Bill Jamieson: Opportunities in an uncertain era

Bill Jamieson
Bill Jamieson
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Every fund manager routinely complains that the investment outlook has never been so uncertain. Listening to this lament is akin to hearing a farmer bemoan the vagaries of the weather or the captain of a ship railing at the movement of the sea.

Uncertainty is a universal constant for any investor in any asset class and at any point in time. But it is particularly pronounced at this time. The signals from Ben Bernanke, chairman of the US Federal Reserve that he may begin tapering quantitative easing (QE) later this year with a view to ending it altogether in 2014 has sent shock waves through markets.

Until recently investors were piling into equities confident that the Fed would keep pumping in extra liquidity. The policy worked to encourage investors to step out along the risk curve and buy equities. That this was actually one of the worst reasons to increase risk exposure was swept aside in a surge of artificially created confidence.

QE had the effect, amongst other things, of keeping interest rates low. But the market rally was dependent not on economic or valuation fundamentals but the continuance of emergency money creation and largesse by central banks. What would happen when the music stopped was not a question we much cared to ask. We are obliged to ask it now. And the answers have not been comfortable.

In the UK share prices have fallen markedly, with the FTSE 100 Index down more than 500 points or 9 per cent from its peak in May to 6,215. Japan has experienced a fast-action monetary boom followed by a sharp sell-off as limits became evident on how far the yen would be allowed to fall. Investors who bought into the Japan surge have had their fingers burnt.

Those who sought to mitigate risk by portfolio diversification through increased exposure to emerging markets have suffered a painful lesson in the vulnerability of these markets to changes in US monetary policy. Emerging market indices have fallen sharply as risk appetites shrank and money flows from west to east reversed.

So called “cautious” investors who have taken shelter in bonds in recent years now find themselves deeply apprehensive about a long and sustained fall in bond prices as interest rate expectations move upwards. The resulting mayhem in markets has been akin to watching revellers trapped in a smoking building, scrambling in different directions for the exits.

In all this, the optimistic view has been that the risk adjustment in markets will be quick and that prices will soon stabilise. But what are the grounds for believing this? It is arguably more likely that the adjustment could take some considerable time because of the uncertainties surrounding the exact timing and scope of the Fed’s tapering.

Remember that Bernanke hedged this round with conditions, principally concerning evidence of sustained economic recovery. The very announcement that tapering may begin later this year might already have worked to dent business confidence and jeopardise the very pace of recovery on which tapering is envisaged. There could be a long interval between the Fed chairman’s warning notice and the actual start of tapering, for starting this too soon would be prejudicial to recovery.

We could thus be at the foothills of a long period of heightened uncertainty. Some argue that markets now offer a buying opportunity. But many investors are still not convinced that even after the fall of the past few weeks shares offer a compelling value proposition. As a result they may opt to keep cash on the sidelines for now or ride the waves of this uncertainty by adding to their portfolios in small amounts over the coming months, pound cost averaging working as a balm to ease the pain of any mis-timing. Equity investment is fundamentally about stock selection and spotting promising opportunities. This is now extremely difficult for a private investor in a world of computer-driven research and instant anomaly-removal among large capitalisation stocks. Little wonder attention has swung back of late to the small company sector.

This has had a very good run over the past year, with 17 trusts in the UK smaller companies investment trust sector enjoying an average rise of 32.7 per cent over the past year – even after the recent shake-out. Only one – SVM UK Emerging – has suffered a fall, slipping 11 per cent as its AIM selections have not performed to expectations.

But 13 of the 17 trusts in the sector have risen by 30 per cent and more, and while they may not offer much in terms of yield, almost all are still standing on discounts to net assets.

Top of the performers list is long standing favourite Dunedin Smaller Companies Investment Trust managed by Ed Beal, which is showing an impressive gain of 55.8 per cent over the past year. Nor is this a flash in the pan, with the trust having doubled in value over three years.

Invesco Perpetual UK Smaller Companies looks to offer value at 260p on a discount of 14.3 per cent to net assets and offering a yield of 2.3 per cent. Henderson Smaller Companies Trust at 424.5p also looks tempting on a discount of 18 per cent.

As we are still in an early stage in the recovery cycle, this sector may have much further to go yet, and these look good “lock-aways”.