Investment lessons for 2011

Note: Although these comments have been made from a UK perspective, the points and examples apply equally well to global markets.

There are few new lessons in investment – just a constant need to be reminded of old ones. 2010 was another year of strong equity returns in which the MSCI World Index returned 15,9% in sterling terms, despite a constant bombardment of concerns from the pessimists. That markets climb a wall of worry is one of the oldest adages of investment but the following are what we believe to be some of the less obvious lessons.

1. Expect abnormal market returns.

The average return on the FTSE All-Share index in the last 20 years has been 10,3%. At the end of each year, strategists, investors and pundits are asked for their expectation for the following year and the majority answer is invariably in high single digits. This is enough to attract investors while still making the forecast appear prudent. In fact, single digit returns are rare and have only been earned once in the last 20 years (2007). In 13 years, the return was over 10% (and over 20% nine times) while in six, it was negative (over 20% twice).

2. Contrarian predictions are often wrong.

Following a year of strong returns and record fund inflows, many were predicting that emerging markets would underperform. Instead, the MSCI Emerging Markets Index returned 22,9%, 7,0% ahead of the developed market MSCI World Index, in sterling terms. With modest valuations, strong earnings growth and favourable economic factors, there was no reason for emerging markets to underperform. Good contrarians fight the consensus but not the fundamental facts. The contrarian call in emerging markets was to avoid large cap and BRIC countries, focusing on smaller companies and smaller markets.

3. Good actively managed funds are worth their fees.

Investors are regularly urged to buy index funds or ETFs rather than actively managed ones on the basis that most actively managed funds underperform their indices in the long term. This ignores the fact that, owing to costs and tracking variances, index funds and ETFs usually (and inevitably) also underperform their benchmarks. 2010 was a good year for many actively managed funds with some outperforming their benchmark indices by large amounts. Outperformance by the top funds of 20% was not uncommon in 2010 (some funds achieved over 40%) and this pays for many years of active fees. Many funds specialising in small or mid-caps, countries, regions, sectors, themes or styles did particularly well. In some areas, outperformance looks systemic: the average fund in the UK Small cap sector (of which there were 58) has outperformed the FTSE Small Cap Index (ex IT) by 13,9%, 6,8% and 6,9% annualised over one, three and five years.

4. Investing in high yielding shares is unreliable.

All are aware of the saying that ‘a bird in the hand is worth two in the bush’ and many are aware that reinvested income forms a key part of long-term returns. This does not mean, as many believe, that high yielding shares always outperform; rather, that a rising dividend is usually the mark of a successful company. The best income investors and funds target moderate but visibly and predictably rising dividends rather than high (and probably stagnant, if not unsustainable) dividends. In 2010, the FTSE 350 Higher Yield index returned 6,2%, less than half the FTSE All-Share Index return of 14,5%, in sterling terms.

5. Active trading destroys returns.

Investors who responded to every market worry or scare story by reducing exposure were not being prudent, they were frittering away returns. Investors, like generals, tend to re-fight the battles of the last war; in 2010, this meant ‘learning the lesson’ of 2008, which was to avoid complacency in the face of bad news. Because many were attempting the same strategy, it was exceptionally hard to sell ahead of the setbacks and buy ahead of the recoveries without appearing reckless. Investors should follow the Warren Buffett dictum of ‘attempting to be fearful when others are greedy and greedy when others are fearful.’

6. ‘Blue chips’ aren’t safe.

There is a popular perception that large household-name companies which have stood the test of time generate reliable profits and pay good dividends are solid investments. The outperformance last year of small and mid-caps, not just in the UK, but also the world over showed that there are additional returns to be made from taking extra risk. This is supported by long-term data for small and midcaps, and also for another category of ‘risk,’ emerging markets. Meanwhile, the misfortunes of BP, once the UK’s largest company by market value, showed that ‘blue chips’ are often much riskier than is realised. BT, another one-time ‘blue chip’ that was once the UK’s largest company, also continues to flounder, while GEC (later Marconi) is now but a distant memory. Equity investment is a risky business and the best way to mitigate that risk and secure good returns is not through a focus on a small number of ‘blue chips’ but through diversification across markets and by size of companies.

7. Recovery stocks need care and patience.

Investors are drawn to stocks which have fallen rather than are at new highs. They tend to remember the successes, those that rebounded as dramatically as they fell, and forget those that never recovered (such as BT and Marconi). Recovery stocks fared well in 2009, but 2010 was a year for growth and momentum – that is, backing winners and being prepared to pay a premium for sustainable growth. Some recovery stocks fared well; Lloyds and RBS produced reasonable performances (though disappointing relative to hopes), ITV and British Airways performed well in difficult circumstances and the recovery at BP is promising. Investing for recovery needs a rationale, not just a belief that what goes down will go back up.

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