Wednesday, 30 January 2013

Why investors should be worried about pensions.

And WS Atkins - Tackling its Pensions Liability


Britain inaugurated a Civil Service pension scheme in 1810. Two hundred years later, the defined benefit scheme, which now includes teachers and employees of the NHS and the Armed Forces, is unfunded to the tune of 1.2 trillion pounds. This is almost as big as the National Debt. But the British state will pay it off piecemeal over decades, as it is here (so it is assumed) forever.

The East India Company inaugurated the first modern company pension scheme in 1813. The company was liquidated in 1874. In 2012, the profitable knitwear company Dawson International went into administration because it was unable to fund its pension's deficit.  The CEO said, " . . .the deficits have widened, mainly due to changes in actuarial assumptions, and associated costs have risen significantly." Pension trustees and the regulator demand that companies, unlike the State, fund their deficits. Company defined benefit pension schemes are wonderful for employees, but they can be lethal for the company they work for. The Motley Fool has warned about company pension obligations for some time.

This year revised standards for pension accounting (under IAS19) come into force. Companies will have to recognize any shortfalls immediately in their accounts and new standards are set for the assumptions behind the financial figures. In 2013, Royal Dutch Shell will be forced to take an additional charge for an unrecognized loss at end December 2011 of 10 billion pounds. (Estimate by the actuaries Lane, Clark and Peacock -LCP). With 169 billion pounds equity, Shell can take this hit in its stride. Others cannot. International Airlines Group (BA & Iberia) will take a charge of 1.2 billion pounds (LCP estimate), which is 30% of the company's market capitalization. LCP calculates that the proposed European Pensions Directive, by requiring solvency reserves for pension funds similar to insurance companies, would cost the FTSE 100 companies 200 billion pounds.

The following table gives an idea of the sensitivity of pension deficits to bond yields and to the Stock Market. The figures are LCP estimates for the 84 FTSE 100 companies with such schemes at May 2012, when the FTSE 100 was at 5,320 and corporate bonds yielded 4.5%. As pension schemes invest in the Stock Market, the higher the market, the higher the value of the scheme's assets. Future liabilities for pension schemes are discounted by corporate bond yields; the lower the bond yield, the lower the discount rate for future liabilities, giving a higher value for their present value:

(Table from Lane Clarke & Peacock: Accounting for Pensions 2012)

Inflation and longevity are two further variables when calculating pension scheme liabilities. Assumptions vary considerably by company: insurer Resolution expects its pension equity investments to increase by a conservative 5.0% p.a., while retailer Kingfisher expects a return of 8.5%.

Defined contribution pension schemes greatly reduce the risk for companies.  The company no longer carries the uncertainty of what the employee's final salary will be on retirement, or the rate of inflation thereafter. Pension asset volatility and returns is carried by the employee, not by the company.

When reviewing a company, the wise investor will ask:

1. Does the company have a defined benefit pension scheme on the books?

2. Does it remain open to new employees?

3. Is the scheme in surplus or deficit?

4. If there is a scheme in place, do the directors address its financing in their report?

5. Are the assumptions for inflation, longevity, return on investment of the fund's assets and the discount rate to calculate its liabilities reasonable?

6. Does the company have the financial strength to pay off its future pension liabilities?

WS Atkins - Tackling its Pensions Liability

The Investors Chronicle recommended WS Atkins as a 'Buy' at 649p in November. The engineering consultancy has a growing worldwide business; it is consistently profitable and has net 30 million cash in the bank, as of September 2012. It is a well managed company. At last night's price of 811p, the stock is on a PE ratio of 10 and yields 3.8%.

In financial terms, WS Atkins is a pension fund with a sideline in engineering consultancy. Pension plan assets, at 1.1 billion pounds, exceed the company's other tangible assets of 0.8 billion. Pension plan liabilities, at 1.4 billion pounds, dwarf other liabilities of 0.65 billion. The management has taken measures to 'de-risk' the defined benefit pension plan. They have persuaded some members to move to a defined contribution plan and they no longer offer a defined benefit plan to new employees (they offer a defined contribution plan instead). They transferred some benefits out of the plan and removed the link with future salary increases of those within the plan. And they agreed to pay 32 million pounds a year into the pension fund for the next 7 years, a sum that exceeds the annual dividend payment to shareholders.

Yet the deficit in the defined benefit plan rose from 251 million pounds at 31 March to 317 million at 30 September (both prior to deferred tax). As a result, the company's reported equity fell from 119 million to 80 million pounds in this 6-month period. As Dawson International's CEO said in April about his own company's demise, " . . .the deficits have widened, mainly due to changes in actuarial assumptions, and associated costs have risen significantly." WS Atkins' plan suffered a 73 million pound actuarial loss in the period.

