Top-down investing is a is an investment approach that involves looking at the overall picture of the economy and then breaking down the various components into finer details. After looking at the big-picture conditions around the world, analysts examine different industrial sectors to select those that are forecast to outperform the market. From this point, they further analyse stocks of specific companies to choose potentially successful ones as investments.
To many regular investors this might sound very complicated and difficult to achieve without using advanced analysis and statistical tools. In reality the analysis could be made as complex or as simple as one likes, as long as the overall results and assumptions taken make sense. Complexity does not necessarily mean that one has a better end result. This post aims to give a practical example that is easy to follow of how top-down investing works. It also goes on to mention some specific equity ideas. The end result will give some real examples of equities one can buy in order to increase exposure to the crypto-currency world which is very interesting but also very risky to buy into directly.
The US Economy
Since the focus of the exercise is to arrive at equities that a regular investor can easily get access to it made sense to focus on US equities. As the focus is on US equities then the starting point is the US economy. The US is considered to be a consumer driven economy meaning the economy is dependent mainly on consumer spending. The gross domestic product (GDP) of a country measures the market value of all final goods and services produced by an economy over a particular period of time. If we look at the GDP of the US we find that around 70% is made up of consumer spending. The other 30% or so is made up of Government Spending, Business Spending and Net Exports of the country (Export less Imports) combined.
As the economy is continuing to show signs of growth and the economy is so dependent on consumer spending one could easily arrive at the conclusion that consumer spending is expected to keep growing. Hence, the next step in the link is to find ways of investing into equities that are somehow exposed to consumer spending. That is quite a big list since many companies service regular consumers. Thus, one would need to narrow down further to find more specific entities to invest into. Moreover, two companies might be involved in the production of the same goods/services to the same type of consumers but still perform differently. If consumer spending increases the entire sector should improve, but not each company will benefit equally and not each company is in the same shape – thus other factors also need to be considered.
Refining the Selection
So, let us now add something else to the mix. There has been a fair share of hype on the crypto-currency universe, especially in the last year or two – see my previous post relating to thishere. Many investors would like to invest into this world but are not comfortable with the direct instruments available due to the high volatility and high risk involved. So how can we combine the analysis we discussed above on consumer spending and the exposure to crypto-currency investing – the answer: by looking at equities that are exposed to both sectors.
A prime example are the payment service provider firms such as Visa and PayPal Holdings. Whether you buy online, buy at the supermarket, travel abroad or simply ride a taxi you could easily pay for your goods or services through one of these payment companies. Furthermore, when buying crypto-currencies people can use these same companies to convert from their hard currency (U
SD, Euro…) to the respective virtual currency such as Bitcoin, Ethereum and others. Just to get an idea of the amount of transactions that are processed by such companies, PayPal is said to handle 193 transactions per second which translates into 16.7 million transactions per day. When it comes to Visa the figures are even more great, reportedly 24,000 transactions per second which translates into over 2 billion transactions per day.
The Bottom Line
Therefore, starting from the analysis of the US economy and working our way down we have arrived at examples of equities that a regular investor could easily invest into. It goes without saying that one should not simply go and buy a bunch of shares of the two companies mentioned and one should always seek professional investment advice to ensure that the investments they are considering are suitable for them. The author held positions in the equities mentioned at the date of publication which may be sold off without notice.
Many people have asked me about what I think about the whole crypto-currency world and if I think they should invest into such virtual currencies. I have attended interesting seminars that discussed the topic in detail and have done my own research on the subject to understand how it all works. Although it is not too complicated to understand the mechanics of what crypto-currencies are and how they work, one must first put in a fair amount of research to in fact understand their universe. Given that crypto-currencies are a relatively new concept they cannot really be compared to other assets, although they will share some traits with other new/disruptive technologies.
Fad vs Serious Investment
One of the first things people think about is whether this is just another fad that is in the news today but gone tomorrow? or is this the best thing since sliced bread that is destined to change the world as we know it? In reality, nobody can truly say. What is certain is that crypto-currencies have grown in importance to a level where even your local butcher is talking about it. Hence, there is no doubt that virtual currencies are being talked about and people are eager to get a slice of the pie by finding the best way to invest into this world.
This creates a dilemma for potential investors since on the one hand they see the returns that were registered over a small period of time with virtual currencies – this creates the biggest psychological problem, i.e. the lost opportunity. On the other-hand people are also aware of the high volatility of such currencies when they read headlines that this or that virtual currencies went up or down 20% in one or two days. This high volatility usually scares away potential investors, especially those that are not that interested in getting to know how virtual currencies work or how they could be used, but just want to make a quick return like that guy on the Facebook ad did. Their normal course of action would be to ask their investment advisor.
