Moment of banking madness

Yesterday was an exciting day for RBS shareholders:

• Expected loss of £22-28bn, the largest in UK corporate history.
• Further shareholder dilution as the govt swaps its preference shares for equity at a price of ~32p, meaning that it will own about 70% of the company.
• A 70% fall in the shareprice to under 11p.

By the afternoon my bank shares constituted only about 1.2% of my portfolio, and a moment of madness spurred me to increase that to about 11%.

I think nationalization is a real possibility, but there is also a real possibility that banks have sufficient capital and no further dilution will occur. In the event of nationalization it's possible that ordinary shareholders might get some compensation, but I wouldn't count on it. So the downside is 0p for RBS, BARC, LLOY and HSBA.

On the other hand, if no further capital is required, then we can expect RBS, BARC, LLOY and HSBA to dominate UK banking and for all but LLOY to have a reasonably substantial global banking operation. Barclays claims to be capable of making about 40p per share even in difficult circumstances. RBS has previously made about £7bn per year, so perhaps £4bn is a reasonable expectation in the future, which is about 7.5p per share. The forecast for Lloyds is about 25p per share. HSBC is forecast to make about 85p in 2010.

Assuming a fair P/E ratio of 10 (although it could be a while before we see the markets agreeing), that gives an upside of:

• 75p for RBS
• 400p for Barclays
• 250p for Lloyds
• 850p for HSBC.

I therefore bought roughly equal shares of these 4. At my purchase price the upside represents 5.5 times for RBS, 4.6 for Barclays, 3.7 for Lloyds and 1.8 for HSBC. I don't expect to achieve this with all 4, but even 2 out of 4 would put me in profit.

This is clearly a bit of a punt, but if these 4 all go under (or even just RBS) sterling will be trashed and my non-sterling assets (IEEM, IDVY, IAPD and actual dollars) will more than offset any losses.

Update

After 1 day my purchases are already down: -35% for LLOY, -25% for RBS, -17% for BARC. HSBA is up 1%. Woohoo! Luckily today's $/£ exchange rate movement ($1.47 to $1.39) more than offset any losses. So far this year my portfolio is very slightly negative, down about 1%.

Regular rebalancing

Rebalancing a portfolio once per year, either by buying and selling, or adding to investments that have become underweight can produce better returns than a passive strategy, provided:

• The elements of the portfolio have broadly similar expected returns. 50/50 cash/shares would do better by being left alone, since the shares (which should have better returns) would progressively dominate the portfolio. Property and shares should have broadly similar returns, so are good candidates for rebalancing.
• The elements are not perfectly correlated. Obviously with perfect correlation rebalancing is unnecessary.
• The market displays a certain amount of mean reversion. This is the key thing that makes rebalancing work - if future returns are unrelated to past returns, then rebalancing is pointless. But if a period of outperformance is typically balanced by a subsequent period of underperformance, then rebalancing can help -it also requires no insight into the relative valuation of the different asset classes.

I don't currently plan to pursue a rigorously balanced portfolio, but may do so at some stage. Currently my portfolio looks like this:

• 46% UK large cap.
• 25% UK small cap.
• 22% International large cap.
• 12% Emerging markets large cap.

I'm heavily weighted to the UK, mainly because of my familiarity with UK companies, and my preference thus far for avoiding index funds.

A more reasonable portfolio might look like:

• 20% UK large cap.
• 10% UK small cap.
• 15% US large cap.
• 20% International large cap.
• 15% Emerging market large cap.
• 20% Property.

I will be roughly tripling the size of my portfolio over the next 2 years, so my current holdings account for:

• 15% UK large cap.
• 8% UK small cap.
• 0% US large cap.
• 7% International large cap.
• 5% Emerging market large cap.
• 0% Property.

So to get the sort of balance I'm looking for, I should be avoiding UK shares almost entirely, and looking to pick up US shares and property as a first port of call.

Diversification

I've been reading "A random walk down wall street" recently. I don't entirely agree with B.G. Malkiel's enthusiasm for efficient markets, but getting a different point of view on things is always welcome.

One thing it has done for me is to reinforce the positive effects of diversification. Unlike Malkiel I do not equate risk with volatility, but reducing volatility is a Good Thing provided it does not significantly increase risk or decrease return. My criteria for adding a new investment to my portfolio should therefore be:

• It must have a similar/better risk/return trade-off compared with my existing portfolio.
• It must not be strongly correlated with an existing investment.

At the moment many asset classes are moving in harness with one another due to the global shortage of liquidity, but this won't last forever.

My current portfolio (considering such things fairly broadly but excluding my pension fund) consists of:

• Residential property, one of, i.e. the house I live in.
• A negative net Sterling cash balance, i.e. cash + mortgage.
• A positive net US Dollar cash balance, coming due in January 2010.
• A share portfolio.

If my house is worth 100, the other components of my portfolio are roughly:

• Sterling balance of -40.
• US dollar balance of 20.
• Share portfolio of 15.

The share portfolio is clearly a relatively small component, but is likely to have superior returns, so I think it's fairly obvious that I should continue to buy shares. In a year or two I think a reasonable position would be: house 100 / sterling -50 / dollars 0 / investments 60.

I've been mulling over whether I should diversify into bonds and/or real estate. Clearly I'm heavily overweight in UK residential property, so any real estate investment will need to be sufficiently different to provide diversification benefits. Any any diversification needs to fulfill my criteria above.

