Buy when there is blood in the street: investing in BREXIT Britain and why nobody is talking about it.

Brexit with a B

I suspect anybody living today in Pre-Brexit Britain, will be forgiven for believing that they live in a parallel universe where up is down – left is right – and forward is actually backward. 

I want to give you cause to look on the bright side and actually Buy Britain!

But first a short recap of where we are in October 2019:

There was the ignominious fall of David Cameron. After all it was Mr Cameron who made the snap decision to call a referendum on Britain’s membership within the EU.  He resigned. That was swiftly followed by Teresa May winning support to take up the reins of the Conservative Party, as a fairly inexperienced and some say rather robotic prime minister (see: Maybot, John Crace coined the phrase). Up until the summer May was widely regarded as one of the worst prime ministers since Neville Chamberlain. Then the media ran stories that suggested she was simply the worst.

Not to be outdone, after that came Boris Johnson on the 24^th of July, beating Jeremy Hunt in the race to become Conservative Party Leader. His populist antics and hyperbolized promises during the referendum on Europe are in part (some would say significantly) to blame for people voting for Brexit in the first place. Since becoming Prime Minister, in a few short weeks, he’s failed to deliver several votes in parliament and this culminated in the proroguing of parliament until mid-October. Presently a constitutional crisis has now transpired whereby he may seriously be able to force a ‘no deal’ Brexit unilaterally by the 31st of October 2019.

Sounds pretty dire doesn’t it?

The Case for Optimism – Total Return

Only when it comes to investing it doesn’t get much better than this! The FTSE has been trailing the returns of other developed markets. While the US market represented by the S&P 500 has quadrupled since the bottom of the market in March 2009, the FTSE remains a much less exciting double the level of what it reached in March 2009.

Other people have tried to use data to paint a bleaker picture – the FTSE All Share index, representing 85% of the market share of all British businesses is only 26.8% higher than it was in September 2000, which was 19 years ago.

What is the truth behind this? Why should you be optimistic if the index of British businesses returned a paltry 26.8% in 19 years?

The simple answer: the value of the index doesn’t represent your total return and therefore those numbers are not reflective of what you would have made. Your total return is a function of two things:

1. How much the price of your underlying investment rises, i.e., the value of the index; and

2. How much income you receive in the form of dividends.

Just read that over once again because it is a HUGELY important point.

Let’s look at the total return of the S&P 500 (key US index) and the FTSE All-Share (Key U.K. index) since September 2000 and also March 2009, which includes dividend income:

The total return of the S&P 500 (including dividends) is 7.45% per year since 1^st January 2000. Surprisingly, when you factor in the stronger dividend yield of the FTSE All Share, the total return is still a decent 5.91% per year. On a total return basis it has paid to be invested in the FTSE All Share despite two extremely bad financial crashes (Dot Com from 2000-2002, and the Great Financial Crisis in 2008) that have only been matched by the Great Depression in the 1930s. The total return is 112% and not 26.8%, and an annual return of 5.91% since the year 2000.

The return of the FTSE 100 over the last 25 years has been 6.4% including dividends, so this isn’t far off of that.

Why British Shares are Cheap by Historical Standards

Let’s look at American shares. The S&P 500 currently yields 1.67%, which historically is much lower than the average yield of over 3% that the index held up until the 1990s. What does that mean? Well, you get 1.67% of your investment returned to you every year in the form of a dividend (income). That percentage is low because prices for American shares are relatively and historically high. As the price for the shares goes up, the income you receive as a percentage of your initial investment reduces.

Yields move in the opposite direction of prices and a lot of research has been dedicated to the fact that dividend yields are a very strong predictor of future returns*. So if prices for stocks fall, and dividends stay static, then the yield rises, right?

The yield on the FTSE 100 is 4.57%. Let’s think about that for a second. Every year, if you just hold a tracker fund that owns the FTSE 100 (the one hundred largest British companies by market cap), you’ll receive 4.57% in income. Maybe a bit more, or a lot more, perhaps a bit less in the event of a recession. To put that into context: this is SIX times the value of the Bank of England base rate. It’s two times the best Help to Buy ISA rate with HSBC today and twice the rate of an online bank like Atom.

It is also – if buy-to-let investors are honest with themselves – better than a great deal of Real Estate investors get when they net-out all fees, mortgage costs, and expenses.

If the return on shares over the next ten years is terrible – we are talking, 1970s slow-down terrible – and the present level of the index were to reduce by 40%, well then you’d actually still not lose money. Why is that? Because if you receive income at 4.57% for ten years that’s just over 45% of your initial investment returned back to you. So if your initial investment falls 45% you’ve not lost any money – you recouped it in the form of income.