What holds for the future?

While WS Atkins's longevity assumptions are conservative compared to its peers, other assumptions appear to be optimistic. The company uses 2.7% for Retail Price Inflation and 1.7% for Consumer Price Inflation; if the rate turns out to be 1% higher, the pension deficit would be 200 million pounds higher. The chosen rate for discounting future liabilities at 4.6% is considerably greater than the current corporate bond rate that is recommended. A decrease to 3.6% would lead to an increase of 280 million in the deficit. This shows that two wee changes in actuarial assumptions and the company's balance sheet is hit with a 480 million pound charge, equivalent to 59%of its market capitalization.

Now, any actuarial change, say for example the 480 million mentioned above, is not a non-cash item that can be ignored. The pension plan trustees will demand that this sum be paid off over a period of years, as they have done with the current deficit. In the case of the current deficit, WS Atkins is paying it off over seven years. Any such period for the hypothetical 480 million would mean that the company would have to pay out 69 million pounds more every year to the pension fund. This is a very large sum when compared to the company's adjusted pre-tax profit of 101 million pounds for 2012.

Should the company be placed in this situation of having to pay large sums annually into its pension fund, it is hard to see how it could afford to maintain any dividend payment to its shareholders.

WS Atkins admits that it "has yet to know the full impact of the amendments to IAS19". Not to mention the proposed European Pensions Directive.

Any investor in WS Atkins must take into account the risk of its pension fund liabilities. The more prudent will choose to wait for its next annual report, by which time it will have been obliged to implement the amendments to IAS19, if not the European Pensions Directive. And watch those assumptions about inflation and the discount rate.





Wednesday, 23 January 2013

Steady as She Goes - Equity Dividends . . .

And a stock for income growth - SSE PLC


Inflation ravages savings - one pound in 1975 is worth only 15p today. Index-linked Gilts were once an excellent protection against inflation, but currently their real yield is a negative 1%, compared to the 4% real yield they habitually provided prior to 1996. This reflects the extraordinary increase in the price of all Gilts since the bursting of the Stock Market bubble in 2001. No doubt they will once again be a good protection against inflation. What to do now?
The income from equities has grown consistently since 1945, as the following table, from Barclays Capital 2012 Equity Gilt Study, demonstrates:

Equity dividends have grown in every five-year period since 1945, with the exception of 1997-2001 and 1998-2002. Once discounting for inflation, dividend income has doubled in real terms since 1945 and by 81% since 1975. However, although in absolute terms dividend income has grown by 34% since 1996, in after-inflation terms it has lost 14% over this period. 1996 was the peak year for real dividend income since 1945.
As companies are loath to reduce dividend payouts, equity income is more stable than equity profits or prices. Over the long term, dividends usually more than keep pace with inflation. Of course, looking forward this depends upon a number of unknowns: will company profits keep pace with economic growth? What will be the future growth of the UK and world economy? Will companies increase dividends in line with profits?
Currently, the FTSE All-Share yields an historical 3.5%. This compares well to 10-year gilts (2.0%), investment grade sterling corporate bonds (3.3% yield to maturity for the ishares Exchange Traded Fund SLXX) and cash (2.0%).
Some thoughts for the long-term investor:
1. Inflation protection must be a high priority for long-term investors, because, while from year to year the effect may be small, over many years it can destroy the value of savings.
2. Index linked Gilts are a wonderful protection. They provide a guarantee that your savings will not be eroded. But, as they are currently offering a negative yield, they are very expensive.
3. If we take the last 20 years, the current yield on equities, at 3.5%, is somewhat superior to the average yield of 2.8%. However, you have to go back a further 21 years, to 1972, to find a year when the equity dividend yield was so low.
4. As managers commonly charge 1.5% p.a., any managed fund that in practice tracks the market, reduces the equity dividend yield from 3.5 to 2.0% before costs. Exchange traded funds are the better option here. Even better, is to construct your own income-producing portfolio.


A stock for income growth - SSE PLC

There is no other company in the FTSE 100 that has a stronger commitment to pay out increasing dividends and has consistently raised its dividend by more than inflation over the last 12 years than SSE (formerly Scottish & Southern Energy). The share is on an historic yield of 5.7% at 1419p. It has increased its dividend by a compound 9.6% p.a. since 2001. In its latest statement SSE promises to increase the 2013 dividend by at least 2% over inflation and in the following period to increase it by more than the rate of inflation.