Of course their investment advisors have their own issues with virtual currencies. Knowing that the product is not easily understood by most retail clients the issue of complexity comes up. This means that it is difficult to prove that a client truly knows what he/she is getting into if they were to invest into virtual currencies. Coupled with the complexity issue you have the high volatility issue which means that the instrument is a highly risky one. So the main issue is basically that from a business risk point of view it does not really pay off for a licensed investment firm to recommend to ordinary retail clients to invest into virtual currencies.
So does this mean that there is no safe way to try and ride the crypto-currency wave? Is there no way that clients can get exposure to virtual currencies at an acceptable level of risk? Is there no way that investment companies could give recommendations to their clients to invest into crypto-currencies? Like in many such situations, there is always a way.
How to invest in virtual currencies, without investing in virtual currencies
Although doing it directly presents an amount of hurdles for both investors and financial advisors, going the indirect route is still an option. One thing that will come to mind for most when thinking of an indirect route is to invest through a fund or ETF. This is in fact one option that has the advantage of adding diversification by investing into many different currencies and not just buying one or two currencies. Thus, the logic would be that if crypto 1 issued by ABC Tech was a flop and ended up with no value, crypto 2 – 100 are still in existence and the risk has been spread. This sounds good, but in reality this just helps with the risk affecting just one virtual currency. In real life we expect bad news on one of the currencies to drag down all the rest. So this might still not be the best option, especially since such a fund would be expected to have a high level of volatility (risk) given the high level of correlation (similarity) of the currencies.
Thus, one needs to go a step further and think more broadly. Of course, investing into the shares of the companies that have issued virtual currencies is not really an option most of the time since they would have issued their “shares” through an initial coin offering and not by issuing traditional shares. Thus their “shares” are basically the virtual currencies they have issued. This has led me to conclude that the best way for most investors to invest into virtual currencies is to invest into the shares of companies that are somehow exposed to this market. So the logic would be to invest into shares of well-established firms, that are highly liquid, that trade on reputable stock exchanges and that already have a track record.
One may look into the shares of certain technology companies that are involved in the production of the virtual currencies. Alternatively, one may look at marketing companies that are involved in the Initial Coin Offering or Initial Token Offering markets since no crypto currency can be launched without having a good marketing strategy. Or else, the area that is interesting me the most is to look into firms involved in the payments sector. In order to buy cypto-currencies most people would need to send a payment using a hard currency such as the US Dollar or Euro. To send their “real” money they need a payment company to do the transfer for them. Hence, such companies have already experience good growth directly linked to the crypto currency world and still have more to gain as demand for such currencies keeps growing.
The Bottom Line
So in conclusion, there is a safer way of getting exposure to the crypto currency world without having to take on the high risk associated with directly investing into such currencies. The ideal portfolio of companies to invest into in order to get this indirect exposure will depend on a number of factors. But the important thing is that there is a solution to the dilemma and it is a solution that investment advisors can more confidently help their clients with.
As usual please take note that nothing in the post is to be interpreted as investment advice. The views are my own and I would urge anyone considering to invest into anything discussed in this post to get professional financial advice. For any queries about this or any other article on this site, or for any recommendations on future topics, please feel free to contact me on email@example.com
There has been a lot of hype over the last years to attract new types of businesses to Malta such as the FinTech (Financial Technology), WealthTech (Wealth Management using Technology), Algo-trades (investing using algorithms) and more recently Investment-based Crowdfunding Platforms. Rightly so, entities such as FinanceMalta have held several seminars and initiatives to attract these types of business and in fact their 2017 annual conference will be focusing on this theme.
Through this post I would like to give a brief description of these types of entities and to also provide some thoughts on the factors which could deter these types of entities from seeking to be registered in Malta. From personal experience of being involved in a start-up Fin-tech, Wealth-Tech and Algo-trading company Novofina I would like to shed some light on the difficulties faced in attaining a suitable license and remaining compliant to rules and regulations which are based on a one size and one type fits all regime.
FinTech can describe any financial services entity that uses technology to perform its service or offer its products. The technological innovation can be applied in different parts of the process from research, retail banking, investment selection and even crypto-currencies such as bitcoin. Technologies can include things like Artificial Intelligence (AI) that could be applied to investment instruments selection or to research gathering for estimating market sentiment for example.
