1st September, 2023
All Roads Lead Home
The ‘price’ of something often doesn’t reflect its true ‘value’. We say things like ‘I wouldn’t pay that price’, getting drawn into the numbers and not necessarily what it means to us. The price of something is merely the cost to buy or sell, whether that’s an investment portfolio or a car. Value on the other hand is what the item is actually worth, or put better, the benefits it provides.
With most physical goods, it’s reasonably easy to see the difference. A holiday has a cost, and we par that off against various benefits such as relaxation time, the warmth of sunshine and the memories we make.
When it comes to financial assets such as savings or an investment portfolio, the difference is still there though it’s much harder to see and understand. The price is the current capital value of that asset – the numbers on the screen. The industry calls this a “valuation” and is updated in real time (we don’t help ourselves do we!)
Value on the other hand really falls into two categories; the income stream produced by that asset, and the opportunity or risk it goes up or down in value. Take two £1m portfolios, one that provides 5% (£50k) in income every year, and the other that provides 1% (£10k). The prices of both are equal, but the first is significantly more valuable than the second, all else equal.
Another easy way to illustrate value is in annuity rates, which represent the level of guaranteed income you can buy by cashing in part or all of your pension scheme. Two years ago, at the last valuation peak in investment markets, a £100k annuity purchase for a 65-year-old would have provided £4,786 per annum in income (Source: Sharing Pensions). Today, the same purchase price would provide £7,500 per annum. Even if prices have fallen 10%, the value, or purchasing power, of that same pension is now around 40% higher.
What we are saying here is that in order to decide whether your portfolio represents good value, you must understand what it is able to deliver in terms of future returns. A sustainable future income stream of 5-6% per annum, and the chance of capital increases, is far more ‘valuable’ than a higher capital price today but an income stream of just 1% per annum. That’s even more so the case because income is much more stable than capital, which is affected by anything and everything.
Now coming back to today’s investment markets, capital values remain volatile as investors continue to assess the future direction of interest rates. Although there are lots of ways things could play out, making it simple, we see three core scenarios. In the first, interest rates go up even further on the back of improving economic growth. Second, an economic slowdown and recession cause interest rates and inflation to come down quickly. Finally, the so called ‘soft landing’, where economic growth muddles through, inflation falls back to 2-3% per annum, and interest rates are slowly and steadily reduced.
Each of these scenarios has a very different investment implication in the short term, though importantly, because of the value (income) now built into portfolios, that doesn’t necessarily change the longer-term outcome.
Take the recession scenario as an example. Here we would expect interest rates to be cut, equities to fall, and bonds to rise. The increase on bonds would help to offset the falls in equities initially, and then returns would improve over subsequent years as bond income and equity growth kicks back in when things recover. On a 5-year investment time horizon, a low-medium investor might see returns like 2% in year 1, then 8% in year 2, 3, 4 and 5. Over the combined five years, that’s 34%.
Conversely, take the “soft landing” scenario. Here interest rates would be slowly reduced, helping both bonds and equities. Your 5-year return profile in this scenario might look like 10% in year 1, but 6%, 6%, 6% and 6% in the following 4 years. Over the combined 5 years, that’s still 34%, but in a very different order.
The north star in both scenarios is the income that’s being delivered into the portfolios each month. It’s not been shining for well over a decade, over which time the portfolios provided very low levels of income and have relied entirely on growing the capital (or price). It should be remembered that prices move around based on lots of factors, but the income will always come through over time. More recently the north star has emerged again. We have spent the last eighteen months building an income stream into our portfolios that means the value today is now significantly greater than at any point in the last decade. Naturally we can’t determine which of our three scenarios’ will play out, though one thing we are confident of is that, given our portfolio ‘value’, all roads will lead home, they will just take different routes to the destination.