Why being gloomy can pay off

Any community that survives and thrives by scoring points off the next person has few qualms about kicking a man when he is down, as Peter Spiller - by some distance the most successful manager of any UK-authorised collective fund over the past 30 years - knows too well.

The share price of Spiller's Capital Gearing Trust has risen by a breathtaking 18,000% plus since 1979, with an unbroken upward line, year-on-year, since 1982.

This denotes acumen and original thinking. But periods of underperformance were occasionally met with opprobrium. While the great majority of fund managers are paid to be optimistic, Spiller is not. He is clearly different.

On the spot

Spiller's most uncomfortable periods, unsurprisingly, were during the internet frenzy a decade ago and the "golden age" euphoria of 2006-07, when many said he had really got it wrong. One critic called him a "misery guts".
"I very much wrestled with that problem in 2006-07," Spiller says. It was made worse by what almost amounted to spite. Spiller, 61, says critics said age was colouring his outlook: "Too bearish; incapable of taking risks; that I had made my money and wasn't prepared to lose any.

"But our concern was that the economic fundamentals were extremely fragile. And I defend myself most strongly on any charge of not taking risks. My prime measure is value."

Spiller is still not for turning. Important indicators suggest a meaningful recovery in global output is underway, markets are rallying and respected commentators are saying the worst is over. But Spiller is having none of it.

"We have not been here before. The level of fiscal and monetary stimulus is unprecedented, he says. "Within this extended recession, strong shorter-term inventory cycles will yield misleading impressions of recovery and relapse."
The inventory cycle has now turned, but whereas some see this as evidence of "green shoots", Spiller is adamant that preservation of capital remains more important than making money.
Hedge funds, which he regards with some scorn, might spout on about targets of 10% returns, but Spiller says it is not unreasonable to be content with gains, in real terms, of 1% to 2%. "But we would not be doing our job, he adds, "if we were not making 30% to 40% gains when the economy was balanced and interest rates were falling."

Spiller, a witty, debonair, old-school City figure, has managed Capital Gearing since 1982, when the share price was 21.24p. On 1 September 2009 it was £24.10.
Today, the corporate identity is something of a misnomer - a legacy of high gearing when it was founded in the 1960s.

Spiller says: "We were 140% geared in the early 1980s. But there have been no borrowings since the mid-1990s, and we de-geared around the time of Alan Greenspan's speech about the market's irrational exuberance. Shares have not looked cheap since. On long-term measures of value, Wall Street is still 20% overvalued."

As Lord Oakeshott, joint investment manager of Value and Income Trust, says of Spiller: "He has been gloomy for years, but it hasn't stopped him making a lot of money for his investors. He works terribly hard."

Spiller's skills are reflected in Capital Gearing's share price premium to net asset value, yet he does not normally take comfort from this. The premium brings added pressures to perform - and it grates with his convictions about value.

However, last April, when Capital Gearing's accounts were signed off, the premium came into its own. "On 5 April, our asset value on the year had fallen by 1/40th of 1%. We've never had a down year since I started running the trust. It was irritating. But the premium meant the share price was not down on the year."

The 5 April balance sheet emphasises Capital Gearing's distance from the crowd. Roughly two-thirds of assets were divided between fixed interest and index-linked securities, the great majority issued by foreign governments.

Equity exposure, some 25% of assets, was almost evenly spread between ordinary shares in other investment trusts - more than 50 in total - and zero-dividend preference shares.

Since then, very little has changed. The largest conventional investment trust holding is the conservatively run London & St Lawrence Investment Company. The largest individual investment is an Allianz Dresdner endowment trust. Spiller says:

"We can invest over a wide spread of opportunities. These endowment funds reached wide discounts and are very low risk." Such trusts are nearing the end of their lives and he compares their appeal with another contrarian call: index-linked bonds. "In 2000, index-linked bonds provided a fabulous opportunity when yields were more than 4%," he says.

Spiller believes not sticking to a rigid template produces "significant advantages" compared with the conventional strategies of more orthodox fund managers. "We don't need to perform on a quarterly basis, he says.

"Equities are always random over six-month periods and we don't know any more than anyone else. But we can make rational judgements of value over longer periods. We can have several quarters of underperformance, as in 2006-07. The economy then reached an unsustainable situation and it looked bound to go wrong."

Discount disasters

Spiller says the proportion of money the trust has exposed to equities outperforms because it uses investment trusts. "We are not doing anything particularly clever. Investment trusts are by far the best way of looking after private money.

