Half way through March already and it’s been an interesting couple of weeks.  Usual mix of good and bad news.  As per the jokes let’s get the bad news out the way first.  First up was Hammond’s Budget with its bad news for businesses paying dividends and folks investing in equity portfolios for income.  The good news?  A visit to our office this week by our old friend, master investor Neil Woodford with his upbeat message on prospects for equity returns.  I’ve known Neil for a long time and I don’t remember seeing him so bullish.  Ya beauty!

Both events got me thinking about what US investor Michael Batnick in January called “The Most Powerful Force In The Universe.” And what Albert Einstein called “Mankind’s Greatest Discovery”- Compound Interest. As Batnick observed “Anyone can solve the equation 6+6+6+6. But ask anybody to calculate 6x6x6x6 without a machine and they’re going to look cross eyed. The human brain was designed for linear not exponential processing.” He hasn’t met my wife obviously.

Recently he joked about the Dow Jones Index reaching 2 million by the year 2099.  That’s a hundred fold gain from now.  He admitted he’d been kidding, but for that to happen the Dow Jones would need to compound at 5.7% for 83 years.  Any idea what it’s done over the last 75 years?  Before you answer think of all the terrible things that have happened since 1942.  (No, that doesn’t include my birth five years later as my PA Alison suggested).

Wars, assassinations, stockmarket crashes, high taxes and inflation, economic and political crises, etc etc.  Despite all that the Dow compounded at 7.14% pa for the last 75 years.  Imagine that.  Doubling every 10 years.  Wow.

I’ve mentioned before Rolf Dobelli’s little gem of a book “The Art of Thinking Clearly.”  Here’s an example from it that explains why the Dow reaching 2 million is hard for us to imagine …. “A piece of paper is folded in two, then in two again and again and again.  How thick will it be after fifty folds?”  What do you reckon?  What would be an outrageous number?  Try again.

If the paper is only 0.004 inches thick the answer after fifty folds is a bit over sixty million miles!  Apparently that’s the distance between here and the Sun (which my friends in England tell me still exists).  Dobelli says “Linear growth we understand intuitively.  However we have no sense of exponential growth.”  Ever looked in my wife’s wardrobe?

UK Chancellors don’t get compound interest either.  Our friends at Artemis tell us that thanks to compounding tax changes the UK tax code at 10 million words and 21,000 pages is the longest in the world.  17 times the length of “War and Peace.”  12 times longer than the complete works of Shakespeare (Alas Poor Taxpayer).  66 times the length of Hong Kong’s tax code.

In Letter From Linlithgow last March I mentioned Professor CN Parkinson who in 1958 wrote the book on bureaucratic incompetence…. “The Parkinson Law and the Pursuit in Progress.”  In 1983 he produced a sequel which I still have.  He found little had changed.  Though bureaucratic incompetence was worse.  Parkinson called it “Comitology”…. How committees and Government departments compound their costs despite becoming increasingly irrelevant.

I was struck by the chapter on Tax.  He said the UK Tax system’s designed to tax Income when you’re living and Capital (Assets) when you die.  So, to pay less tax we should swap them round.   Only Capital when you’re living.  Only Income when you die.  Bingo.

Now that sounded good in theory but would it work?  Yes and still does.  So from then on we encouraged clients to invest as tax effectively as possible taking advantage of opportunities available, building capital for tax free income later.

Not difficult, but you need dedication and deep research.  As Yogi Berra said “It’s not rocket surgery.”  Maximise tax relief, save religiously in tax free flexible growth opportunities like PEPs from 1986, ISAs from 1999, shove leftovers into other areas offering tax freedom or deferral.  Turn taxable income into tax free “capital.”  Simples.  But the X factor is what investments you keep in your tax friendly plans.

Neil Woodford was in charge since 1988 of Invesco Perpetual High Income fund, a trust well known to long standing clients.  When he left to form his own company almost three years ago his long term colleague Mark Barnett took over.  Those currently obsessed by “cheap” passive funds, “low risk” Absolute Return or Deposits have missed out big style when compared to their approach.

Old pal Chris at Prescient provides me with UK fund investment flows.  In 2016 investors pulled over £8 billion out of equities, eight times more than in crisis torn 2008.  It gets worse.  While savers hold £275 Billion in ISAs…. good news on the face of it..… over 80% of new ISAs are Cash ISAs. 90% of female ISA savers sit in Cash.  Ouch.  (Earning next to zilch for almost eight years now).  And “they” tell us investors are euphoric?  With all this fear around?

On Monday, US investor Jim O’Shaughnessy reminded us that successful active investing is bloody hard.  Outstanding fund managers like Neil don’t grow on trees.  O’Shaughnessy believes they require seven traits, including a long term perspective, always ignoring Headline noise, having a consistent process through thick and thin, being persistent and patient, a strong mental attitude, highly disciplined and stick to objective probabilities.

I’ll give you an example of that last trait.  A study conducted in 2009 looked at the 50 worst ten year returns in stockmarkets since 1871.  It found the ten years ending February 2009 was the second worst in over 100 years.  More importantly the study looked at what happened after these terrible 50 year period.  It found in every case the following three to ten year returns were positive.  Thus the probability that February 2009 was a time to buy quality equity funds as I wrote in a 23rd February 2009 in the Daily Telegraph.  But the majority sold instead fleeing to “safety.”

While you’ve seen that the Neil Woodfords of our world deliver good returns, do you know how their returns compare to “passives?”  Over 10 years the FT100 Index Total Return (no charges) produced 78% gain, over 20 years 225%, and over 25 years 591%.  Not bad eh?

Woodford’s old Fund produced, after all charges, 101% over 10 years, 626% over 20 years and 1756% over 25 years.  (Source: Lipper stats).  Money for Nothing.  But I must warn you that past performance is not a guide to future returns.  But it's up to you to decide what to conclude.  For what it’s worth Neil believes that pessimism right now is grossly overdone.  In his almost 30 years of his unshaken, process driven persistence he is as confident now about the future as I’ve ever seen him.  I’d say that was cause for a wee celebration wouldn’t you?  Cheers!

Alan Steel
This article is the personal view of Alan Steel. Please check the appropriateness to your individual position with your advisor before taking or refraining from any action.

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