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Finding good investment returns in ill winds

Of all my mother’s oft-repeated sayings, the one I was most dubious about was “it’s an ill wind that blows nobody any good”. It means something like: “The neighbour’s tree may have fallen in the gale, but at least our garden will get more sun now!”

In recent years, UK investors have been exposed to several ill winds — not least inflation and its side effects. Many will look at their investments and savings and feel bruised. The cost of living has risen by more than 20 per cent over the past three years — not good for those sitting on a lot of cash.

And for those fully invested? If you include dividends, investors in the MSCI World global equity index have seen markets rise by around 30 per cent over the past three years — more than the cost of living. In the UK the FTSE All-Share index is up just 14 per cent, but dividends should take that to around 23 per cent — underlining how important they can be. 

Not so well off are those in what were supposed to be the safe havens of UK gilts. The iShares UK Gilts ETF is down 30 per cent over three years; its index-linked sibling is down 35 per cent. In other words, these investments have at least halved in real terms.

The winds of inflation are probably now subsiding. The consumer price index was up 4.7 per cent in the year to October 2023, but that was better than the 11 per cent recorded a year earlier. Be prepared for the wind-chill to last a bit longer, though. Inflation has a nasty habit of sticking around, especially as people expect their wages to rise to help them cope with the higher cost of living — and the companies agreeing to higher wages then raise the prices of their goods and services.

Factor in, too, the likelihood of periodic rises associated with unplanned events — like the Opec countries deliberately cutting oil production to raise energy prices or poor harvests fuelling higher grain prices.

Look for returns above inflation

The best bargains are often to be found in debris. If you have no cash, you may need to rebalance your portfolio to pick up these bargains. US technology stocks have withstood the storms of the year well, but expectations and valuations now seem full.

Briefly, if artificial intelligence significantly increases their profits, there could be more upside — but better opportunities may be found elsewhere if extra income comes through more slowly than expected.

This might make anyone holding an S&P 500 index fund nervous. The “Magnificent Seven” technology companies — Apple, Alphabet (Google), Amazon, Meta, Microsoft, Nvidia and Tesla — now make up about 29 per cent of its value (and around 18 per cent of the MSCI World Index). These stocks tend to rise and fall together. Both indices therefore seem quite unbalanced. Neither offers the diversification I want in these uncertain economic conditions.

While technology stocks have hogged the headlines this year, other areas of the equity world have been forgotten — or deserted. Many fund managers have pointed out how cheap UK equities look compared with US equities. This is a market that has been battered since 2016. The average price-to-earnings ratio for US equities is around 16 times for next year. The UK market is closer to 10 times and offers double the dividend yield — 4 per cent.

Blame the Brexit storm and ensuing political mayhem if you like. But I think the bulk of this difference in performance can be explained by composition. The UK has few technology companies; tech companies tend to have high price-to-earnings ratios and offer lower yields.

UK growth stocks — of which there are few — are usually similarly priced to overseas equivalents. Not today. The ratio of the share price to earnings is a crude valuation measure as earnings figures are quoted differently in each country, but it is a useful starting point for comparisons.

According to Bloomberg, accounting software developer Sage Group is on 32 times earnings. Its US equivalent, Intuit, trades on 35 times earnings (maybe 37 times after adjustments I would make, but a pretty similar valuation).

The power of dividends

To my mind, more interesting opportunities lie in lower-growth UK companies that have solid longstanding businesses and a history of coping well with inflation. Many large UK companies pay a dividend yield well in excess of the 5 per cent you can now hunt down in a decent cash savings account.

A word of caution: no dividend is guaranteed, and some companies offering high dividends today look stretched to sustain them. Look up Vodafone and you are likely to find it pays a 10 per cent dividend yield, but that assumes they can maintain the dividend. If you check earnings per share vs dividend per share and roughly how much debt costs have gone up (there is lots of debt in Vodafone) you might quickly conclude that this dividend will get cut. This is not a forecast; it is a risk.

Large property companies and the miners are perhaps better bets. These are supported by tangible assets — the opposite of technology companies, which live on intangible assets. The rental income of property companies has much in common with bonds — steady over long periods — but unlike bonds, property companies can raise the rent when a new lease is agreed, so rental income tends to adjust for inflation.

Like bonds, property shares have performed poorly over the past few years, especially as investors have worried about rising interest costs and that work from home might threaten office demand forever. Land Securities’ shares, which I hold, touched nearly £10 before the pandemic and now lie at just over £6.

The share price in the long term has support from the sale value of the company’s properties, less the debts to be paid — called “net tangible assets per share”. Before the pandemic this value peaked at £14 a share, but it has been marked down below £9 in the recent figures — reflecting higher interest rates.

Working from home has affected many property companies, but a large part of Land Securities’ portfolio is the recently redeveloped London area of Victoria, which reports 100 per cent occupancy. The company has managed debt levels well. It can afford to reconfigure properties to suit changing needs while smaller companies struggle to re-let older space.

Land Securities shares trade at £6.28, which represents a 30 per cent discount to the written-down value of the portfolio, even after you have adjusted for any debt. Little account is taken in these numbers for properties in development that might have significant value when complete. The rent from its properties supports a dividend yield of over six per cent, and the management team works to improve properties so it can raise rates ahead of inflation over the long term.

Mum may have had a point about ill winds after all. The hurricane that has blown through the property market has hurt many existing shareholders, but this unloved area could do my portfolio some good.

Simon Edelsten is a former fund manager

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