Investment Strategy of a Morris Capital Company - Essay Example

Investment Report for Morris Capital Investor Fund Profile Morris Capital is a UK fund dedicated to support charitable educational purposes. Its members make regular financial contributions which acts as seed money for five years, after which the original contributor is free to choose to withdraw it from the fund. The option to withdraw commences in June 2010, and is expected to reduce the fund by 3% per annum, between new contributions and withdrawals. Issues The following are considered the current issues that could affect the performance of the portfolio. General election to be held this year The country is due for the next general election, to be held no later than 3 June 2010 Polls of January 30, 2010: Conservatives lead with 40%, Labour Party with 24% and Liberal Democrats with 19%. Another 17% voted for other parties. This signals a shift from the presently governing Labour Party (Angus Reid, 2010). The move towards conservatism is a reaction to the recent crisis, as more people worldwide felt that not enough regulation was exercised by the government to control risky instruments and markets. However, there is also a possibility that a more protectionist attitude may characterize the new administration, which may hamper economic growth. The more conservative economic policy may work either way; it could provide a more stable environment for business by eliminating risks, but at the same time it might limit business opportunities. Thus new directions must be carefully watched post-election. Concern about poor prospects of UK economy According to the Wall Street Journal report, this year’s treasury’s budget deficit forecast, at 12.6%, remains to be the highest in the nation’s history, while forecasts for 2011 to 2011 economic growth appear to optimistic. Tax receipts remain weak because of the poor earnings level in both the business and household sectors of the economy (Norman, 2010). However, the Office of National Statistics reported that the UK economy actually grew by 0.1% for the last quarter of 2009, the first following six quarters of economic contraction. It may not be conclusive that the recession is ended, but it does provide a hopeful sign which may be confirmed in the coming quarters (Angus Reid, 2010) Rising debt level in public and private sectors According to Price (2010), the current high levels of US government debt is a cause for worry. The uncertainty in the possible outcome of the credit “tug-o-war” itself exerts pressure on the market to perform with greater volatility (erratic price movements). Price notes that the supply of gilts is moving upwards consistently, and together with it the UK’s credit fundamentals will continue to quickly deteriorate. What would be worse is the threatened debt downgrade from one of the ratings agencies. This could mean that the UK will be able to source additional debt only at higher interest rates. Concern about possible monetary devaluation The increasing debt burden on the UK economy has sparked fears that an devaluation of the country’s currency will follow soon. Ferguson (2010) admits that downward pressure on the sterling’s value has already taken place. He mentions that since early 2009, the sterling fell about 31% within the 18 months following the start of the crisis in 2007. However, he also noticed that since the low then established, the sterling has risen already by some 10% beginning early 2009. The question now is whether or not additional debt will cause a further drop in the sterling after this tentative recovery. A further drop could cause foreign investors to continue to stay away from buying UK assets, keeping prices down further, and inflate the foreign debt because of the deterioration of the forex rate. Alternatives for Asset Allocation UK Equities Equities refer to stocks, representing the rights of ownership, particularly entitlement to dividend payments. For the purposes of Morris Capital, what is needed is the cash income that comes from the investments, not necessarily the increase in the value of the asset. For stocks, this means that it is the dividend yield that is controlling. According to the Bloomberg services (2010), the overall dividend yield for the FTSE all shares for the past year is about -10%. This is easy to understand. On the basis of the all-shares, then there will be a majority of companies that did not give out dividends, and instead required additional capital infusion (thus the negative sign). While this probably worsened due to the crisis, not all firms give out dividends even during regular economic growth. However, among the top UK equities there is a list of companies that are considered “blue chip” (Appendix A). Blue chip companies are considered the cream of the crop, with a good dividend record. A look at the dividend yield rate for the FTSE 100 (considered the top 100 stocks in the UK stock exchange) shows a rate of 6%, indicating that stocks selectively invested in could provide cash income to the fund. UK Commercial Bonds Commercial bonds are debt instruments that indicate funds on loan for the long term to prime corporations, with the promise of annual interest payments and the return of the principal at maturity. The quality of the bond depends on the financial stability of the