Originally FinTech referred to technological innovations applied to the back office of banks and investment firms, nowadays it refers to a wider variety of technological interventions in the retail and institutional markets. The level of technology used varies depending on the type of company and the services it seeks to offer. It can range from mobile wallet systems to robo-advisor services. Even within a category of firm types the technologies applied can be wide ranging. For example, if we take the robo-advisory firms, you could have companies that simply use online data entered by the client to determine their risk profile, financial bearability and knowledge and experience in order to offer a bundled Exchanged Trade Fund (ETF) solution. You can also have so called forth-generation robo-advisors that use algorithm based trading in combination with AI in order to trade different investment strategies on behalf of clients.
An Algo-trader would use a mathematical algorithm that would be pre-programmed with certain rules in order to trade large amounts of instruments (example shares) on the market. The algorithm would be programmed to trade a particular trading strategy and configured in a specific way relating to price, position sizing, timing and risk-mitigating techniques. Thus, not all robo-advisors are the same and even more so not all FinTech or WealthTech firms are the same. This makes it even more difficult to fit into the local financial services regulatory framework and categories of licenses.
Crowdfunding, as the name suggests involves the process of gathering a lot of small amounts from a lot of people in order to collectively raise a larger amount. This can range from a simple project such as raising the funds to finance the publication of a book to more complex issues such as using the funds to invest into a new FinTech start-up through an equity stake. So far in Malta investment-based crowdfunding is not really possible since the current regulatory framework dose not really provide for this form of investment. However, we have seen some progress here with a donations-based crowdfunding initiative being launched that raises money against donations and can give back certain perks. There has also been a consultation paper issued by the regulator late last year which period had closed in March 2017. So we are beginning to see some progress here. A very interesting article for anyone looking to find more information on investment-based crowd funding can be found on the latest publication of the Malta Business Bureau here.
Barriers to Entry and Operate
It is a great initiative to attract the most technologically advanced financial services companies to Malta. However, there are certain issues that are hindering their entry and once operative, their operational viability. One of the largest barriers is the regulatory issue. Our current regulatory framework was not designed for these technologically advanced firms and the current situation is that these firms either fit themselves into an existing license category or else they are not welcomed. This is a major issue since it could be forcing firms to have in place certain items which are not applicable to their business model, are costly to maintain and would lead to deterring a potential newcomer from setting up shop in Malta.
To put it more simply, if a FinTech company would like to attain a license to provide services A B and C, why does it still have to apply for a license that caters for services A to G? Although there is some flexibility in the license application process and certain derogations may be applied it is still far from being an attractive preposition balancing investor protection and the reputation of the local financial services industry on one side and attracting the right players that could take the Maltese financial sector to a whole new level attracting cutting edge, niche market firms. On the other hand, the current regulatory framework may present certain loopholes for certain types of FinTech companies since the current regulatory requirements may not fully appreciate the different risks such firms pose to investors and the financial sector in general which could be quite different compared to more traditional financial services entities. Having said that, risk management has taken a much more prominent role nowadays.
With respect to the ongoing obligations of such entities once they have been licensed it is not logical that their capital requirements should be the same as those of other more traditional firms. To put it simply, certain investment services providers are subject not only to minimum initial capital requirements but also to on-going minimum capital requirements. This capital requirement is not simply a calculation of asset less liabilities, but involved certain amendments to arrive at the regulatory capital requirement. One of the deductions from an entity’s capital figure is its intangible assets figure in its balance sheet. Given that FinTech, WealthTech, Algo-Traders, Robo-Advisors and all the rest of these firms invest heavily in software and licensing of such software, and software is an intangible asset, they are currently being penalised for doing so. So on the one hand we want to attract the most technologically advanced firms and on the other hand we are telling them that their software is worth nothing and must be deducted from their capital. To be clear, this is not simply imposed by the local regulator but comes out of the EU Capital Requirement Directive. Simply blaming the EU legislation is not a solution however and when it comes to these technologically advanced firms it is even more so that we are not simply competing just with other EU countries but the whole world. Being online based makes it even easier to setup anywhere in the world with a decent internet connection.
Another problem we are facing locally is the shortage of talent. The gaming industry has brought many benefits to Malta, however it has also created a shortage in IT developers. Administrative staff is also becoming a problem for some firms, especially since most FinTech firms are start-ups and thus have a higher risk of going bust compared to the larger players in the industry. Another problem I see locally is the lack of promotion and support for being an entrepreneur. This last obstacle may the most difficult to overcome since it could be considered a cultural issue. However, with proper incentives and moral support from a young age there is no reason why we cannot produce more students who desire to become business owners. Interestingly enough, investment-based crowdfunding could be a very good avenue where such budding entrepreneurs could find funding to start off their project until they get to a level where other sources of finance could become available to them.
