Just as one of the most dangerous phrases you can hear in investing is…

“This time it’s different.”

…one of the least profitable things you can utter to yourself is:

“I’ll never touch that again.”

Let me qualify that. The investing world does have its untouchables – not in the Prohibition Agent Eliot Ness sense, but in the old Hindu caste system sense, in that you should ready your bargepole at the first sniff of them.

I’m thinking of expensive managed funds, initial and trail fees paid to financial advisers, structured products you don’t understand, and opaque long-term vehicles that lock away your money for a few decades before returning it (assuming the managers haven’t squandered the lot in-between) – all radioactive from an investing standpoint.

Moreover, in today’s low interest rate era, anything offering 10-15% a year like clockwork is either a Ponzi scheme or you don’t properly understand the risks.

Nothing either good or bad, but thinking makes it so

Away from those perennial nasties, however, there’s a time and a place for most investments.

In particular, when it comes to asset classes and out-of-favour strategies, yesteryear’s irrational exuberance is often tomorrow’s post-crash bargain.

Obviously I am speaking mainly to more active investors here. If you’re a purely passive investor, then you may consider that even pondering these gyrations is beyond the pale1. More power to you, but for those of us who stray from the true path, to quote Ecclesiastes III and The Byrds:

“To every thing there is a season, and a time to every purpose under the heaven.”

House rules

Let me illustrate the point with something everyone can relate to: residential housing. At the time of writing, barely a week goes by without some American columnist proclaiming they’d never be so stupid as to buy a house in America again. The whole consumer economy there is mired in the doldrums as a result, despite already significant house price falls.

US websites have ran countless articles this year on why housing is a terrible investment, and how it will remain so for generations. In one piece entitled Attention America: We are terrible homebuyers, the Motley Fool’s author writes:

Fact: It’s a crapshoot whether most people make money on the purchase of their home.

The real fact is that’s not something you heard much in the run up to 2006.

Even when I began Monevator, I regularly heard that America was immune to a nationwide property crash. Another fact: Nearly everyone only wakes up to the downside of any risky investment after the slump, and then they go overboard trying to understand what hit them, as if it will belatedly protect them.

Some articles do dig deeper: One good New York Times piece I read recently has a useful table of rent-versus-buy comparisons across various American cities.

But others express sincerely held views that I suspect only find a wider audience because of the tenor of the times, such as hedge fund manager and infuriatingly great writer James Altucher’s Why I Would Rather Shoot Myself In The Head Than Own A Home.

Recent event syndrome

The plain reason why US publications are filled with articles extolling the carefree benefits of renting are summed up by this graph from The Big Picture blog, which updates Robert Shiller’s legendary graph of US home values in real terms:

After the bubble must come the bust. Prices may not have completely bottomed, but another boom is surely just around the corner, if your time perspective is long enough.

Unlike American house prices, which until recently were flat for many decades in real terms, UK house prices have shown modest but meaningful real growth over time. Blame the small island effect.

Yet this doesn’t justify any old price for a two-bed terrace – and these small real gains also underwrite one of the most volatile housing markets in the developed world.

Check out this graph of real UK house prices from Economics Help:

The graph runs until summer 2007; I have left filling in the sharp lurch down that began later that year as an exercise for the reader.

But now look back to the trough of 1995; in real terms house prices were approaching half their 1989 peak. I was newly-graduated in those days, and I can well remember reading articles explaining that my rootless generation would never buy again, but would instead holiday for months in Thailand and telecommute (as it was called then) from Berlin.

In reality of course the journalists were trying to put a plausible story on an age-old cycle – few had any inkling that the greatest house price bubble the UK has ever seen and the birth of buy-to-let mania were just around the corner.

The lesson? It’s safer to trust the graphs, the numbers, and reversion to the mean than any fanciful macro-economic theories.

The main boom-to-bust cycles

I’ve labored the point with house prices because nearly everyone knows they move from boom to bust with some regularity, even if timing the shifts can make an idiot out of even the smartest of us (he says, having been calling the top of London property prices since 2004…)

But you get these waves in most assets, driven by deep and recurrent cycles:

The inventory cycle – Companies expand as business booms until they’ve got too much stock (/materials), then halt new orders, which hits their suppliers, shakes out weaker ones, causes a downturn, and so on.

