on the 10-year gilt, which emphasises that the starting yield is key in forming forward-looking return expectations in fixed income.”

“Clearly, just focusing on capital losses ignores the bigger picture.”

Here’s the graph (sorry about the size, it came that way):

Rates higher (as being predicted by the market at the time of the White Paper) would have resulted in an okay long-term return, as a decade of increasing income made up for the capital losses.

Cut out and keep that graph if you want to understand bonds.

More reading week on bonds:

Bonds: Looking beyond interest rate risk – A Wealth of Common Sense

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Good reads from around the Web.

Unlucky, Morgan Housel. The Motley Fool überwriter has just written the ultimate parody of all those pundits who pin the random fluttering of the stock market on the wayward wings of some geopolitical butterfly.

Alas his piece has been published in a rare week when, unusually, there really were explicit moves in the market based on investor’s will-they-won’t-they feelings towards the Russian/Ukranian conflict.

Of course, in a few years we’ll probably be chortling as we look back:

“Remember when we actually thought Russia might invade Ukraine? And NATO might even respond? LOL! And to think they now all rub along together at Disneyland Kiev”.

Well, let’s hope so.

Timing aside, Housel’s article is just the latest in a long line from him that I wish I’d written.

Here’s a taster:

Stocks gained momentum on Monday, with the Dow Jones Industrial Average closing up 48 points, reversing losses from last week’s decline.

Experts hailed both moves as a “remarkable, textbook example of pure statistical chance,” chalking up Monday’s gains to a couple of random marginal buyers being slightly more motivated than a few random marginal sellers.

“Imagine you pick 1 million random people from around the world every day,” said Toby McDade, chief investment officer of Momentum Fee Capital Management. “Some days, 51% would be in a good mood, 49% in a bad mood. The next day maybe it’s the opposite. Other days, random chance could mean 8% of people are really pissed off for no real reason. This is basically what the market is on a day-to-day basis,” he said.

Asked what his clients thought of this view, Mr. McDade laughed.

“Oh my God, you think I could tell my clients that? How could I justify my salary?”

Genius.

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“Data! Data! Data! I can’t make bricks without clay.”
– Sherlock Holmes, The Adventure of the Copper Beeches

A regular Monevator reader, G., recently wrote in with a question about how to properly organise the deluge of information he comes across in his investment research.

Indeed, all of the information available can easily produce, as G. called it, “paralysis by analysis” – that is, being so overwhelmed by data that you decide no decision is the best decision.

G. noted that this issue was starting to frustrate his active investing:

Whilst I am making progress on building a portfolio with ‘good’ dividend companies, I have created a problem with amassing a great deal of information during my research.

With this in mind I was wondering if there were any ‘tips’ on how best to organise this?

I have newspaper / magazine cutouts, information from various books written down on A4 pads, extracts from your website and many others.

The term paralysis by analysis springs to mind. I appreciate that this may not be a subject that you could provide a steer with. It’s just that it is starting to demotivate me on a subject that like.

Thank you for reading this message and keep up the excellent work.

I can certainly relate to the reader’s frustration, as I’m sure many of you can.

Even ten years ago, I would see my stock quotes just once a day in the morning newspaper. Sometimes I’d go to the local library to look up the by-then dated company information that was printed in a monthly shares magazine.

Today, by contrast, investors can have any piece of public information available with just a few keystrokes.

In some ways, this easy availability of financial data makes research less time-consuming.

However the amount of data can also unnecessarily obfuscate the process, and make investing decidedly less fun.

You call the shots

It’s important to start with the premise that investing is a decision-making business. As with most decisions you need to make, you’ll never have complete information nor will all of the data you compile necessarily lead to one conclusion.

Still, you must make a decision to either buy, sell, or do nothing.

What’s great about investing is that doing nothing is a valuable option for individual investors. As Warren Buffett said in 1999, “You don’t have to swing at everything (in the stock market) – you can wait for your pitch”.

In other words, when you’re managing your own money, you don’t need to buy or sell a share if you don’t want to.

This advantage for individual investors shouldn’t be underestimated.

Professional money managers don’t often have the luxury of doing nothing. Their clients usually insist they take action, any action, and falsely equate action with the manager earning his paycheck.

With that in mind, a key to good investing research is to relax.