The Bottom Line
All-in-all I truly believe that Malta has the potential to become a major player in the FinTech arena. It has already proved itself in the fund industry and the online gaming industry for example and there is no reason why a market for FinTech and other technology based financial services firms should not also be successful. However, to reach such a realisation there must be more support and initiatives for such firms to choose Malta. Some barriers like certain regulatory issues are not entirely under our control. However, if our regulator decides to gold plate an EU directive this would hurt our chances of attaining success in this sector. One such example that comes to mind is the “holding and controlling” of clients’ money requirement locally, when the EU directive speaks only of “holding” clients’ money.
The views expressed are the personal opinion of the writer and do not necessarily reflect the opinion of any entity the author is associated with.
Investing in equities, stocks or shares all refer to the same thing – being a part owner of a company as a shareholder and participating in the profits and losses of the company(ies) you invest in. There are two main ways of making money when investing in equities:
With respect to capital gain this can be done in more than one way. The simplest form is to buy an equity at a low price and then sell it at a higher price. However, one could also short an equity. The desired result is still to sell high and buy low, but instead of first buying the equity and then selling it the process is done in reverse. Thus, if one would expect an equity to fall in price one could sell the share (by essentially borrowing the shares from one’s broker) and then buy them back at a later stage.
The risks associated with shorting are higher than the traditional way of buying and then selling later (known as “going long”). The reason is simple – if one buys €10,000 worth of shares the maximum one could lose is their €10,000 since a share cannot have a negative price and go down to €0 at most. In the case of shorting however the downside risk is much bigger. For example, if I sold €10,000 worth of a share at a price of €100 per share – so I would have sold 100 units (€10,000 divided by the price per share of €100) and the price subsequently skyrocketed to €250 per share and I was forced to close my position I would have to pay 100 multiplied by €250 = €25,000 to buy those shares. So deducting the €10,000 I would have gotten when I would have shorted the same shares, I would end up with a loss of €15,000, which is higher than the original amount I traded.
The above example is simple way to see the difference between the two methods of going long and of shorting. However, they are very extreme cases and are not as likely to happen. This is not to say that a company cannot go bankrupt (example after a major scandal) or cannot have its shares price skyrocket (example after the announcement of a takeover). However, through some simple risk management techniques such as sticking to the larger capitalised stocks and investing a portfolio of different shares, such extreme cases can be minimised and their impact on your overall wealth can be reduced significantly.
Can equity investing be profitable?
The easiest way to answer this question is to look at a broad-based index such as the S&P 500 which is a US stock market index based on the market capitalisations of 500 large companies having equities listed on the NYSE or NASDAQ.
The chart below shows the performance of the S&P 500 over the last 5 years from 5 April 2012 to 4th April 2017
*Source: Google Finance
As can be clearly seen form the above chart the performance over 5 years of this equity index has been 67.57% equating to a 13.514% return per annum. Thus, it is true that double digit returns are still possible on equities and it has been the case for the last five years, based on real figures. What if we increase the time frame, perhaps the last 5 years were exceptional? The chart below shows the same S&P 500 index but over a 10 year period from 5th April 2007 to 4th April 2017. Hence, it also includes the latest major financial crisis:
*Source: Google Finance
Some interesting points to note:
The 5 year and 10 year return on the same index are very similar which means that the annual equivalent of holding the same index for 10 years was 6.611% per annum (i.e. around half the last 5 year annual equivalent).
The price can go down and it can go down significantly. Anyone who bought at the highs of 2007 and was panicking in early 2009 and decided to sell could have lost around 50% of their investment.
Investing in shares is a long-term game – the same person who invested in the highs of 2007 and decided to hold on to their investment would be gaining 66% currently.
Does this mean that one should always invest in a broad range of equities such as buying an index fund that tracks the S&P 500 in a passive way?
Not necessarily. Increasing the amount of equities within one’s portfolio is a good thing only until a certain point. Diversification (the lowering of risk by spreading the investment across different equities) will be a positive factor, however the amount of gain through diversification is reduced further and further the more equities one adds. One must consider that although increasing the amount of equities lowers the impact of the negative trades, it also reduces the impact of the positive trades. Furthermore, one also should consider other factors such as transaction costs and costs for maintain the portfolio. The smaller the amount that is invested per share the larger the cost since most brokerage firms will have a minimum cost per share and some also have safe-custody fees which is a fee for holding the equity on your behalf.