Capital spending – Like the inventory cycle, only slower to unfold because it costs more to build new factories or oil wells than it does to make more widgets – and therefore it’s more expensive and protracted when it blows up.

The business cycle – There is a clear pattern to how economic expansion and contraction ripples through different segments of the economy, related in the crudest form to how we first get raw goods out of the ground and eventually turn the value into iPhone-wielding designer clad hairdressers.

The property cycle – As detailed in the graphs above, this is intimately linked to…

The credit cycle – Banks move from hyper-cautious to carefree with money, increasing the extent of their loans over many years even as the quality of those loans deteriorates. The buck invariably stops with an over-priced semi at Number 23 Acacia Avenue, and/or Number 1 Canary Wharf. The downswing of a credit cycle can be hugely painful, as we’re experiencing as I write.

Investor sentiment cycles – Investors move from fear to greed as they remember and forget the risks inherent in different asset classes. Sometimes investor cycles proceed in tandem with the cycles above, other times investors have a mind of their own. They’re perhaps linked to demographic cycles, that see new generations of inexperienced professional money managers take the place of seasoned veterans put out to pasture.

These are my off-the-cuff terms, and they may differ from the textbooks. But the basic point should be clear – more often than not, the downturn is something we’ve seen a dozen times before, and yes, there will be an upturn. Yet in the midst of that slide down, you won’t be able to open a newspaper or click on a blog post without reading that some new and invariably grim reality is afoot.

Cycles in asset classes

Let’s consider a few more examples of how these wider cycles have been manifested in investing terms.

Commercial property from 2007 to 2011

In early 2007, commercial property was yielding less than you could get from risk-free cash on deposit. Madness. After the credit crunch, owning and letting out an office was considered akin to base jumping or shark wrestling in terms of riskiness. Yet it was hugely unlikely that the biggest real estate companies would never see their prime properties come back in fashion. Accordingly, I was buying commercial property in summer 2009. The property ETF I mentioned in that piece is up nearly 42% since then.

Oil explorers since the late 1990s

In 1999, The Economist famously published a piece arguing oil would remain at around $10 a barrel for the foreseeable future. It wasn’t a particularly contrary view – that was the prevailing wisdom in an era when the future was digital and energy intensity was declining in the West. Needless to say oil subsequently boomed in the next decade as the emerging markets, well, emerged, reaching $145 in 2008 before being knocked back by global recession. Innumerable small cap oil companies spiraled up with it. A typical winner (there were plenty of losers, too), which I held for a stint, was Soco International, which rose 4,900% between that Economist article’s publication year of 1999 and mid-2007.

The gold price

After a huge rally in the late 1970s, the gold price broke through $800 in 1980. Finally miners were convinced the demand for gold was here to stay, and ramped up investment and production (see the cycles above), which only helped usher in a 20-year bear market in the metal. Gold declined in value year-after-year, contrary to claims that it was a great inflation hedge. It took our own former prime minister Gordon Brown to inadvertently signal the bottom for the slump when he flogged off more than half the UK’s reserves at prices between $256 and $296 an ounce. As I write, gold is back above $1,500.

Tech shares AFTER the dotcom crash

You’d have to be a mug to ever touch tech shares after the dotcom slump, right? No, you just had to be patient. After most investors had sold out and innumerable tech funds and investment trusts had been shut down, the handful of survivors began rebuilding again from the bargain basement. Herald Investment Trust, for instance, is up 178% since the start of 2003 (around the bottom of the dotcom slump) compared to a mere 53% rise in the FTSE 100. Not bad given there’s been a second bear market in between then and now. Some individual tech shares, such as ARM and Autonomy, have done magnificently.

Cowardice will cost you dear

The takeaway is that being an active investor and trying to time markets is dangerous, but being a permanently bearish active investor is even worse – perhaps even worse than being perma-bullish. After all, stocks and most asset classes (though not most commodities) tend to go up over time.

