Ian Cowie explains why investors should be wary of blindly following the crowd.
London Fashion Week, which begins on September 13, often unveils eye-catching designs but might also prompt profitable thoughts for investment company shareholders this year. At first glance, fashion and finance might seem to have little in common but any market where people buy and sell goods and services will see the popularity of different styles and sectors rise and fall over time, driving prices up and down.
For example, consider the so-called FAANG stocks; Facebook, Apple, Amazon, Netflix and Google (which is listed in New York as Alphabet). Rising demand for this relatively small group of technology companies has delivered most of the share price returns from the world’s biggest stock market during the last year.
At the other end of the popularity scale, consider another acronym; the so-called BRIC economies of Brazil, Russia, India and China. These emerging markets have recently fallen from favour for a variety of reasons – including talk of trade wars, a stronger dollar and political instability – depressing returns from shares listed there.
This dramatic divergence in financial fashion raises important questions for investors. Will these trends prove sustained or merely passing fads and what is the best way to maximise our exposure to wealth-creating opportunities while minimising our vulnerability to stock market shocks?
While the past is not necessarily a guide to the future, it is only fair to say that history is not altogether reassuring for followers of fashion who are biting into FAANG stocks for the first time today. The risk of buying high and selling low was demonstrated at the start of this century when the technology, media and telecommunications (TMT) bubble burst in 2000 and share prices fell sharply from record peaks hit in the late 1990s.
Then, as now, there was rising excitement about technology in general and the internet in particular. Talk of a ‘new paradigm’ encouraged many investors to value businesses on hopes of growth rather than traditional measures, such as expressing share prices as a multiple of earnings – or the price/earnings (P/E) ratio.
However, it may be excessively simplistic to fear a repeat of the TMT boom and bust today because many technology companies are now generating substantial revenues, earnings per share and profits. Another important consideration for investors is that, although acronyms can help simplify complex concepts, the performance of individual shares within these groups varies widely.
The simplest and surest way for investors to cope with these uncertainties is diversification; or spreading our investment exposure over a range of assets rather than relying too heavily on a single company or country. Investment companies automatically implement this strategy with the added benefit of sharing the cost of professional fund management or stock selection.
This enables individual investors to gain exposure to sectors where we may have little personal knowledge. For example, at both ends of the financial fashion extremes discussed here, I am a shareholder in Polar Capital Technology (PCT) as well as BlackRock Latin America (BRLA), Fidelity China Special Situations (FCSS) and JPMorgan Global Emerging Markets Income (JEMI).
Unlike other forms of pooled fund, investment company shares are priced by the interaction of demand and supply on the stock market. So, if demand is lower than supply these shares may be priced below their net asset value (NAV) – when they are said to be trading at a discount. Contrariwise, if demand exceeds supply then these shares may be priced above NAV – when they are said to be trading at a premium.
Discounts can narrow or widen and are not necessarily a guide to good value. Some shares are cheap for a reason.
Premiums also fluctuate and do not necessarily indicate that a trust is overpriced. As FAANG stocks and technology investment companies have shown in recent years, some expensive shares can go on to become even more expensive.
However, when an investment company is priced at a premium or a discount this provides a numerical indication of whether an investment company is in or out of favour. That can be a useful factor to consider for investors seeking growth, value or momentum; another name for followers of fashion.
Most investment companies are priced at a discount to their NAV, although the average is shrinking as more people become aware of these funds’ advantages. Whatever financial fads come and go, the presence of discounts and premiums may continue to provide helpful indicators for investors who either reckon nothing succeeds like success or, alternatively, others who believe the first step toward making a profit is to buy low.
Ian Cowie is a columnist at The Sunday Times.