company issuing the bond; the poorer the quality of the bond, based on credit rating agencies’ classifications, then the riskier the investment and the higher the interest rate that the investor is justified in demanding. Referring to the Bank of England Market Statistics, the yields on UK commercial bonds are shown on the second column of the table that follows. For the purpose of this recommendation, the average of the closing rates for February 1 to 15 shall be used as proxy. UK Government Bonds Government bonds are instruments of long-term debt that the government owes the bondholder. It represents a promise by the government to pay the investor a certain fixed amount of money at regular intervals. This amount is determined by the coupon rate, a percentage applied to the face value of the bond, and representing an interest in consideration for the use of the bondholder’s money. At the end of the life of the bond, the face value of the bond shall also be returned to the investor. In the UK, government bonds are called “gilts” which is short for gilt-edged securities (MoneyWeek, 2007). There is a debate going on as to whether gilts remain a good investment. According to Price investors should avoid buying gilt, but Ferguson adopt the opposite position and observes that banks buy them as a regulatory measure. In any case, again referring to the Bank of England Market Statistics, the yields on UK government bonds are shown on the third column of the table that follows. Also as with commercial bonds, for the purpose of this recommendation, the average of the closing rates for February 1 to 15 shall be used as proxy. Overseas Equities, Commercial Property and Cash / Near-Cash For three of the assets in the Morris Capital portfolio, this study shall take a neutral position but will assign assumed return levels. Overseas equities are stocks of corporations operating across the border, and given the better state of economies particularly in mainland Europe (Germany), China and India, and most of Asia, keeping foreign-denominated assets may be a defensive strategy in case the sterling falls further. Commercial property and cash account for only a small part of the portfolio. It is advised that commercial profit be kept as is, because the depressed property prices at present may mean disposing of the asset at a loss, close to the bottom. Commercial property, by its nature, probably earns commercial rent for the fund, so it should be maintained. Finally, a reasonable measure of cash should be kept, not for its yield (the lowest among the assets) but because liquidity will be necessary to finance pay-offs. The bank interest rate is shown in the right side of the table below. Source: Bank of England Market Statistics Recommendations Before making any recommendations, the original portfolio composition is assessed in the following table: Asset Class Allocation Original yield Wtd Yield UK Equities 35% - 10 % - 3.5 % Overseas Equities 20% 6 % 1.2 % UK Corporate Bonds 15% 3.1% 0.47% UK Government Bonds 20% 2.92% 0.58% Commercial Property 5% 3.0 % 1.5 % Cash & Near Cash 5% 0.8 % 0.04% ------------- Total Weighted Yield - 1.06% ======== The “original yield” figures above have been derived from the discussion in the preceding section. They were taken from Bloomberg and Bank of England statistics as cited. Since these are assumed, the overall values are not as important as the change that is seen upon applying recommendations that shall be made here. Using the proxy values assumed, the yield from the original portfolio is computed to be -1.06%, indicating the possibility of erosion of the fund’s seed capital. On the basis of the given data, it is assumed that the present yield is actually sufficient to defray operations and costs of education programs for which the fund is intended. The loss of -3% per annum refers to the difference between incoming contributions and outgoing withdrawals. Thus, if the yield above were designed such that an incremental benefit of at least 3% materializes, then it is assumed to make up for the withdrawals and keep the fund’s capital constant. From the foregoing discussion, the following are held to be accepted concerning the asset allocations: Equity allocations may not be divested of because of their depressed valuation as a group, but may be shifted to better quality stocks. Overseas equities may be maintained as currency risk hedge. Property may not be disposed of either for the same reason. Government securities must be retained for the safety factor, but should not be increased due to poor yield and present controversy about debt levels. Commercial property and cash should be maintained at their levels. From the foregoing, the following table shows the recommended outcome: Asset Class Allocation Adjusted yield Wtd Yield UK Equities 35% 6 % 2.1 % Overseas Equities 20% 6 % 1.2 % UK Corporate Bonds 15% 3.1% 0.47% UK Government Bonds 20% 2.92% 0.58% Commercial Property 5% 3.0 % 1.5 % Cash & Near Cash 5% 0.8 % 0.04% ------------- Total Weighted Yield 4.54% ======= The table above maintains the same asset class allocation as the original, for the reasons earlier given: the inopportune disposal of assets at a loss. However, a move to quality is made in the UK equities, which effected an incremental improvement from a -1.06% to 5.45%, or by 5.6%. Through