Poor timing will decimate your returns. When I looked at strategies for investing in bear markets, I shared some telling results from a study of 12 post-World War II bear markets that stand repeating:

• Investors who held their shares through the bear market gained an average of 32.5% during the first year of recovery.

• Investors who bought one week after the market rally began saw a 24.3% return.

• Those who waited for three months before jumping back in achieved only 14.8%.

These are enormous differences – and in reality, many investors won’t have even bought shares again after three months!

For shares, read whatever spurned asset class you care to mention. The best time to buy is after an almighty crash, when everyone is telling you you’re an idiot, yet you can still see a future for the asset or sector. Yet most people do the opposite, timing their purchases with stunning incompetence.

For example, one recent study found the US S&P 500 market has returned 8.4% a year, but the average US investor has earned just 1.9%! The enormous gap is due in large part to their terrible timing decisions.

I’m not saying that you should leap into any old share or market sector that has wobbled recently. As I write, for example, many energy and commodity shares are down about 10% on worries about China. That’s not a rollercoaster, that’s a speed bump.

But when an asset class is really unloved, and really in the doldrums, and screaming that it’s going cheap – think ‘this too shall pass’.

To conclude, I couldn’t help smiling when Warren Buffett declared he was buying the Burlington Northern Santa Fe railroad company in late 2009. That’s one industry that’s been written off more times than Madonna, and yet it keeps on coming back.

When Buffett slapped down $34 billion to buy all the outstanding shares in the train freight giant, was he worrying about the railroad stock mania of many generations before that was the dotcom equivalent of its day? Was he thinking the US and its consumers were mired in recession and therefore always would be?

No, he was thinking it looked cheap for the long-term. And so he bought it.

1. Though even mechanical rebalancing demands the fortitude to put money into beaten down asset classes, however queasy you feel [↩]

Saturday musings and then links to the rest of the Web.

I have almost gotten the money together to buy the full tranche of the new NS&I index linked certificates.

What a faff! Savings accounts that still take a week of working days to transfer your money – that’s surely unacceptable in 2011?

I’m also frustrated that the money I raised from selling a chunk of Halma shares is taking days to become available for withdrawal. This always happens with this particular broker, I presume because I bought the shares in a Sharebuilder account (like the one used for my new HYP) and it takes a while for it to corral my money from other investors’.

In his rollicking read How to Get Rich, Felix Dennis explains how even the super-wealthy struggle to get access to their assets in short order. I know how they feel.

Such issues seem prehistoric, however, in light of the $9 billion valuation given to LinkedIn, the business network that’s mainly used to see who got bored after you left your old job, or to check up on that PR hottie you met at a product launch.

Or is that just me?

Certainly such functionality can’t be worth the $100 per user the FT puts on the company, which notes:

LinkedIn’s rise in value has been extraordinarily rapid. Larry Allen, chief executive of private share network Nyppex, said that investors who had bought LinkedIn’s shares privately earned unusually large returns – as much as a multiple of 5.4 if they had bought the shares a year ago on private markets, when prices were $17.74 a share.

Valuing such companies is of course a black art. I was amused to see how Aswath Damodaran – a professor of finance in New York whose highbrow blog is often worth a read – managed to mislay half the issued share count when he first had a stab at valuation. He’s an expert in valuing growth companies!1

Damodaran eventually decided LinkedIn shares are fairly valued at around $21. They are currently priced at over $100 a share, after doubling on the first day of trading.

This gangbusters performance – and the scores of private technology companies waiting in the wings, including the mighty Facebook – has prompted a slew of articles suggesting Dotcom 2.0 is already upon us, and that by implication DotCom Crash 2.0 can’t be far behind.

The Independent writes:

For those old enough to remember the heady years of the late nineties – when many of today’s young technology entrepreneurs were still in short trousers – the stock market’s new-found fascination with social networking and all-things internet prompts a weary sense of déjà vu.

Even the US treasury secretary Larry Summers has given warning, says Bloomberg:

“Who could have imagined that the concern with respect to any American financial asset, just two years after the crisis, would be a bubble?” Summers, who is now a professor at Harvard University, said at a conference today in Shanghai. “Yet that concern is increasingly raised with respect to American technology, with respect to certain other American assets.”