There’s nothing wrong with saying, “I don’t understand this” or “this isn’t the right time to buy this share” and moving onto the next idea.

Keep the notes you’ve taken on that particular idea to review at a later date.

Go your own way

I believe the best way to reduce all the information you feel the need to keep track of is to focus your investment process.

Each investor’s research process is different. An investor taking a dividend-focused approach, for instance, will likely collect and process data differently than someone with a high-growth approach. That’s what makes a market.

What’s important is that you develop a process that’s repeatable and simple.

The start of a good, repeatable process is to establish some simple screening criteria that greatly reduce the thousands of available shares to a few dozen or so that more closely fit your objective.

To illustrate using a dividend-focused approach, I’ve previously outlined a few screening criteria. The next step in that process would be reviewing the screening results and identifying a few companies that are worthy of further research.

I suggest studying one company at a time, otherwise you’re likely to be overwhelmed.

Once you’ve found a company to research, read the last two or three annual reports and the most recent interim report to get a better feel for the company’s business. If you don’t understand how the company makes its money by that point, I’d pass on the idea.

If you still like the company at that point, take a closer look at the balance sheet, cash flow statement, management, and if you’re an income investor how the dividend has grown over time.

Another key to a good investing research is to focus on avoiding mistakes rather than seeking winners.

When you’re looking at the financial statements, you don’t need to get bogged down in the details (unless you’re an accountant by trade or really enjoy digging into the numbers).

You do, however, want to look closely enough to ensure that the company is profitable, that it generates solid cash flow, and has a balance sheet that’s appropriate for its line of business.

This should sound obvious, but it’s amazing how many messages I get from other investors suggesting I look into a company that has yet to generate a pound in profit.

How do they manage it?

I’d also suggest taking a closer look at the company’s management to see if the leaders of the company are properly incentivised and what major investment decisions (mergers, expansion plans, and so on) they’ve made in recent years.

Have a look through the board’s remuneration report found in the annual report (it’s found in the proxy filing in the U.S.).

Here are a few questions you’ll want to answer

• How is management compensated relative to its major peers?

• Upon which metrics are management’s annual bonuses based?

• Are these the right metrics for this business?

• Have management’s investment decisions made the company stronger or weaker compared to the competition?

Price is what you pay, value is what you get

If you still like the company at this point, I suggest getting a feel for the company’s valuation and comparing it to the market price.

Even the best company can make for a bad investment if you pay £1.50 for it when it’s really worth a pound.

Admittedly, valuation is part art and part science, but again, your aim should be avoiding mistakes – the purchase of overvalued shares – rather than seeking successes.

Anyone can make a share look cheap in a valuation model by changing a few assumptions. Err on the side of conservatism with your forecasts, and if the market seems to be assuming too much growth for now, consider waiting for a pullback in the share price.

The valuation phase is another area of the research process where I see too many investors being overwhelmed by the data or, alternatively, feeling that the more complex and detailed their models are the more likely they’ll be right.

In my experience, even simple models like the dividend discount model that use a few data points can tell you a lot about the market’s expectations and the company’s value.

Seek to follow the 80/20 rule – find the 20% of available data that explains 80% of the valuation.

Manage your time wisely

Finally, it’s important not to follow more companies than you can reasonably cover, given the time you have available for research.

It’s always fun buying new shares, but remember that each company requires what I call maintenance research – that is, reading the quarterly or half-year results, the annual reports, updating model assumptions, keeping up on management changes, and so on.

If you have only a few hours a month for research and you own 50 separate shares, you’ll certainly feel overwhelmed with all the data you need to analyse.

I’d much rather own five shares that I know very well and can reasonably manage than own shares in 50 companies but have little idea of what’s happening at each one.

You might ask, “But what about diversification?”

Well, that’s where index trackers can help even us active investors.

If you can only follow five companies, carve out a portion of your portfolio dedicated to active investments (say 40% of the total) that will contain those five companies. The balance can go into a broad-based tracker fund.

Back to basics

If you’re feeling overwhelmed by your investing process, remember to relax, focus on the parts that are repeatable (because your process should improve with each iteration), and seek to simplify rather than complicate it.

Please post any further thoughts or questions you have in the comments section below. It’d be great to hear from you.

It’s hard to believe it’s been a year since my previous post on Monevator! I promise not to make a habit of being away for so long.

Note: You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.