Another factor to keep in mind when analysing the example above of investing into the S&P 500 is that we were just considering the more traditional method of investing buy buying and holding in a passive way. In the example, the investor would have bought at the begging of the period considered, left the investment running without any intervention, and then sold at the end of the period to make the capital gain. If we had to take a closer look at the ten year chart however it is clear to see that there were opportunities to make more than 66% by for example shorting the same S&P 500 between 2007 and the first quarter of 2009, by going long again from 2009 to the first quarter of 2010 and selling off again.
This method of investing is called active management where an investor would try to anticipate market movements and earn returns above the market rate. Of course, we have the benefit of hindsight in our simple example so it would not be that easy to outperform the market. However, there are methods that exist that attempt to analyse the past patterns and directions of equities with the aim of anticipating future movements. Technical analysis is all about building models and trading rules based on observed price and volume changes. Back testing is regarded by many as highly relevant to creating models and algorithms that can trade equities in a long term profitable manner and in fact outperform the market.
The Bottom Line
The aim of this post was to give a general introduction to equity investing. Locally, many investors tend to shy away from equities and they prefer fixed income investments such as bonds and bond fund since they pay more reliable regular income. However, given the interest rate scenario, which I have made reference to quite a lot in my previous posts, one has to be careful of the interest rate risk present in bonds and bond funds. Adding an element of equity investment to a portfolio could help mitigate the interest rate risk and diversify one’s portfolio to be positioned better for the months and years to come. There are different ways of investing into equities and I will be uploading more posts in the coming year which discuss such methods. One of the most advanced methods of investing into equities is through algorithmic trading. Anyone wishing to read more about this method should see my previous post here.
I would like to start this post by pointing out a very important fact: Planning for retirement does not mean buying an investment called “Pension Fund” or “Retirement Fund”. Many seem to think that in order to plan for their retirement they need to buy an investment that somehow has “retirement plan” of “pension plan” in its name. This is definitely not the case. In order to plan for one’s retirement one must think of all their assets as forming part of one overall portfolio.
The principal aim of retirement planning is to have a decent income once one retires from their employment and for estate planning. It is no secret that the state aid will not be enough for many people to earn an income in retirement that is compatible with the standard of living that they would have become accustomed to during their working life. Thus, it is important to plan in order to earn supplementary income. Does this mean that everyone should start buying income paying products from a young age – NO!
The best way to plan for retirement planning is for one to structure his/her assets in an overall portfolio structure. As with any portfolio investment one needs to plan according to one’s:
knowledge and experience.
It must also be kept in mind that all the above points will evolve over time and are not static. Thus your retirement portfolio must also evolve to reflect these changes.
For someone who is in their initial years of their working life their investment object is going to be quite different than for one who is close to the final years of their working life. Furthermore, it is not only an age thing, but other factors also have an effect on the investment objective. An initial objective of any investor would be protection. So a wise choice would be to acquire some form of life insurance and if affordable some form of disability insurance.
Let us assume we have an investor who has purchased their first home, has some form of insurance in place and a decent cash balance for regular expense items. Such a person would have a long term investment horizon and their investment objective would normally be to increase their overall capital. Thus, such an investor would be better off investing in products that focus on capital growth rather than income. The growth in capital possible through equity investing rather than investing in bonds is exponential. Therefore, it would not be wise to invest totally into income paying bonds when one has 30 odd years left until retirement.
On the other hand, someone who is nearing their retirement age should start shifting their portfolio more towards income paying investments. For such a person it would be more important to have something extra coming in rather than possibly doubling their capital in 10 years’ time. So the investment objective is going to have an effect on what investments one should have in their overall portfolio. Moreover, although income is important and normally is the main concern of many investors, if one would also like to leave something extra for their heirs then they should also consider this in their overall portfolio.
This is something very specific to the investor. As a general rule most people are risk averse, meaning that they would rather avoid rather than increase risk. However there is the risk reward trade-off to consider which basically means that the lower the risk the lower the potential return. In general, one who is still a number of years away from retirement would tend to be more able to take on risk for the potential of higher returns compared to someone who is closer to retirement. Even psychologically, investors would be more willing to take on risk when they are younger than when they are older. However, every investor is different in the degree of risk that they are comfortable in taking on. This will affect the type of individual investments that one would put into their overall portfolio. So although a younger person might want to invest in equities to increase their capital in the long term they can buy conservative equities/equity like investments such as an ETF that tracks the overall market, or they could buy a more speculative product that for example moves 3 times the price of oil.