Summers words have already bounced around the web, although tellingly what he said next is usually lopped off by bearish bloggers. He added:

“That is a reflection of the resumption of confidence.”

Indeed it is. The bearmania that has gripped investors for three years now (for obvious reasons!) means we’re still a long way from bubble conditions in my view. Back in the late-90s, every story reporting on this float would have been titled ‘How YOU can cash in on the next LinkedIn!’

It truly was a remarkable time, and anyone who lived through it is understandably twitchy that it could be upon us again. But one thing I’ve learned from the UK housing market is it takes a long time for bubbles to build.

Yes, as The Economist notes in my links below, that the Shiller P/E is signalling the US market is already over-valued. I expect growing earnings to bring down the ratio, however, not falling share prices. No guarantees of course, and the market is certainly much less of a bargain than a year ago. If you’ve  been overweight in stocks it wouldn’t be a bad time to rebalance.

As for LinkedIn, I’m feeling in a heretical mood.

I wouldn’t buy the shares, but even at 600-odd times earnings and 25 times sales I can see a case for them. This is a unique company, and a profitable one. It’s earnings are growing remarkably fast, albeit it from a low base.

If you want to invest in, say, a mining company, there are literally thousands around the world to choose from. If you want to buy a social networking leader, LinkedIn is one of the very few. One sign of bubble conditions will be if or when we see nonsense like ‘the mobile social network for dentists’ being floated for hundreds of millions of dollars. There’s no sign so far.

Also, LinkedIn’s $9 billion valuation is a drop in the ocean of the market capitalisation: Google alone is priced at $170 billion.

I’m not saying LinkedIn necessarily has a great future, but I can understand why, in aggregate, investors are prepared to put a few chips on the square. We’re still a long way from being at risk of a second dotcom collapse, given we’ve not yet had the dotcom bubble.

Rather, I’d say this is 1997, in comparative terms, rather than 1999.

[continue reading…]

1. Damodaran’s mistake was to rely on online data, instead of going back to the company’s prospectus, which is a good reminder for any investor. [↩]

I have previously introduced subscription shares, and explained how they can leverage your returns. Please read those two posts first, since they explain the basics of subscription shares, which I’ll assume you know below.

Today, I’m going to outline the pros and cons of subscription shares, and give you some ideas as to when and why someone might choose to buy them.

Warning: Subscription shares are very volatile and much more risky than ordinary shares, which are themselves far riskier than cash or bonds. They are only suitable for experienced investors, who have done their homework and understand the dangers as well as the potential gains.

The executive summary is you can make explosive gains through subscription shares if you’re right (or lucky). But you can easily lose your entire investment, too, so you must understand the risk and return profile.

To do this you’ll need to drill into the numbers, which we’ll do in the next post in this occasional series. For today, let’s consider the main Need To Knows.

Advantages of subscription shares

Gearing

You can hugely amplify your capital gains compared to buying the underlying investment trust. Leverage of 3x is typical, and even 10x gearing is not unusual, though obviously far riskier. I have a small position in a particular subscription share that is geared over 20x! I expect it to expire worthless, but the upside is considerable if it doesn’t, and I think the odds are reasonable.

Fixed downside risk

The most you can lose is 100% of your investment. Not a champagne moment, but better than a spreadbet that runs against you and so incurs losses beyond what you first put in, for example.

Tradeable

Subscription shares are quoted on the stock market, and can be bought and sold like any other share through most brokers. You don’t have to hold until they expire. You can trade in and out before then, to take advantage of short term enthusiasm in the market.

Transparent

You can see exactly what price the underlying trust needs to hit for your subscription shares to be in the money, and how much you might make if the price continues higher. You can also read the underlying investment trust’s updates to form a view on its holdings and prospects, and thus the outlook for the subscription shares.

Liquid (sort of)

The bid/offer spreads on some subscription shares are horrible, and the prices do jump around. But at least you can dispose of your holding if you have to, at some price, up until the excise date (even if you don’t like the price you’re offered!) Far better than with guaranteed equity bonds, say, which you must usually hold until a fixed date.