SSE claims to be the only quoted energy company that is fully integrated. It produces, stores, generates and distributes gas and electricity and supplies households and businesses. And SSE invests heavily in renewable energy resources. This requires substantial capital expenditure, which it must recoup through a combination of volume and price increases. Volume is restricted by demand from the UK economy (it also has an Irish business), and the trend is downward, though by investing in generation and distribution SSE does add value. Most prices are set according to a formula agreed with the regulator, Ofgem.

Can the company keep up its pace of increasing dividends, given that prices are mostly regulated and new capital must be found for new plant and installations? Capital expenditure regularly exceeds the company's cash flow, once the dividend payment is deducted.

Looking at the past, the Debt to Equity ratio has increased from 81% in 2001 to 132% in 2012; debt reached its highest point in 2010 (185%), when the company issued new capital to bring it down. Provided SSE continues to invest its new funds as well as in the past (average return on equity is 22% and the average return on new investments for the last 12 years has been 17% - both outstanding for a utility), this is not a worry. Management has made good use of its funds.

SSE says that the dividend cover should not be less than 1.5 times earnings per share (EPS), so its EPS record is of great importance in enabling the company to meet its dividend objectives. While SSE has managed to increase its EPS by a compound 8.9% p.a. since 2001-3, this has not kept up with the increase in dividends. The 2012 dividend cover (using the company's 'adjusted' EPS) is 1.4. But it is also true that 2011/12 was subject to both very mild weather and energy price gyrations that made it atypical. Nevertheless, EPS growth is slowing and the dividend cover is shrinking.

The main risks are:

1. SSE depends on government policy and regulation for pricing. A decision to delay price increases in 2012 reduced profit. The energy companies were under strong pressure from Government to keep their prices down. This pressure looks set to continue.

2. How much of the cost of the government 's energy policy to substitute renewable energy sources for fossil fuels will fall on companies like SSE?

3. UK demand for energy is falling.

4. How much longer can the company afford to increase its dividend by more than the rate of inflation?

 A valuation model for SSE throws up 1330p as a price worth paying for its share. This is an average of three calculations based on a) Earnings (1152p), b) Return on Equity (1305) and c) Equity per share (1532p) for the five years 2012-2016. The assumptions are: 1. EPS growth of 7.5% pa. 2. Return on Equity of 17%. 3. Increase in Equity per Share of 9% p.a. 4. A discount rate of 10.2% (5.2% is SSE's weighted cost of debt plus 5% for profit and safety). 5. An average PE ratio of 12.5. 6. Retained earnings are 24% of profit after tax.

The share price of SSE has fluctuated between 1200p (30 January 2012) and 1470p (24 December 2012)in the last 12 months.

(Note: The CEO today announced he was resigning. He will be replaced by Alistair Phillips-Davies. In the last Annual Report, Mr Phillips-Davies said, "Dividend growth isn't just a financial commitment. It's a management commitment to being disciplined, consistent and long term. That's entirely appropriate in a sector like energy and I think goes to the heart of the type of company SSE is.")





Wednesday, 16 January 2013

Why Volatility Matters.

And an Asian Fund yielding 4.8%

Our financial goals determine the asset classes we choose to invest in. In the financial markets, the choice is mainly between cash, bonds and equities. Barclays Capital Equity Gilt Study 2010 compares the returns from equity to the returns from cash and gilts since 1899. Taking this 111 year period, the following table shows that equities outperform cash and gilts, more often than not, for every single 2-year, 3-year etc. period from 1899 to 2010:

The Probability of Equity Outperformance 

Number of Consecutive years
2 years
3 years
4 years
5 years
10 years
18 years
Equity outperforms cash
67% of the time
Equity outperforms gilts
68% of the time

While one reading of this table suggests that the odds favours equity over gilts and cash for any period of time, this has to be tempered by the greater volatility, and so greater risk, of holding equities over a short period of time.

This is illustrated by another chart. While in a single year the returns from equities can vary wildly, much more so than gilts or cash, from periods of 10 years on, equities actually represent a lower risk to the investor than holding cash or gilts and they provide a better return, once results are adjusted for inflation.

Another table from Barcap shows the after-inflation return on five asset classes since 1899 (where available): 

Annualised real investment return, after discounting for inflation: 

Last 10 years
Last 20 years
Last 50 years
Last 112 years
Corporate Bonds
Index linked

Cash and gilts are less profitable when held over long (20 years) and very long (50 and 112 years) periods compared to equities, which are remarkably stable, returning around 5% per annum after inflation. The last 10 years has been an abnormal period of low returns for equities, a result of starting the period near the peak of the Dotcom bubble. 