Like with anything else in life we should only buy investments that we can afford. The affordability factor should be considered in two main ways. The first is that certain products have a high initial cost. So for example, certain bonds trade in multiples of €100,000 meaning that one needs to buy a minimum of €100,000 in order to buy the bond. The second factor connected to affordability is the percentage of the overall portfolio that the investment will make up. What I am referring to here is the fact that although the investor might afford to buy the asset, he/she would be left too exposed to the one asset if they do in fact invest in it.
An easy way to see how this second factor could be detrimental to a portfolio is to consider investing into property. With interest rates very low and the local rental market doing well we are seeing many people investing into property with a buy-to-let setup. Let us take a hypothetical situation where we have an investor who owns their main residence which is worth around €250,000 at current market rates, has a portfolio of €50,000 in investments, has €10,000 in the bank and is now considering buying an apartment costing say €100,000 in order to rent it out. Without going into the debt factor that this will have, let us assume that the €10,000 will remain on his bank account to cater for unforeseen expenses and act as a buffer. The €50,000 will all be used to purchase the property and the balance will be borrowed from the bank. If this is the case, the assets that make up this persons’ overall portfolio would be €350,000 in property and €10,000 in cash. This would mean that over 97% of this person’s portfolio would be invested into two properties, less than 3% would be in liquid, easily accessible cash and no other investments. Through such an example it is easy to see the concentration risk of going down such a route.
Knowledge & Experience
Another important factor to consider when deciding on which assets to put into one’s overall portfolio is to invest in assets which they are familiar with. This does not mean that one should invest only in things which they have already invested into and not consider anything else. However, one should research investments which they are considering investing into before they actually financially commit themselves. There are many good investment advisors around that can help here, but supplementary research is always a plus. By searching a bit online one will find many avenues where good information can be attained on the assets they are considering investing into. So just like one would consult websites such as booking.com and trip advisor when booking a hotel, investors should also do some supplementary reading before investing their money.
For many the main goal when it comes to their retirement planning is to secure a decent return after they stop or reduce their main work activity. In my view this is best attained by slowly building a portfolio of diversified assets over the years. The accumulation of income paying products should evolve over time and one is not expected to invest all their money in capital growth products and switch all their money into income paying products on the day they retire. The ideal situation would be to have income coming from different sources so if one of the sources is negatively affected in some way one would have alternatives that they could depend on. So by having some income coming from rental income, some coming from direct bonds and bond funds and some coming from income paying equities one would have different streams of income which are affected by different things.
As one is building their portfolio over the years they should not forget to think of alternative investments to the regular bonds, shares and property mix. Such alternatives would include investing into commodities such as precious metals and oil, investing into art and collectables and also investing into private businesses. A good source where one could attain a good capital appreciation and even income through dividends is by investing into private companies. Many start-ups end up needing additional finance while many other well established businesses also would need extra financing for new projects or to get through a rough patch. It is true that the risk could be lager here than investing into regulated and quoted companies, but if one does their research well and finds a good opportunity they can attain an equity stake in a good company at a decent price which would pay-off in the future. Such an investment could offer good income opportunities and a good asset for the heirs of the person who would eventually take over these shares.
The Bottom Line
The main message I would like to convey through this post is that there is no fixed formula to use when it comes to retirement planning. Everyone has to assess their own characteristics and find the best mix of products that suits them. So called retirement plans are a good start but they are not an end in themselves. Some of these retirement plans do give you a tax break if you use them, but the amount of tax saved per year on them is ridiculously low to have any significant weight.
According to Invetopedia.com, the definition of Ethical Investing is the use of one’s ethical principles as the main filter for investment selection. The idea can be applied by either eliminating certain industries altogether, for example gambling, alcohol and tobacco, or by over-allocating into industries that meet one’s ethical guidelines.
There are many funds that use this principle when it comes to choosing the investments (mainly equities) that they allocate their clients’ funds to. But at the end of the day, should one really care where the money is invested, as long as it is profitable? This question will be answered different for every investor since every investor will have his/her own criteria as to what is or is not appropriate. I am just simply trying to ask – where do you draw the line?
One may argue that investing in a company that manufactures tobacco or alcohol for example is not a really big issue. People who consume such products know of the negative effect that these products have and they choose to consume them anyway. On the other hand the products are addictive and hence they also have an immoral control over the consumers, especially addicts. Furthermore, it may be highlighted that such firms invest a lot of money into lobbying and propaganda and so they are not really playing fair and thus tricking people into consuming their products. So should I eliminate these companies from my portfolio?