Tax efficient

You can hold subscription shares in an ISA, and so avoid capital gains tax when you sell. Given their gearing can produce big capital gains, this can be very beneficial. Also, as I understand it1, exercising your subscription shares to buy into the underlying trust’s shares does not generate capital gains at that point (though it does require you invest more money).

Some disadvantages of subscription shares

There are fewer entries in this section, but don’t be fooled – these are big enough downsides to rule out subscription share for most active investors.

They can expire worthless

And if they do you’ll lose 100% of what you put in. That’s very unattractive compared to buying the underlying trust, which you can hold for years to see if it comes good again if you want to. A company share can go bust, too, so many active investors won’t be daunted by this risk (but see ‘time sensitivity’ below).

Gearing

As well as those big gains, you can easily lose most of your money from relatively small downward moves in a trust’s share price.

Poor liquidity and large bid/offer spreads

Most subscription shares are issued in relatively small numbers and are rarely traded. If the price falls to penny share status, you could easily take a 20% or more initial hit on buying the shares, just from the bid/offer spread. The bigger and more liquid subscription shares are on much tighter spreads, but there’s no guarantee you’ll be able to buy and sell them whenever you want; you may have to call your broker to get them to work a deal, and if you really must sell that day you’ll need to take whatever price you’re given.

No income

The underlying investment trust may pay a dividend, but you get nothing as a subscription share owner. In fact, big dividend payments are undesirable since they mean less money for the trust to reinvest into growing net assets that could benefit the share price. (Conversely, share buybacks by the trust are beneficial).

Time sensitive

Every subscription share issue has an expiration date. It is always a huge disadvantage to buy any stock market linked investment that has to keep to a calendar, given the short-term volatility of share prices.

So why might you buy subscription shares?

Most private investors have no business trading individual company shares, let alone subscription shares. You should stick to index trackers and perhaps high-quality income investment trusts and the like.

For those of us who do actively manage some portion of our portfolio, however, subscription shares enable some interesting trades:

Value opportunities: Sometimes the subscription shares look very cheap for no good reason, especially if the market is panicking or if somebody has to dump their holding. A keen-eyed active investor might put on a trade for a big profit if they spot this happening.

Special situations: A subset of value opportunities, these typically come about because of a scary crisis. When the Japanese stock market plunged in early March, for example, I bought JP Morgan Smaller Companies Trust subscription shares, which I judged to be oversold given they had a few years to come good again, among other things. The spread was horrible, but the gearing on subscription shares can compensate; after my subs rose nearly 50% in a few days shortly afterwards that spread hardly mattered. There are subscription shares covering India, several Asian ones, at least one green technology one, and more, so plenty of themes to play.

Short-term trading: Some people believe they can regularly gamble with stocks over the short-term, irrespective of special situations or insights. If that’s you, then the leveraged returns from subscription shares can make them an option to add to the mix, though beware the huge costs of the spread. Personally I wouldn’t recommend this – frequent traders usually lose more money.

Long-term leverage: Very few people consider this as a reason to buy subscription shares, but I think it’s potentially the best reason. While you’ll find many subscription shares have only a year or two (or even less) to run, there are a few with several years to go before they expire. I own some with around seven years to go! Given how they gear up your investment, this is a way to greatly increase your exposure to a rising stock market without actually investing any more money. The downside is far higher volatility along the way, and the potential of losing everything (together with the other risks above), but you can mitigate some of this by top-splicing your holding if it shoots higher, and averaging down if it falls, to control your exposure.

I suppose one final reason to buy the subscription shares would be if you really admired an investment trust manager and wanted to increase your exposure to his or her stock picking. But most trusts don’t yet have associated subscription shares, so this isn’t generally applicable.

The final part of this mini-series on subscription shares will look at how you can try to value what a particular subscription share is offering, to judge whether you want to invest. Subscribe to ensure you see it.

1. The caveat is I have never actually exercised my subscription shares. I have always sold them before expiry in the market. [↩]