Fees are modest, you can have gearing, and there are significant tax advantages and all sorts of levels of protection. There is also a board of directors to look after you".

"The bad news, he says, "is the blight of discounts." Spiller cites Personal Assets Trust as the best model for keeping the discount under control. "The trust issues shares at a small premium and buys back at a small discount. Others will have to go down that route."

Capital Gearing's poor returns from investments trusts last year were aggravated by instances of inadequate, even irresponsible, corporate governance. Commitments to control share price discounts were often not met. "A range of companies have not kept their pledges to control discounts, he says. "It is extremely damaging to the faith."

Spiller accepts that discounts always represent opportunities, but he would rather investment trusts traded at close to asset value. "We would then focus more on the quality of the management - or even use exchange traded funds to obtain equity exposure, he says.

"Asset allocation is all-important. Most academic studies show that asset allocation is responsible for 80% of performance and selection is just 20%."

Last year, Spiller made a rare foray into the world of hedge funds. "Every dog has its day," he says, and for him, that day came in December 2008 when some fund of hedge funds discounts widened to 40%.
"The fees these people charge investors seriously overrate their management abilities," he says, and believes the present system of charges - 2% fixed and 20% based on performance - is on borrowed time. "It is perfectly proper for these hedge funds to pick up the £5 notes their investors leave on the pavement, but I question why people should leave them there."

Spiller, who is as bearish as anyone about the prospects for sterling and more pessimistic than most about impending levels of inflation in Anglo-Saxon countries, achieved good returns last year from conventional government bonds. Sweden and Japan were sold, yielding returns of between 19 and 32%.

But increased exposure to index-linked securities has focused on the US. "This is where I defend myself against charges of not taking risks, he says. "I believe US Treasury inflation-protected bonds (TIPs) are very cheap and real interest rates will fall. This will give us capital gains."
Given the wide range of possible outcomes from the banking collapse, Spiller says it is worth a "great deal" to have an investment that provides a yield of 2.2% plus inflation, plus capital gains if long-term interest rates fall.

He is convinced they will. "People are desperate for yield. I am almost entirely invested in long bonds - 25 to 29 years. When inflation comes, large pools of capital will be directed into these."

Spiller's management firm, CG Asset Management, also manages CG Real Return Fund, which invests solely in inflation-linked bonds. Since launch in 2004, returns are around 50%. CG Dollar Fund confines itself to Tips. A third vehicle, CG Portfolio Fund, is an offshore clone of Capital Gearing. These funds are only available to professional investors.

Spiller is almost evangelical in his belief in an inflationary surge. "Inflation is the only way of avoiding at least 10 years of very modest growth," he says. US and UK consumers are saving more - up from nothing to around 5% of income. In past financial crises, the ratio has risen to nearer 10%. "Reducing debt, in the absence of inflation, will take a number of years."

Some fund managers and private investors regard the inflationary outlook as positive for equities, but Spiller disagrees. "History shows that equities like a low rate of inflation; less than 4%. Above 4%, they hate it. But you get substantial re-rating of equities when high inflation falls to low inflation."

Spiller says the current fad for the Keynesian idea that you can borrow your way to prosperity is absurd. "There is going to be a very long hangover to pay for the party, he predicts. How long? "I am quite humble about specific forecasts.

We have never been here before. The big problem with borrowing is that it might be fine at the time but the time is never right to make the repayments."

Spiller is agnostic on China and is similarly ambivalent about equity markets. "We'll be going into a headwind before we get fair value, which is a 20%-plus improvement in the fundamentals.

Returns will be modest, and if you can get fair value a return of 5 to 6% should be possible. "Index-linked securities will outperform this, he says. "There is more money to be made in US bonds than UK bonds. Yields will fall in the US, but in the UK they might rise a bit."

Spiller has little cheer for investors seeking comfort through European equities. "The reluctance to print money is greater there than here or the US, he says. "The authorities will probably settle for a rising exchange rate, and this will mean an economy much like Japan's. Bonds will make significant gains as yields fall."

Spiller would not be human if his 30-year, peerless record did not cause a slight expansion of the chest. "If I were starting now, a similar, 18,000% gain would not be out of the question.

Difficult but not impossible: provided equities were valued at the same levels as they were in 1979."

This article was originally published in Money Observer - Moneywise's sister publication - in October 2009

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