After nearly two years of waiting, the FTSE 100 broke through its record high of 6,930 this week; a level last seen on 30 December 1999 during the height of the dotcom bubble.
Price performance of index since 30 Dec 1999
Source: FE Analytics
Almost inevitably, concerns have been raised about the outlook for UK equities, given that the last time the market was at this level there was a significant correction shortly afterwards.
Nevertheless, a number of experts have said the blue chip index can continue to power forward as there are positive differences between then and the late 90s – such as lower price to earnings and price to book ratios.
However, Lance and Teahan – who run the RWC Income Opportunities and Enhanced Income funds with Nick Purves – say the current environment is much more dangerous than it was this time 15 years ago, thanks to central banks’ extraordinary monetary policy such as ultra-low interest rates and quantitative easing (QE).
“There is a peculiarity with the market which is quite interesting, which is that last week the FTSE 100 hit its all-time high which was previously made in 1999,” Lance (pictured) said. “The FTSE 100 is at the same level it was then, but actually, if you drill down and look at the valuations within it, it is completely different. That is because, in 1999, one-third of the index was incredibly expensive and we know now that was technology at the top of the dotcom boom.”
“However, you had ‘old economy’ stocks like tobacco and utility companies which were incredibly cheap. Although the index was high, it was actually a good time to be a value orientated investor as you could find cheap stocks. Lots of people made their careers by buying old economy stocks and holding them for the next 10 years or so.”
One of the best examples was star manager Neil Woodford, who avoided tech stocks like the plague as the TMT bubble inflated – causing his Invesco Perpetual High Income fund to underperform the wider market as a result.
Performance of fund vs sector and index between Dec 1997 and Dec 1999
Source: FE Analytics
Rumour has it he was close to losing his job due to the underperformance, but he stuck to his guns and held out-of-favour defensive companies within the pharmaceutical and tobacco industries. As the graph below shows, the call massively paid off for him over the following 10 years.
Performance of fund versus sector and index Dec 1999 and Dec 2009
Source: FE Analytics
However, Lance says managers just don’t have that opportunity set anymore.
“Today, the shape of the market is quite different. Like with all asset classes, QE has effectively driven up all stocks so you see the same wide spread in terms of valuations. What that has meant is that as valuations have gone up, we’ve sold stocks which are expensive,” Lance said.
He added: “We’ve looked for places to redeploy that cash, but we have found it hard.”
As a result, Lance and Teahan currently have the smallest number of stocks they have ever held and are running their maximum level of cash.
Their £243m RWC Income Opportunities fund has just 24 holdings and has 27.6 per cent in cash, while their £370m RWC Enhanced Income fund – which uses call options to boost their dividend steam – is made up of 26 companies and has 21 per cent in the money market.
Both funds sit in the IA Specialist sector, but are predominantly UK equity income funds.
Lance added: “We don’t come in one morning and think, god we feel bearish, let’s do a programme trade and sell a slice of every stock in the portfolio. Because we have strong valuation discipline, we do what we are meant to do, which is to sell stocks when they get expensive.”
Despite that, a number of experts have told FE Trustnet recently that they expect the FTSE to continue pushing forward as the current market is far more attractively priced than it was in 1999.
“It is understandable from a behavioural perspective, but completely illogical from a valuation perspective. The UK market is now better valued on price-to-book and price-to-earnings ratios than arguably it was in 1999, and even again in 2007,” Charles Hepworth, investment director at GAM, said.
“This justifies its current level from a fundamental analysis viewpoint. On a technical perspective I am optimistic that the market can make further gains from here with the FTSE 100 trading towards an upper range of 7,500, and this level possibly being met sometime during 2014.”
However, Teahan says there is another reason for being so defensive in the current environment as protection is incredibly cheap relative to its history.
The managers use put options, but more specifically, they buy put option spreads. These are often called “bear put spreads” as it is an option a manager uses when they expects a decline in the price of the underlying asset – the FTSE All Share, in the case of the team at RWC.
“We buy a put option at 90 per cent and are selling one at 80 per cent. The cost of that is now at a five-year low and the market, as we have seen, is hitting new record highs. It’s been seven years since the last crash and if you think how long market cycles have lasted over the last 30 years, it has typically been about seven years,” Teahan (pictured) said.
“We are not saying the market is going to come down and that we are trying to time the market, but the cost [of a put option spread] is at a five-year low so we think it is a very opportune time to use protection.” The managers’ views on the current market mean their portfolio is heavily skewed towards high yielding mega-cap companies with reliable earnings and therefore well-covered dividends.
This trade has been a popular one, but has come under increasing criticism as – with yields on fixed income very low levels and as they don’t offer a huge level of growth – these defensive income paying companies have been viewed as “bond proxies” – which means they could struggle if bond yields and rates were to rise.
Our data shows, for example, that their largest sector weightings in the RWC Income Opportunities fund are to healthcare and telecoms. However, Lance says he isn’t concerned about holding these “bond proxies” in the current environment.
“We have heard that argument quite a lot,” Lance said.
“Number one, there is no sign of bond yields going up at the moment. Actually, it’s quite the opposite. Number two, that’s just not how we think about investing. We are looking for decent businesses we can buy at the right price.”
He added: “We don’t claim to have any ability to forecast bond yields.”
Lance, Teahan and Purves worked together at Schroders where they ran the Schroder Income and Schroder Income Opportunities funds.
They launched their two portfolios at RWC in October 2010, over which time they have both underperformed relative to their FTSE All Share benchmark.
Performance of funds versus index since Oct 2010
Source: FE Analytics
However, there is a major reason for that as the managers’ focus on capital preservation and income generation. That means they don’t expect to outperform in a rising market – as has been the case over recent years – but to provide a reliable source dividends and protection against falling markets.
As the table below shows, this has been the case over the recent years for investors in the RWC Income Opportunities fund.
Source: FE Analytics
The fund, which yields 3.6 per cent, has also been less volatile and had a lower maximum drawdown – which measures the most an investor would have lost if they had bought and sold at the worst possible time – than the index since its launch.
RWC Income Opps has an ongoing charges figure of 1.05 per cent.
