Money Matters

How Does Fundamental Tracking Work?

Companies regularly report their results to the stock exchange and hence the public. And we know that analysts revise their earnings forecasts every time this happens. In practice it is hard for companies to provide guidance much beyond the next financial year so in reality the furthest out we can look is the year after next. But that’s not bad. Using that data should enable us to incorporate all the known forecasts into our portfolio.  And those forecasts of earnings are based on the fundamentals of the company, not on the valuations applied to them.

Our aim is to at least match the performance of an index, to track it in other words. And the only way to do that is to buy all the stocks that comprise that index. If you don’t you run the risk that a company you don’t own will surprise you and perform better than the rest of the stocks, or it might get taken over at a high price.

The key question of course is how much to hold of each stock? Our solution is to base the portfolio weight on the one element in the accounts that is not an opinion; the dividend. Every analyst will forecast a dividend for a company, usually with some guidance from the company itself. We use that estimate to calculate the size of the position in the portfolio.  In total the largest 350 companies on the stock market pay out a total of about £70 billion in dividends a year. Next year it will be slightly more and slightly more the year after. If we use this number as a reference point for our portfolio we can then allocate a weight for each and every stock that depends solely on the amount we expect it to pay out. So, for example, a company that is forecast to pay out £520m in dividends will be allocated a 1% weight and one paying out £1,040m will have a 2% weight. By adjusting these figures every month we can ensure that the *The Munro Fund* always has the biggest exposure to the companies paying out the most amount of money.  It is no coincidence that the ten biggest companies in the UK stock market accounting for half the value of the market also account for half its dividend income. The chances are that relationship will still apply in ten years time.

Two Key Benefits of the Process: Lower Costs and Lower Risk

Technology Reduces our Trading Costs

There was a time, not so long ago, when dealing in shares was a face to face time consuming procedure. A broker, who acted as an agent only, would approach a number of jobbers, who never dealt with investors, and requested a price for a particular share. He, it was always a he in those days, would jot down the answer in his note book and repeat the process with other jobbers. There then followed a series of discussions while the broker endeavoured to find the best price for the share in the volume he was seeking to deal in. And that was just for one share. To trade a portfolio of shares was a day’s work. The process was protracted, very labour intensive and, not surprisingly, expensive. Commissions in those days were fixed using a sliding scale but started at well over 1%. All that changed with Big Bang in 1986 and the old division between jobbers and brokers was swept away and investors could negotiate the commission they paid. That was a change in culture and market practice caused by wider economic and social factors. At the same time there was a massive revolution in technology and communications as the personal computer became more widespread in the eighties and then, later, the Internet in the nineties.

These two factors, technology and market practice, revolutionised the way that banks and brokers went about their business of buying and selling shares. Now, an institutional investor or a fund will send an order to a broker as a spreadsheet containing perhaps several hundred transactions that cover shares in the UK, overseas, different currencies and a mixture of buys and sells. The broker will subject the order to a number of checks and tests before submitting it to be executed and it may be that very large or specialised orders are done manually. Normally this will not be necessary and the order, usually known as a programme trade, can be executed at the touch of button. This process is of course far cheaper to execute than the old manual person to person system and is also far more accurate. Using this system there is very little scope to mishear an order or jot down a 6 instead of a 7. And the best bit is that all this efficiency and reliability can be secured for a trading cost of a few basis points, maybe 0.07% or even less.

Now here is the strange thing. Twenty years ago brokers were charging fund managers fairly high rates of commission to do this labour intensive work. Fund managers naturally had to reflect their cost of business in their fee structure and costs were passed through to the investor as fairly high initial fees and annual management fees. Over the last few decades dealing costs for fund managers have declined dramatically but there has been little, if any, reduction in fund management charges for the retail investor. The Munro Fund intends to pass those cost savings through to the investor so that they too can benefit from the changes in technology in recent years. Moreover, the very concept of trading several hundred shares at a time is something that could not even have been contemplated in the age of manual dealing. The Munro Fund, with its ability to hold many shares, dramatically reduces the risk for individual investors compared to funds that only hold a handful of shares. That too is something that could not have been done in the previous era. Technology now allows us to run this type of fund, and it can be done at a much lower cost than before. It makes sense to use that to reduce our risk and improve our returns.

A Mechanical Process Improves Decision Making

Anyone who has ever worked in finance knows how much people like talking about companies and finance. That can range from the personal idiosyncrasies of the management to the merits, or lack of them, of the company’s products and of course the ever present issues of interest rates, exchange rates and politics. The Munro Fund doesn’t indulge in these intellectual discussions. That’s not because we don’t enjoy them; we do. The trouble is that they don’t generate answers. These discussions can go on for hours and occupy asset allocation, investment committees and the like for hours on end. When you consider that each participant in those meetings is paid very handsomely and then multiply their hourly rate by the number of hours they are discussing these issues it is easy to see why costs are high.

At The Munro Fund we don’t do this because we use numbers that have already been extensively reviewed, discussed and calculated. Our process uses consensus forecasts for earnings published by the analysts for each company. That’s it. We don’t argue with the analysts and tell them they are wrong, or argue among ourselves. In reality these numbers are a moving target and are being constantly updated by the analysts in conjunction with the companies themselves. The same goes for exchange rates. Many of the larger companies in the UK stock market report their results, and declare dividends in other currencies, mostly dollars. We simply convert that to sterling at the current exchange rate.

Using these techniques enables us to run The Munro Fund with few people. That saves money which we pass on by way of lower management fees.

Of course there is a little more to it than that. We have to allow for companies that issue shares, buy back shares, have rights issues and get taken over. But that is what you are paying us to do. You are not paying us to second guess every analyst on every stock as you do with active managers. So how much are you paying us? Not much is the answer. Look at the next page.

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