There are some general lessons here for the thoughtful investor: 

1. The risk of heavy losses rises dramatically as the investment period shortens. So trading equities over short periods, even for as long as a year, is very risky and to be avoided. The reason is that in the short term markets are governed by sentiment, which is erratic, rather than fundamentals, which are more stable and predictable. 

2. Equities offer better returns than cash or bonds, with no significantly greater risk, over periods of 10 years or more. So for anyone who can put away their funds for a period of 10 or more years would be wise to consider placing 100% in equities. 

3. As a rule of thumb, bonds are a good alternative to equities for up to 5 years. 

4. Cash is a good short-term investment with minimal volatility, but returns soon fall away. 

Naturally, there are periods (one in ten for cash and one in four for bonds) when other assets outperform equities over ten years. But over 18 years cash only outperforms equities once in a hundred times, while Gilts outperform equities only once in seven times. Go with the odds!


An Asian Fund yielding 4.8%

There are two ways to tap into growth in Asia and Pacific area. Indirectly on the UK stock market by investing in companies such as Unilever that have a significant market presence in the area or directly via a fund that concentrates on Asia and the Pacific region. Both have their merits. Today I'm looking for an Asia Pacific fund that invests in equities with a good yield. Given the stagnant Japanese economy, I choose to avoid it.  

BNY Mellon  (Newton) Asian Income Fund at 185p to yield 4.8% fits the bill. This fund has a good record of capital gains and dividend payouts and Morningstar awards it a maximum rating of 5 crowns.

Performance over                          1 Year +19.5%                   3 Years +61.2%                 5 Years +85.1%

Quartile ranking compared
to all funds in the sector                      1                                             1                                             1

The managers invest in companies, mainly in Australia, Hong Kong, and Singapore (60% of the total), that yield 30% over the MSCI Asia ex Japan Index and sell them when they no longer meet this goal. This clear and straightforward strategy should ensure a regular increase in dividend income, which fits my overall goal. The yield is paid out of income and not capital gain, an important consideration in any investment. I do not have the expertise to trade in these markets and could not trade as cheaply as a fund, so I am willing to pay their 1.5% annual fee.  

Jason Pidcock has been managing the fund since 2005, and while fund managers will almost always underperform their colleagues and the comparative index at times, over the long haul one is better off with a manager with a good record than one who hasn't. The small exposure to the Chinese stock market and no exposure to the Indian stock market is wise, given the high volatility of both, which are also subject to insider trading and poor governance. As the fund has outperformed the MSCI Asia ex Japan Index by a wide margin and is concentrated on yield, it is in my opinion preferable to an ETF tracker, though it has a higher cost. 

The main drag on performance might well be the huge size, now 3 billion pounds, of the fund. This is the winner's curse. Very successful funds earn a reputation that causes a snowball of new funds that cannot be invested as well as before.

Tuesday, 8 January 2013

Jacko the Gorilla and Investment Portfolio Benchmarking . . .

And an Investment Grade Bond Yielding 7.5%


In January 2000 Jacko the gorilla, who lives in Amsterdam's zoo, picked ten bananas from the seventy-five he was offered. Each banana was marked with the name of one of the 75 largest companies, by stock market capitalization, on the Amsterdam Stock Exchange. Every month Jacko picks out one of ten bananas corresponding to his portfolio and that stock is sold. Then he chooses one banana from another pile of 65 bananas, corresponding to shares he does not hold, and that is his buy. Jacko's portfolio outperformed the Amsterdam Exchange Index (AEX) every year in the 11 years between 2000 and 2010. If he had been a fund manager, Jacko would have had a stellar reputation. Then in 2011 his portfolio bombed. He underperformed the AEX by more than 32%. Was this the end of Jacko's good judgement? Well, in 2012 Jacko is back to his good old ways and he outperformed the AEX.  In the 13 years he has been choosing bananas, Jacko's portfolio has increased by 32%, which compares to a loss  of 54% for the AEX (both exclude  income).

    As Jacko's investments are reported daily, neither Jacko nor his human interface have had the opportunity of cheating. Unlike an investor, Jacko pays no trading commissions. With a portfolio turnover of 120% per annum, these would have been substantial. But as the Index itself has no trading commissions, Jacko's performance does compare to it on a like-for-like basis. Or does it? Jacko's portfolio is chosen from the 75 largest stocks while the AEX index is based only on the 25 largest stocks traded in Amsterdam. The other stocks are quoted on 2 different indices, the AMX - mid-cap and the AScX - small cap shares, representing the 26 to 50 largest stocks and the 51 to 75 largest stocks traded in Amsterdam.

