A strong, income-based buy-and-sell discipline is key to avoid falling in love with “Dracula stocks” in an investment environment dominated by greed over fear, according to Newton Investment Management’s Nick Clay.
Clay, manager of the £5.5bn Newton Global Income fund, said having a buy-and-sell discipline for income has never been more important given that markets are at all-time highs and are being led by a small group of stocks.
Indeed, in recent years, returns have mainly been driven by growth stocks such as the FAANGs -Facebook, Amazon, Apple, Netflix and Google-parent Alphabet in the US – or the BATs, their Chinese counterparts: Baidu, Alibaba and Tencent.
As such, investors have been piling into the markets’ most popular and best performing stocks: ‘FOMO’ (fear of missing out) or ‘Dracula’ stocks in the manager’s words.
Clay noted that even income managers have jumped on the bandwagon, taking a shorter-term approach to income by constructing portfolios with FOMO stocks to generate capital and high-yielding stocks to generate income.
“We already know that FOMOs are not that attractive,” he said. “But, equally, buying stocks with high yields is not that attractive either.
“The market is not stupid, it puts stocks on a high yield for good reasons: because something is going on with the business, something is going on with the cashflow, there are chances they are going to cut the dividend.
Performance of Alphabet over 5yrs
Source: Google Finance
He added: “In today’s world where we’ve just had a market of utter perfection – it goes up and up – people are starting to do strange things and to think about greed over fear.
“So, having a discipline is really important because, when markets are at all-time highs and are being led by fewer and fewer stocks like the FAANGs and BATs, the valuations of these just keep going higher and higher, and a manager with no discipline will be attracted to them.”
Clay said fund managers with few restrictions have more freedom but experience greater pressure to buy FOMO stocks to the point where they ask themselves: ‘These stocks keep going up, when am I going to buy them?’
But by limiting the options Clay said it can avoid that pressure, as the FAANG stocks don’t yield enough for the four FE Crown-rated strategy.
As such, the buy-and-sell discipline focuses the team upon what Clay said they know works through time: the compounding of a sustainable number.
The team can only buy a stock for the first time if it yields 25 per cent above the FTSE World index, which is currently yielding 2.4 per cent.
If the stocks in the Newton Global Income fund yield less than the index, the team will automatically sell them.
“It is hard to know when to trade into the momentum stocks and when to get back out of them again,” he explained. “It is a difficult call to get right and given that we’ve been doing it for 30 years, you have to keep doing it again and again.
“Fishing in this statistically unattractive part of the market seems like a difficult thing to do. Instead, what we do is focus upon companies that can pay sustainable dividends. Why? Because that leads us to fundamentally good companies.
“And if you look at the returns on markets from 1970 to Q2 2018 in the major markets around the world, the returns you have from that markets are completely dominated by your starting dividend and the growth in that dividend through time.
“That growth is the power of compounding,” Clay added. “It is, as Warren Buffet would tell you ‘the snowball effect’. It just gets bigger and bigger through time and that is what we are trying to do on our strategy.”
Dividends’ role in major markets’ equity returns
According to the income manager, because the team focuses on ‘good’ companies, the fund delivers a much better total return.
Not only is the return positive but by choosing good dividend payers that make them benefit from the power of compounding, the volatility of that return profile is lower than that of the stock market.
However, he noted it is not just about choosing the good companies. For a fund to deliver returns the fundamentally good companies must be bought when they are cheap.
“The only way we are going to generate money is if we are able to buy those companies when they are cheap but that’s easier said than done,” said the Newton manager. “As human beings we fall in love with things and we fall in love with stocks.
“So, if I find one of these really good companies and I really want to buy it because it’s a good company I easily make up a valuation to justify buying that company, we are all clever people we can all manipulate numbers.
“But what you need is an objective discipline that stops you buying them when they are expensive, it forces you to be patient so when good companies are expensive it doesn’t matter how much we love it, we have to be patient and wait for them to yield 25 per cent above the market,” the manager added.
As human beings, Clay noted selling stocks when everybody else has fallen in love with them is not an easy thing to do.
“As a human being, to do something different than the herd is an uncomfortable place to be,” he explained. “When you are looking at these stocks and they are out-of-favour everybody is telling you that you are an idiot.
“Equally when you sell them everyone is telling you are mad, they say: ‘these are the best companies in the world, why would you do that?’.”
“And yet statistically if you are going to generate a different return profile from the market you are going to have to be different from the market,” he concluded.
Although Clay joined the strategy at launch in 2012, he has been lead manager since 2015. Over that time, Newton Global Income it has delivered a 55.28 per cent compared with a 44.26 per cent gain for the average fund in the IA Global Equity sector and a gain of 63.59 per cent for the FTSE World index.
Performance of fund vs sector & index under Clay
Source: FE Analytics
The fund yields 3.06 per cent and has an OCF of 0.79 per cent.