To be honest, shouldn’t we really think the same of fast food producers? They are the cause of a lot of health issues, yet we do not restrict the intake of fast food consumption for people under a certain age as we do for alcohol and tobacco consumption. So should I not invest in the shares of McDonalds or The Coca Cola Company based on my ethical thinking?
With the legalisation of the personal consumption of Marijuana in certain US states one can now invest in companies that produce this product. The same arguments brought up for the tobacco and alcohol industries can be used here. By investing into such a company am I indirectly causing people to consume more of the product?
Reasons to invest in these industries.
Such industries that invest in addictive product such as alcohol, gambling and tobacco tend to be less affected by economic trends. The reasoning is that even in an economic downturn, people will still gamble, they will still smoke and they will still drink. Thus, having equities of companies that offer these products in one’s portfolio will add to diversification and theoretically lead to less of a downturn when the majority of shares are going down.
But this is not the full story of course. Yes these shares can lead to a less risky portfolio and potentially better returns, however they do not come without certain other negative features. If you take the tobacco and alcohol industries these are frequently subject to lawsuits and new regulations that limit their ability to market their products. When we have a new research paper come out that this product or that product causes more harm than we previously thought, these shares will suffer.
On the gambling side, if we take for example casinos, all the large casino shares have interests in Macau which is the “Las Vegas of China” (although it is much larger than Las Vegas to be fair). This means that these stocks are affected by the news coming out of China which is still a volatile market. A quick look at the shares of companies like Wynn Resorts Ltd and Las Vegas Sands Corp will easily allow one to appreciate the volatility of such shares.
What about the fire-arms, ammunition and military supplies industry?
Now let us take it a step further. For argument’s sake, let us assume that with the industries that produce addictive products that have detrimental health issues an investor argues that one cannot save someone from their own foolishness and hence they should not eliminate these companies from their portfolio. In other words, these companies pass the ethical criteria for this investor. What if we now consider arms and ammunition companies? What if we consider companies that develop jet fighters, missiles and other military supplies?
With the current tensions around the world following many terrorist attack incidents, the most recent being the Paris Attacks which have led to France declaring war on ISIS some investor are backing companies like Boeing, Lockheed Martin and BAE Systems to do well. These companies sell the supplies that would be used by military and hence the current scenario is looking very profitable for them. So this begs the question – Should I invest in this industry to profit from the conflict in Syria? How much is too much?
The shares of these three companies are up an average of 10% over the past 3 months alone. With tension very high and more countries signalling their intentions to join France the potential for these shares to keep doing well is easy to see. This is not to say that the risk is low with these sort of companies. These is still no clear plans regarding the continued war on terror that the US had initiated back in 2001 following the twin towers events. There is nothing to say that these shares are not already overvalued in the sense that people have already pushed up the prices of these shares in the knowledge of the potential for future profits.
The Bottom Line
The aim of this post was not to argue in favour or against the concept of ethical investing. The aim was to create awareness and make investors question how much they are willing to accept from an ethical point of view when it comes to choosing the products they invest into.
As many are aware by now, the German multinational automotive giant Volkswagen (VW) has been linked to a scandal relating to the manipulation of emissions relating to its diesel models. What’s more this is not just speculation, but the company has actually admitted to the accusations and insisted that it will “pay whatever it needs to pay”.
“Both the U.S. Environmental Protection Agency and the California Air Resources Board accused Volkswagen of fudging test results for “clean diesel” products, including the Golf, Passat, Jetta, Beetle and Audi A3 models, in some cases going back to 2009.”
In a nutshell the company was using devices to purposely reduce emission levels during testing and thus making its diesel engines appear much cleaner than they actually are. Why? Keep in mind that nowadays, even locally the license paid for registration and the annual road tax of a car are directly linked to the emission levels that the car produces. Furthermore, people have become more environmentally concious over the last decades as we have seen advances in many ‘clean energy’ products such as household appliances and the surge in renewable energy systems.
Therefore, the worst part of the scandal could be the reputational damage that it has created. This is besides the fines that the company could face which are expected to potentially reach USD 18 bln in the US alone (with possible law suits elsewhere). The matter is made even worse when one considers the vast range of brands that VW owns. Volkswagen Group sells passenger cars under the Audi, Bentley, Bugatti, Lamborghini, Porsche, SEAT, Škoda and Volkswagen marques; motorcycles under the Ducati brand; and commercial vehicles under the MAN, Scania, Neoplan and Volkswagen Commercial Vehicles marques.
