The beginnings of a bubble in simplicity

I interviewed Hugh Young, managing director of Aberdeen Asia a few weeks ago. We spoke about a variety of interesting things – just how “venal” the financial industry is and how the saddest thing about his job is watching the way in which the proceeds of growth all to often disappear into inequality, corruption and Swiss bank accounts.

However, his key point was on investing style. Most investors, he said, start off thinking that investing is terribly simple. Then they start to think it is terribly complicated, but in the end they come round to realising that it really is “quite simple.”

That’s a pretty accurate summary of the behaviour of the industry over the last few decades. Back in the early 1990s, stockbrokers mainly talked about price/earnings (PE) ratios and earnings growth when they were pushing stocks. Then in the second half of the 1900s and the early 2000s, everyone went mildly mad with a variety of over complicated, often incomprehensible and usually useless valuation methods.

And now we are back where we started. Post bubble and post crisis everyone – be they deflationists or inflationists, emerging markets zealots or US cheerleaders, technology investors or commodity supercyclers – accepts that the best performers in most equity markets over most timescales are good quality dividend/high yield payers.

So all investors have to do is ask a few basic questions. Does a stock have an average to low price/earnings ratio?  Are its earnings honest and likely to be a sustainable? Does it pay a reasonable dividend? Get three yeses and it’s a buy. Job done. Everyone agrees. And so we enter the beginnings of a bubble in simplicity.

Look at some of the investment trusts in the UK that invest in this kind of thing. The Diverse Income Trust trades on a premium of 2.7% (you have to pay 2.7% more than the value of the underlying assets to buy shares in the trust). The Murray Income investment trust is on a premium of2.6%. Shires Income is on over 5%. This isn’t just the case in the UK of course: Aberdeen Asian Income is on a premium of 7%.

Then look at the equity markets that are suffering at the moment. Those who invest in China probably aren’t primarily dividend focused, as Christopher Wood of CLSA points out. But given the “unattractive” yield on the market (2.75% at a time when inflation is officially 1.8% but widely considered to be understated), it is still worth noting that in the last 12 months there has been an outflow of ¥259bn from equity and mixed funds in China and a ¥356bn inflow into money market and bond funds. The CSI300 index has fallen 21% over the same period. 

This brings me to one of my favourite long term investments – what many readers insist is my ‘blind spot’ and one market no one has used the word ‘bubble’ about for a long time: Japan. We know it is cheap on all sorts of levels. Peter Bennett of Walker Crips puts it on a price to book ratio of around one. That’s a 40% discount to the average price to book of the stocks in the MSCI world index. At the same time 40% of the companies listed in Japan have net cash equal to their stock market value (so there is some real protection on the downside!).

There’s more. Price to cash flow is about six times – so much lower than the current p/e, something that suggests to Bennett that “large corporates in Japan might still low ball profits to avoid high corporate tax levels.”

Still, given that all anyone cares about these days is yield, let’s just look at that. No one considers Japan to be a market worth investing in for the dividends. But that might be a mistake. Over the last decade or so, dividends in Japan have risen faster than in any other market and the nominal yield on equities is about 2.6%. Pah, you might say – that’s less than the yield in China. But add back in Japan’s deflation at, say, 0.5-1% and you get a real (inflation adjusted) yield of 3% plus. In the US you are getting a real yield of around zero. In the UK you are getting around 1%; in Europe around 2%; and in China something negative – how negative depends on what you think inflation is. I’d like to say that this gives investors a win-win situation.

Long term, the Japanese market looks like a steal. If the market as a whole doesn’t rise, dividend stocks still should – from 1989, notes a report from Allianz Global Investors, the equity market in Japan as whole lost 50%, but anyone investing just in high dividend payers would have “managed to achieve a positive return.” And if that doesn’t happen, domestic investors will at least have their 3% and foreign investors should see the real bit of their income return in relative currency strength and (as they long have) make a turn on the strong yen.

Given Japan’s market history, I’m not going to say the ‘win-win’ words. But I will end by pointing out that across the world, Japan is the only market giving investors what they insist they want – cheap yield. One day investors will get round to buying it. If you want to do so first, the Jupiter Japan Income fund might be one way to go.

• This article was first published in the Financial Times