Foresight Capital Partners

Any industry has two sets of prices, one for those ‘in the trade’ and another for the retail customer. The difference between the trade and retail price provides a mark-up, which enables a distribution network to function. With financial products by obtaining some knowledge and acquiring market access, will enable you to purchase lower cost institutional type collective financial products. Though this requires some effort on your part, it is within the grasp of just about everyone.

Obtaining market access is very straightforward and just involves opened a brokerage account, the procedure for which is roughly analogous to opening a bank account. Without a brokerage account, access to financial markets will only be available via an intermediary. Most intermediaries whether in banks or IFAs, are commission based which in my mind often leads to a conflict of interest. In particular, the sales person is only likely to suggest products for which they receive a sales commission, ignoring all other available options. Hence, listed collective products such as investment trusts and ETFs (Exchange Traded Funds), which typically have lower internal charges than unit trusts, will generally not be suggested by commission based IFAs and bank representatives.

From a very young age, I have always had an interested in finance, and since my student days have invested directly in stock markets. To this day, I have been continually educating myself via books, web sites and private conservations, on the workings of markets. This investment in my education turned out to be the best investment I ever made and I strongly recommend such an investment to others. In particular, if you do not feel comfortable buying financial products directly then why not invest in your own education and investigate further such topics as how brokerage accounts work, the mechanics of the stock market and available listed collective investment products such as ETFs and investment trusts.

After reading up, if you a still wish to use the services of a commission based financial advisor having a basic knowledge of the products available will put you in a much stronger position when judging the suitability of the products suggested to you. Please note that the financial advisory business is rife with conflicts of interest. In the UK, the FSA has tried to address this situation and now requires IFAs to disclose to customers the commissions paid on financial products purchased. They recently took a step back by scrapped the IDD Menu requirement, which required disclosure on commissions of similar products allowing the customer to transparently compare commissions. In the Isle of Man, the situation is much worse in that there is no requirement on intermediaries to disclose the commissions paid on financial products sold. So please take care.

Explanatory Notres on IDD Menu

IDD Menu is short for “initial disclosure documents (IDD) and the Menu of commission and other charges”. The IDD Menu requirement is an attempt by the FSA to implement parts of the Markets in Financial Instruments Directive (MiFID) which is due for implementation in November 2007. MiFID is new European wide legislation for financial products and services, from which it is hoped that a single European wide market for financial products will start to form.tramadol testing drug from
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It seems that the best strategy a manager can take to ensure survival during a risky project is to hire what I refer to as a “blame me” consultant. The “blame me” consultant in theory is hired to provide management with expert advice, but in reality the motivation is that the management will have someone to blame if anything goes wrong with the project. Hence, the term “blame me” consultant. This approach is used to great effect and offers a compelling pay-off to all parties, namely the consultants can pick up large fees and the management never gets blamed for anything.

In the world of investing we also have managers who are involved in a risky project known as investment management. Now in the investment world such managers would also like to adopt a similar strategy however by the very nature of their position they cannot hire a third party to decide investment decisions because that is the essence of their job. In order to get around this problem the investment management community has invented the notion of “Mr Market”. Any under-performance of a fund is often explained with regard to this notional person “Mr Market”. In particular, you will often hear statements like: “Due to market volatility the fund experienced underperformed during Q3”. Hence, in the investment world the usual “blame me” consultant has been replaced by a notional construct where the notional construct serves the same purpose but has the added advantage that he cannot disclose any information and does not require any fee.

This is not meant to be taken completely at face value but I think I am on to something. Moreover, there is a very serious point that any investor should take personal responsibility for their investment decisions and over-all investment performance. The reason for this is that an investors (long term) performance is primarily determined by the ability of the investor rather than the prevailing market conditions. I would even go so far as to say that every day of every year there are opportunities in financial markets. This is just one example of the many psychological pit holes within the investment world and getting into a “Mr Market” blame me Consultant mentality really is a rather dangerous pit-hole since it delegates the responsibility that every investor has to continually strive to make themselves a better investor.

Interim dividend was announced at 5.1p this morning which implies a full-year dividend around 14.2p, which raises the divided by 19% putting the shares back onto a 5% yield. However, if you consider for example my original average entry price this year of 220.62p then the yield on this original investment is now running at 6.44%.

The reason I mention this is because the dividend which a stock pays is directly related to the earnings (or more precisely the cash flow), where as the price at which a stock trades is determined by the price market participants are prepared to pay for the present and expected future earnings. In short, the divided is determined by cash in hand, where as the stock price growth is determined by a change in perception which though will be influenced by changes in earnings is not directly related to them. Saying this, typically if the dividend payments of a stock move outside the normal range for that industry (to say 6.44%), and this payout is comfortably covered by the underlying business then one of two things will normally happen: (1) the dividend will eventually be cut because the earnings fall, (2) the share price moves so that the yield becomes more in line with typical market values (say 5%). Hence, if you can eliminate (1) and buy stocks on a high yield for the sector in question then the odds are already leant in your favor.