   Even if these indices were included, they would misrepresent Jackos's choice of stocks, as the indices themselves have changed radically over the 13 years that Jacko has been trading. 

Number of constituent companies in the index in both 2000 and 2013:

Amsterdam large cap    AEX                       13 of 25 constituents

Amsterdam mid-cap      AMX                        3 of 25 constituents

Amsterdam small-cap   AScX                        0 of 25 constituents

In the case of the small caps AScX, the oldest constituent of the index today only dates back to March 2005.

   The same distortion occurs with our own indices. The FTSE 100 has gained 147 constituents and lost 147 constituents during the last 13 years. With this level of volatility, why compare our own portfolio to an index, unless we are happy to leave our money in an index-linked fund? Did I feel any the better because the FTSE 100's fall of 45% between May 2008 and March 2009 exceeded my portfolio's stomach-wrenching fall? Or did I feel any less relieved by the prodigious recovery in the value of my portfolio in the following 12 months because the FTSE 100's bounce of 62% exceeded my own?

   Benchmarking a portfolio is good practice: without a benchmark we are like a rudderless dinghy bobbing along at sea, with no idea and no control over where we will eventually land. Fund managers require a generally accepted yardstick in the public domain, and they rely on indices, but that doesn't mean this is the right yardstick for an individual. In fact it is fiendishly complicated to account for one's investment history, taking into account all the vagaries of life, that  can be compared to an index such as the FTSE 100.

   Financially speaking, individual investors have messy lives. We spend large sums on weddings, houses, divorces, our children's education and our own businesses. We save as best we can, we receive bonuses and inheritances and by downsizing our homes we release capital to invest. We invest when we can and disinvest when we have to; at bottom our objectives have nothing to do with the vagaries of the FTSE 100.

   Benchmarking should reflect our goals. For a young professional, who wants to buy a first home, the most appropriate benchmark might be to accumulate X thousand pounds within Y years as a deposit.  This he must achieve through savings and capital gains. For the self-employed homeowner, who wants to secure his retirement, the benchmark might be a Self Invested Pension Plan that, with current annuity rates, will provide an income of at least X pounds a year from the age of 65. And for someone nearing retirement, who wants his income to keep pace with inflation, the most relevant benchmark will be based on the income generated by his investments and not the asset value of his portfolio. Our benchmarks change as our lives and circumstances change. And by being specifically related to our financial objectives our personal benchmarks point us to the financial assets that best suit our needs.

An investment grade bond yielding 7.5% p.a. 

The Co-operative Bank's 13% Perpetual Subordinated Bond (symbol CPBC) is yielding, at the present offer price of 173p, 7.5% into perpetuity, and the Co-op is rated A3 (investment grade) by Moody's for long term obligations. Does this make CPBC a good buy? With 3.5% War Loan yielding 3.8%, the 370 basis point premium over Gilts is attractive in the present low interest and low inflation environment. Indeed, if the present rate of inflation of 2.7% were to continue forever the 4.8% real return from CPBC would match the long-term historical real return from equities, but without equity's volatility. And, unlike most Permanent Interest Bearing Notes (PIBS), there is no provision for resetting the coupon at specific dates or for calling the issue early.  As the Investors Chronicle noted 22 August 2012, "Principality Building Society did this in 2011 with its 5.375 per cent Pib, which had a reset rate of just 1.05 points over Libor, slashing the running yield from around 8 per cent to just 2.67 per cent."  
   No doubt the recent failures of the Bradford and Bingley and Dunfermline building societies and the 'rebasing', i.e cutting the coupon from other building society obligations has helped to supress the price of CPBC.

    As the coupon is paid gross of the tax credit, the best place to buy CPBC is in an ISA or SIPP wrapper. The main risks are: 
  • There is no protection in the coupon against rising inflation.
  • As a perpetual bond never reaches maturity, the capital value of the bond could fall quite drastically if inflation and interest rates rose.
  • CPBC is subordinated to all other debt, so that in the event that the Coop went into administration, the bond would become worthless. In this sense, it resembles common stock in a publicly quoted bank.
    CPBC is the only investment grade perpetual bond of any size (110 million pounds), with no recall or reset feature that I have been able to find with such an attractive yield in sterling.