this action, the fund seeks to preserve it capital integrity by not selling at abnormally low prices, but enhances the cash yield of the portfolio, since what the fund needs is an additional cashflow of at least 3%. Passive vs. Active Investment management Due to the large amount of research involved, the expertise of the fund manager, the cost of hiring analysts and transaction costs for buying and selling securities, an actively managed fund charges a higher fee. An investor would have to pay 1.8% annually based on the volume of his funds. On the other hand, a passively managed fund relies purely on an automated process and does not need the decision of the fund manager and the frequent trades. All it needs is a streamlined process where the buying and selling are based on a predetermined portfolio, like the stocks linked to an index. Investment in such a manner will cost an investor only 0.3% each year – only one-sixth of the cost of an actively managed fund (Pawar, 2009). As to which type to use for Morris Capital, this study recommends the optimal combination of the two, depending on the existence of market inefficiencies that present opportunity for use of information. As Tyer (2009) points out, uneventful markets may be passively managed and costs saved in the process. On the other hand, volatile market may present occasional chances to outperform the market, allowing for active management. Works Cited Angus Reid Public Poll. 2010 Conservatives Steady at the Top in Britain. Polls and Research, 30 January 2010. Retrieved on 15 February 2010 from http://www.angus-reid.com/polls/view/34962/conservatives_steady_at_the_top_in_britain Bank of England, Market Statistics. Yield curves. Retrieved on 18 February 2010 from http://www.bankofengland.co.uk/statistics/yieldcurve/index.htm Bloomberg. 2010. Retrieved on 15 February 2010 from http://www.bloomberg.com/markets/rates/uk.html Ferguson, J. 2010 The MoneyWeek debate: Is Bill Gross right to warn investors to get out of gilts? Answer: No, He’s Just Talking His Book. Retrieved on February 15, 2010 from http://www.moneyweek.com/investments/is-bill-gross-right-to-warn-investors-to-get-out-of-gilts-47215.aspxo Money Week. 2007 What should you expect if you invest in bonds? MoneyWeek, 7 August 2007. Retrieved on February 17, 2010 from http://www.moneyweek.com/investments/what-should-you-expect-if-you-invest-in-bonds.aspx Norman, L 2010 Focus: UK Borrowing Forecasts Credible Despite January Data The Wall Street Journal, 18 February 2010. Retrieved on 18 February 2010 from http://online.wsj.com/article/BT-CO-20100218-709469.html?mod=WSJ_World_MIDDLEHeadlinesEurope Pawar, J 2009 Passive v Active Investment Management. Buzzle.com. Business & Finance, 8 December 2009. Retrieved on 15 February 2010 from http://www.buzzle.com/articles/passive-v-active-investment-management.html Price, T 2010 Yes. How could anyone quibble? The MoneyWeek debate: Is Bill Gross right to warn investors to get out of gilts? 5 February 2010. Retrieved 15 February 2010 from http://www.moneyweek.com/investments/is-bill-gross-right-to-warn-investors-to-get-out-of-gilts-47215.aspx Stock Market for Beginners. 2010 UK blue chip companies – top blue chip companies. Retrieved 15 February 2010 from http://stockmarketforbeginnersguide.com/uk-blue-chip-companies-top-blue-chip-companies/ Tyer, A 2009 Space for both active and passive investment. Finweek, 3 December 2009, pp. 49-50. Appendix A List of Blue-Chip UK Equities (Stock Market for Beginners, 2010) Admiral Group plc (LON:ADM) AMEC plc (LON:AMEC) Anglo American plc (LON:AAL) Antofagasta plc (LON:ANTO) Associated British Foods plc (LON:ABF) AstraZeneca plc (LON:AZN) Autonomy Corporation plc (LON:AU.) BAE Systems plc (LON:BA.) Barclays PLC (LON:BARC) BG Group plc (LON:BG.) BHP Billiton plc (LON:BLT) BP plc (LON:BP.) British American Tobacco plc (LON:BATS) British Sky Broadcasting Group plc (LON:BSY) Bunzl plc (LON:BNZL) Cable and Wireless plc (LON:CW.) Cadbury plc (LON:CBRY) Capita Group plc (LON:CPI) Carnival plc (LON:CCL) Cobham plc (LON:COB) Compass Group plc (LON:CPG) Diageo plc (LON:DGE) Eurasian Natural Resources Corporation (LON:ENRC) Experian plc (LON:EXPN) Fresnillo Plc (LON:FRES) G4S plc (LON:GFS) GlaxoSmithKline plc (LON:GSK) ICAP plc (LON:IAP) Inmarsat Plc (LON:ISAT) InterContinental Hotels Group PLC (LON:IHG) International Power plc (LON:IPR) Intertek Group plc (LON:ITRK) Invensys plc (LON:ISYS) Kazakhmys plc (LON:KAZ) Lloyds Banking Group PLC (LON:LLOY) Lonmin Plc (LON:LMI) Man Group Plc (LON:EMG) Marks and Spencer Group Plc (LON:MKS) National Grid plc (LON:NG.) NEXT plc (LON:NXT) Pearson plc (LON:PSON) Pennon Group plc (LON:PNN) Petrofac Limited (LON:PFC) Randgold Resources Limited (LON:RRS) Reckitt Benckiser Group Plc (LON:RB.) Reed Elsevier plc (LON:REL) Royal Dutch Shell plc (LON:RDSA) RSA Insurance Group plc (LON:RSA) SABMiller plc (LON:SAB) Serco Group plc (LON:SRP) Shire Plc. (LON:SHP) Smith & Nephew plc (LON:SN.) Smiths Group plc (LON:SMIN) Standard Chartered PLC (LON:STAN) Tesco PLC (LON:TSCO) The Sage Group plc (LON:SGE) Tullow Oil plc (LON:TLW) Unilever plc (LON:ULVR) United Utilities Group PLC (LON:UU.) Vedanta Resources plc (LON:VED) Vodafone Group plc (LON:VOD) Wm. Morrison Supermarkets plc (LON:MRW) WPP PLC (LON:WPP) Xstrata PLC (LON:XTA) Cairn Energy PLC (LON:CNE) Read More