Of course this is not the first time that VW and many other car manufacturers were involved in negative situations which are normally in the form of recalls. It will also not be the last time that a car manufacturer is faced with law suits or recall expenses.
Ideas to Trade the Scandal
1. Trade the VW Shares
The most obvious manner in which one could ‘trade the scandal’ and try to benefit from it is to trade in the company’s shares. The main listing of the shares is EUR, however the share can also be traded in USD through the ADR. The big question if one decides to trade in the shares directly is should one buy the share or should one short the share? This all depends on one’s expectation of events.
Many a time in such situations of big news the stock market tends to over-do the situation and shares tend to move a lot more than they should. Is this the case with VW shares? Could be…however there are still a lot of unknowns surrounding the case. So we know that the company has admitted to the manipulation of the figures and we also know that the company has issued a profit warning directly related to this incident, meaning that the company is expected to have less profits this year directly as a result of the incident. These two facts have lead the company to lose roughly one third (-33%) of its value on the stock market in 2 days.
Thus investors who believe that the worst is over and think that the market has overdone the situation might consider buying shares or waiting a bit further to buy some shares in the coming days. The problem with this strategy is the unknown factors – will there be more law suits? Will the company come out with more negative news to get it all dealt with at once? How will sales figures actually be affected? How will the entire range be affected?
The other option if one wants to trade the shares of VW is to short the shares rather than buy them. When one shorts the shares one effectively ‘borrows’ them and sells them with the intention of buying them back at a later stage. Thus if one shorts the shares of VW today and buys them back in a few days/weeks time at a price lower than the current price, a profit will be made. Check out the video below for a visual description of what shorting is:
2. Trade Competitors’ Shares
Another option to try to profit from the VW scandal is to trade shares of competitors. Given that economies are improving and the price of running a car have gone down (as a direct result of lower oil prices), global car sales are expected to have a positive year. So an alternative trading strategy would be to buy the shares of competitors of VW – these stand to gain from the loss of market share of VW.
Some examples that come to mind that have publically listed shares include:
Toyota Motor Company
Ford Motor Company
Fiat Chrysler Automobiles
3. Trade the VW Bonds
In the wake of the news the bonds issued by VW have gone down in value and could present an opportunity to buy them at a discounted price. Please see the following link for a list of bonds issued by VW. If we take as an example the 2% Volkswagen International Finance 2021 bond the price has gone down from around €109 per 100 nominal in March of this year to a current price of around €100.70 per 100 nominal. This gives one a yield of around 1.90% (please see my previous posts on yields and the worth of buying bonds).
This means that this bond has gone down around 8.25% since March, however it is still only trading a yield of less than 2%. This is saying two things to investors: a) Yields are so desperately low that even with such negative news the price of the bond did not go down enough to present a very high yield; b) bond investors are not expecting the scandal in question to be too severe for the company.
4. Trade an ETF containing VW
Another option is to buy an ETF that has VW as one of its holdings. Please refer to a previous post of mine which discusses what an ETF is. One such ETF that comes to mind is the iShares STOXX Europe 600 Automobiles & Parts UCITS ETF (DE) which has an exposure of around 11.55% in VW. The idea here is to gain exposure to VW, but to do it in a limited manner. Furthermore, if the other automobile companies benefit from the loss of market share of VW one would also stand to gain in such a fund since the other 88.45% of the fund is invested into competitors of VW.
The Bottom Line
VW is still a very large company with a diversified range of brands and very large reserves (as at June 2015 the half yearly report of Volkswagen AG Group showed a figure of €17.6 bln in cash reserves). The incident will continue to affect them negatively in the months to come when sales figures are expected to be lower as a direct cause of this scandal. There are many unknown factors surrounding the company so investing directly into the shares of VW could be quite a risky preposition. However, as I discussed above, there are other ways of potentially profiting from the situation without having too much exposure to the company.
Group premium brands such as Porsche, Bently, Bugatti, Lamborghini and Ducati will not be expected to be affected by this incident. However there could be a spill over effect in the lower to mid range brands such as Seat, Audi and Skoda. All in all it is very difficult to gauge the severity of the situation and as always only time will tell how this one will play out.
As usual please keep in mind that nothing on this site should constitute investment advice and further discussions with a financial professional would be required before considering any option mentioned in this post. Please refer the full disclaimer.