I'm looking for an after-inflation return of approximately 6% over the long-term. The ishares International Property Yield ETF (IWDP) has a yield of 9.66%, although that is skewed by an abnormally high dividend payment almost a year ago. Stripping that out, the yield is about 6.3% - and commercial property has historically been a good inflation hedge. So the return on this is adequate. It will be correlated with shares and UK residential property to some extent, but the correlation should be less than 1.

The ishares £ corporate bond (SLXX) has a gross yield to redemption of 8.16%. With no defaults and inflation of 2%, that gives a real return of just over 6%... but I don't fancy predicting the rate of inflation given the current circumstances. Also, most of the holdings appear to be banking-related, which isn't necessarily the safest place to be.

I think for now I'll continue to monitor these two. I think IWDP is reasonable at its current price, and SLXX needs to be a little bit cheaper. But I probably won't be adding any new investments for a month or two.

Update:

In the last 5 days IWDP has shifted in price so it now has a yield of 10.97%, which I estimate to be about 7.3% adjusting for last year's freakish dividend. That's at a price of $11.18. However, I do have some concerns about some of the REITs that constitute this ETF.

Here are the top 5 holdings:

• Sun Hung Kai Properties, weighted at 5.1%. Hong Kong properties. Payout ratio of 0.5. Gearing 25%. Interest cover 7.5 times.
• Westfield Group, weighted at 5.1%. Australia, NZ, US, UK property. Payout ratio 1. Gearing 70%. Interest cover 3.5 times.
• Unibail-Rodamco, weighted at 3.6%. French. Payout ratio 0.9. Gearing 85%. Interest cover 7 times.
• Simon Property Group, weighted at 3.1%. US commercial property. Gearing 600%. Payout ratio 2.2 or 0.6 (depending on whether you look at net earnings or FFO). Interest cover 1.6 times.
• Vornado Realty Trust, weighted at 2.5%. US commercial property. Gearing 260%. Payout ratio 1.1 or 0.6. Interest cover 2.1 times.

The US REITS seem to be very heavily geared. By contrast, REITs from other countries have relatively modest gearing. I would not be surprised to see some of the more heavily geared REITs go down the pan - so I would need to take account of that before investing.

Next and Tesco

I've added to my investment in Next and Tesco. The portfolio breakdown is now:
GNK: 14.0%
TSCO: 13.8%
NXT: 13.5%
IEEM: 11.9%
IAPD: 10.9%
IDVY: 10.5%
RBS: 6.5%
BDI: 5.4%
MXM: 4.0%
ZRX: 3.9%
QDG: 3.5%
TW: 2.1%

Annual review

2008 has drawn to a close. It's a year to forget in terms of my share portfolio, but luckily the appreciation of the dollar against sterling has resulted in an overall profit of just over 6%.

Over the course of the year my returns have come from 4 places:

• Interest on my dollars.


• Dollar / sterling exchange rate movement.


• Dividends


• Share price movements
  

The effect of these 4 on my total portfolio have been:

• Interest: +2%


• Exchange rate: +23%


• Dividends: +1%


• Share price movement: -20%

With hindsight, my best decision was made at the start of the year and was to avoid hedging the currency risk I faced. I've since decided that my decision was based on faulty reasoning, and that the "correct" thing to do was to fix the rate. So I think we can place that result firmly in the camp of luck.

My share purchases have substantially underperformed the market. I believe I've learnt from my mistakes and can apply greater discipline in the future.

Insufficient research

I made my first investment in RBS based on very little research. I didn't even look at the annual report. The P/E ratio was low, the dividend yield was high, and I listened to what management were saying without applying sufficient scepticism. I failed to assess the possible impact of a rights issue, and failed to think logically about the impact of the credit crunch.

I made a similar mistake with Taylor Wimpey, failing to correctly analyze the nature of their debt and the effect on their land portfolio that a sharp fall in house prices would have.

I've learnt two lessons here: that more research is required, and that I need to focus on companies that I can understand.

Emotional involvement

Having made faulty investments, and watched the share price punish me, I refused to accept that I might have made a mistake, and compounded my original error by averaging down. While spreading purchases over time is sensible, automatically purchasing more shares on a price drop is not.

I have ended up investing a very large amount of money in RBS, Zirax and TW, and these have been the worst performing shares in my portfolio.

In future I plan to be more cautious, leave much longer gaps between adding to an existing investment. I'd like to think that I will be more self-critical, but I doubt I will ever fully learn that lesson.

Excessive contrarianism

While I think being a contrarian is a good thing, much of the time the crowd is actually correct. I need to be much more selective about when I move against the crowd.

Portfolio

As of today, a week after New Year, my portfolio breakdown is:
GNK: 15.9%
IEEM: 14.2%
IAPD: 13.0%
IDVY: 12.7%
TSCO: 9.4%
RBS: 7.3%
NXT: 7.3%
BDI: 5.1%
MXM: 4.7%
QDG: 4.1%
ZRX: 4.1%
TW: 2.0%

The dismal performance over the year is as follows:

Actions

Looking at the portfolio breakdown, I think my next steps will be:

• Bring my investment in larger companies up to a similar level as GNK. That means adding more Tesco, Next and RBS.
• Take a decision on Taylor Wimpey. Either add to the investment or sell. I think I'll wait for the outcome of the debt refinancing.
• Add to my investments in IEEM, IAPD and IDVY. These currently constitute around 40% of my portfolio, and I want them to keep at least that ratio.
• Consider investing in US shares to increase my international exposure. Another dip in the Berkshire Hathaway share price would be perfect, since I don't want a large number of US shares.
• Avoid adding to my investments in smaller companies. My instinct is to double up on these, and I may do so at some point, but think I'll wait to see how they do this year.