This is exactly what has happened in the case of BT.A, and provides an illustration why a dividend investing approach can offer tremendous risk/reward investment opportunities. Back in the Spring BT was trading at around 10 times earnings and yielding 5%. In the Spring BT management made it clear that they wished to move towards a divided payout of 2/3 of earnings which lead further support to the dividend and lead investors to believe that management believed a 2/3 payout to be a sustainable level for the underlying business. Now under such a situation and assuming the underlying business is healthy (please see earlier blog posts for this) the odds of a 25%+ return over the next year are very much stacked in the investors favor.

For example with my BT investment this year, there has been some multiple expansion from around 10 to 11, resulting in a 10% capital return before any move in earnings, the earnings have moved forward a healthy 20%, resulting in a total capital return of around 30%, while all the time I have been earning a 5% yield. Resulting in around a 35% return so far this year, even without any multiple expansion a total return of 25% would still have been achieved.

The final point I wish to make with such an approach is that in it important not only to analysis the health of the underlying business (i.e. the growth in earnings) but also have an insight into the way in which stocks multiples vary according to market cycles and themes. Since the large fluctuations in multiples which stocks trade has an outsized effect on performance. For example back in 2000, BT was on a multiply of over 40, and tobacco stocks such as BAT was on a single digit multiple; this year BAT has been on around 16 times earning where as BT has been as low as 9.5. Therefore, the effect of such changes in multiples over this period ignoring the effect of changes in earnings would be for BT to fall over 75%, and for BAT to rally over 60%. Therefore, understanding the dynamics of changes in multiplies is essential to realizing equity like returns (which in my mind our 25%+ annual returns). To be honest, for me the judgment of market themes and associated changes in multiples is more of an art than a science. Coming to a view on market themes does not follow as a deductive process but more of a slow realization, or evolving intuition of the underlying dynamics. However saying this, the development of this intuition is feed from undertaking daily research of the market which is generally undertaking as a formal maybe even scientific activity.

Maybe the market is 90% efficient, maybe even 99%, but personally the exact level of the inefficiency really is of no consequence because as far as I am concerned I only look at the in-efficiencies.

Listening to market commentary can often drive you completely nuts. Financial news channels such as Bloomberg TV and CNBC are a hot-bed of market commentators and such media content achieve a wide audience among market professions and active private investors. Bloomberg TV and CNBC do provide value and personally though I do not go in for all the market commentary I do like the more purely news reporting on Bloomberg TV such as the ‘US Market Wrap-up’ (at 9pm GMT) and ‘after the bell’ (soon after) which really can be quite good, maybe even enjoyable. Particularly, for investors based in the UK timezone who want to keep a tab on US markets but also do not want to be sitting in front of a PC after 9pm.

Now going back to market commentators just to give you an example of what I am taking about, at present there are some commentators who I will not name (but who you can regularly hear on CNBC) who claim that in the next few months before the end of 2006, the FTSE will drop 25%. In particular, one commentator claims this year the market will trend upwards to around 6,000, before selling off and hitting a low around 4,500 before rallying towards the end of the year. Sounds like a bit of an Oracle to me and unless this individual has supernatural powers I really cannot see how such statements can be made with any certainty. After all the only certainty in financial markets is that they are uncertain. However, what is a certainty is that if you want to buy more details regarding this commentary/research then you will need to part with 500 GBP for 12 monthly issues.

So lets take a closer look at these predictions. Now the up move has played out but since most years in history are up years this was never much of a call. The commentator also claims interest rates will fall later this year and next but this information follows from just reading off the yield curve which has been predicting this exact out-come (at least) over the last 10 months. All the commentator is doing is reading off the yield curve which the bond market crowds activity has produced for the benefit of the stock market crowd. If you do not believe me then take a look at: US/UK Yield Curves.

Anyway, where I differ is the call for an “up to 25% fall in equity prices by the year end”. I assume the 25% fall is from the top, i.e. he is calling for the FTSE to hit:

6,000 * (100-25)% = 4,500,

some time this year. Now, maybe I am involved in wishful thinking, maybe this guy knows something I do not know or understands ideas which are beyond me. But at the present point in time, my view of (my) reality tells me that such an event is just not going to happen. Moreover, if I did (even to a degree) believe such an event may happen then I would be gearing up on (out-of-the-money) put options, for example the ones listed at: FTSE Covered Warrants, since the writers of such securitised equity options (from the prices at least) believe such an event to very unlikely indeed.

The reason why I am going on about this, is not because I actually enjoy writing post on the web which criticizes other people. But because I worry other people will take such views on board without really thinking through the commentary or analyst for themselves. As we will see taking such commentary at face value really can be a bad approach.

For example, going back to May 2005, the article Summer shares - Should you sell? by Naomi Caine appeared in Money Weekly Magazine, and informed us of the then views of a number of market commentators. In particular, quoting from the article:

Robin Griffiths of Rathbones is one of the most closely heeded chartists. He thinks shares could even nosedive to as low as 3,277 – the same level as the nadir in 2003….