Warren Buffett is one of the best investors alive in terms of market returns and reputation. Even he has turned his sights on Europe and he is specifically hunting around Britain for companies worthy of buying (See here). I suspect with Berkshire Hathaway’s enormous cash pile – which hit a record $122 billion – billion with a ‘b’ – he’d be keen to find a business that is severely depressed and to make a purchase.

For us mere mortals though, this isn’t a path we can generally follow. Which is why Buffett and many other professionals recommend index funds. You need to instead learn a small amount about investing and park your hard earned cash in diversified investments that offer you the potential for growth. 

[* Read Jeremy Siegels book The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New Hardcover – 1 Apr 2005, for a comprehensive overview of why dividend-paying companies tend to perform better, on average, than companies that do not pay a dividend. ]

So just to recap. The political situation is dire (and will probably get worse by October!) people don’t believe in Britain anymore. Asset prices are low. Dividend yields and financial measures suggest that the stock market is undervalued. The recommendation is that you consider investing. How do you do it ?

If you’ve got other investments, or you have a particular inclination to want to profit from the Brexit chaos, then there are 2 ETFs that are worth taking a look at:

1. FTSE 100 Equal Weight UCITS ETF (XFEW)

One issue people have is this: the FTSE 100 is heavily weighted towards banks and oil companies. I would agree on one front: it is heavily weighted to those companies because Royal Dutch Shell, BP and HSBC hold disproportionately large positions in the index.  This is absolutely the case and it is part of the reason why the dividend yield is so high. The FTSE 100 in particular is quite heavily weighted towards the top companies.

The FTSE 100 Equal Weight Index solves that. It’s a miraculously simple product. This fund owns the top 100 companies in the U.K., just the same as the standard FTSE 100 tracker and the same list and number of companies. The only difference is that rather than weighting your money by market cap (so HSBC is 8% of the index because it is 8% by size, as measured by market cap) it gives an even weighting to every constituent. That means you have a lot more exposure to smaller companies that are part of the FTSE.

The dividend is still a market busting 3.92%. That’s money in your pocket every year. In terms of fees (the biggest killer of returns!) they are only 0.25%, which is very competitive, considering your average pension in the U.K. charges you 1.85% in fees. Although they are more expensive than the FTSE 100 tracker (Ticker: VUKE) that I recommend in my Home Base Portfolio (here).

2. Vanguard FTSE U.K. All Share Index Unit Trust Accumulation

Again to respond to this issue around weighting, another way to invest in the U.K. is to buy a tracker that invests in the top 641 businesses and covers 85% of the total stock market by market cap in the U.K. Sounds like a good idea doesn’t it?

The approach still leads to weighting’s towards HSBC, Shell and BP but the effect is more muted. The top 10 constituents only represent 18% of the assets. In other words buying this fund with £1000 means only £180 gets allocated to these top 10 businesses. In return more of your money gets allocated to smaller and faster growing businesses like (Smith & Nephew, Victrex, Ashtead. When Brexit eventually gets resolved and this country returns to a sense of normality expect these businesses to do extremely well.

The dividend yield is a solid 3.7% and you rake in that income with a comforting knowledge that you are “buying Britain” in spades, having exposure to 85% of the total domestic market. If the market falls 10% in 3 years time, you’ve still made money if you kept hold of the income you gained.

The fees are a paltry 0.09%, and to be honest, in the decade or so that I have been investing this is the single closest way of investing “like a trader” with very low costs and higher returns. The trick is having the self-discipline and personal control to hold onto that investment for 10 years or more!

Conclusions

I remember in 2011 spending most of my investing time reading and studying the news. Surely – I thought – the answer to whether or not I should pour all of my savings into stocks would be in the news. That was a huge mistake: apart from a few targeted shares, I remained on the side-lines because the news was positively frightening – the Euro debt crisis, double dip recession, Grexit; Frexit. But since 2012 world stock markets have enjoyed a long and fruitful bull market. The expectation for poor returns was followed by the complete opposite.

I vowed – from that time onwards – to stay the course, as a long term investor, and avoid falling into the mind-set of trying to predict the future. Instead I take solace in Frugally allocating my hard earned capital to areas where I can earn an inflation beating return over the long term.

After all: if you’re still working – a lot of your capital hasn’t even been earned yet – so when equities fall, like they did in December 2018, you need to train your brain to ‘buy, buy, buy!’