Other chartists are similarly downbeat. John Prior, a chartist at Killik, the stockbroker, says: “A drop to about 4,500 in the next 12 months would not be surprising.”

David Schwartz, the stock-market historian, believes the bear market has already begun and that the FTSE 100 index will fall to 4,500 by the end of this year….

Unfortunately, at least for the three commentators in question we now know that the views turned out to be mis founded. Moreover, if you had had been in cash (or worst still gone short) then you would have missed out on a market which moved healthily forward by around 15%.

What are Equity Warrants?

Investment Trust warrants (see Trustnet’s list) are all examples of what is referred to as equity warrants which are a close relative of the familiar vanilla call options. Equity warrants are issued by a company in its own stock and are settled by the company at maturity by issuing more stock to warrant holders for a given predefined price (i.e. the strike). The feature of issuing more stock produces an effect known as dilution, since warrant holders have the right to purchase a stock as a pre-defined price not in the present capital structure of the company but in a new capital structure where there will be more shares in issue, that is, a structure where the earnings of the company are dilution over a larger number of shares. If you wish to read-up a bit further of equity warrants then I recommend the guide provided at: Incademy.

Equity Warrants offer a clean exit at maturity

Now equity warrants have the useful feature that even if you do not choose to exercise the warrants in order to obtain the underlying stock, then they will still pay-out their intrinsic value. The mechanics of how this is achieved in that the trustees of the fund will exercise all warrants which have not been exercised which have a (positive) intrinsic value, they will then buy-back the new stock issued at the market price, the strike of the warrant is then deducted from the buy-back price and what remains is returned to the original warrant holder. What this means in practice is that at the maturity of the warrant you always have a clean low cost exit route, where (exiting) dealing costs will not eat into your profits. Remember the spread on equity warrants such as PLIW.L, can be more than 3% and if you want to trade in any volume (i.e. more than say 10K GBP at a time) then the market makers may only offer you a bid outside the normal spread.

Building and unwinding positions in Equity Warrants

Typically with assets such as equity warrants you will need to build or unwind a position of any size over several days or weeks. This can be time consuming exercise, which will consist of a game of cat-and-dog you will need to play with the market makers. Games such as this do have a hidden cost in that they will eat into your investment research time, naturally you do not need to play this game but then you will end up sacrificing a large portion of your return to the market makers. Remember the mechanical performance enhancing parts of investment are the easiest parts to get right, and though getting good fills on exiting illiquid positions can be a tedious exercise, all investors should be putting in the effort and diligence to obtain this.

I was playing this game over the post Christmas 05 - early January 06 period when I unwound my own holdings in PLIW.L. Now when I was unwinding I typically placed a 5K GBP limit sell order at the best market making quote, typically I put the order in after 2pm when the US was active and typically spreads improve. If it filled, I updated my records and then sometimes placed another limit order (of similar but not exactly the same size) or waited to the next day and repeat the process.

Investment Trust (IT) Equity Warrants and Window Dressing

The reason why I selected the post Christmas - early January period in particular to unwind the position, is because of a phenomenon known as ‘Window Dressing’. Now a fund manager such as Mark Barnett of PLI.L can buy back the stock in this own fund using fund monies. By buying back the fund in the end-of-year period when liquidity is rather low, a manager will typically be able to narrow the discount at which the investment trust trades without needing to trade is particularly large volumes. The reason why managers such as Mark are particularly interested in the end-of-year period is that typical bonus and performance figures are typical based on the traded price of the fund at the end of the year. By selling into this manager generating buying can often be an ideal time in which to exit such funds, as was the case this year with PLI.L and PLIW.L.

Example of a Equity Warrant Investment

I detail a particular Equity Warrants investment within the post PLIW.L Equity Warrants Matures.

In short, if it works (i.e. you make money) then it’s OK. As an example, I recently referred to a commentary within a meeting with fellow investors as “garbish” (there where reasons for this which I will detail another time). This certainly was a little harsh (maybe even rude). What I should have said was “this is garbish for me”, meaning that for me reading this type of commentary has not helped me (at least up to this point in time) make money within financial markets. However, the same commentary may be helping others make great investment decisions and therefore to refer to anything is “garbish” is an absolute sense does not really help matters and may not even be true, even with regard to a small group.

As a general point I would say that any commentary or technique which helps you make money is a good idea. After all we are not doing philosophy or science, and the only meaningful objective measure is how much money you make. Some investors get rather hung-up on technique, and you hear comments like: “I’m a value investor and I have never met a rich technical investor”. Recently, in the last few years quantitative investing has been all the rage and you often hear statements like, “I’m a quantitative investor and this allows me to stay relaxed in times of market turbulence”. Personally, I do not care what box I am put in, or what technique I use just as long as I am making money. My mantra is, “I would rather be right for the wrong reasons than wrong for the right reasons”. Or Warren Buffet would say, “Rule number 1: Don’t lose money, Rule number 2: Don’t forget rule number 1″.