Is it a good or bad idea to invest in UK shares?:

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On a recent visit to London from New Zealand, one of my objectives was to get up to date with the UK sharemarket by getting the latest view on markets from a range of analysts, economists, fund managers and, of course, taxi drivers.

Most New Zealand investors, like those anywhere, have what we call a ‘home bias’ in their share portfolios, meaning that they have a high proportion of their share portfolios invested in their local markets.

When it comes to New Zealand, the justification for having more invested overseas is strong. We have a small, fragile economy, which is dependent on agricultural exports. An outbreak of foot and mouth would have a disastrous impact on the New Zealand economy. So would a large earthquake.

As well, we need to acknowledge that our days of being the ‘Switzerland of the Pacific’ ended in 1970. Our currency today buys a lot less in London than it did in those golden times. We have got poorer relative to the rest of the world.

The easiest way to protect your savings from a continuation in this long-term decline in spending power is to invest some money in overseas currencies and assets. This is the rationalization for global diversification.

There is a counter argument. First, New Zealand shares provide higher dividends than available overseas, and these are boosted by imputation credits. Also, the Kiwi dollar is very volatile and it often rises strongly, which undermines the returns from global shares.

For example, the current bounce in markets that began in early March has seen the UK market rise 21 percent, but the New Zealand dollar has risen 9 percent over the same time, so in New Zealand dollar terms the return is just 12 percent.

Everyone I met with was very concerned about the UK economy. The impact of the banking crisis has been dramatic, the government’s financial management is regarded poorly, house prices are falling and economic growth is weak.

However, all are comfortable remaining invested in UK shares simply because they regard their market as a global market rather than being reliant on the domestic UK economy.

The top 100 companies on the UK market earn more than 60 percent of their revenues from outside the UK and are large multinationals such as GlaxoSmithKline, BP, Shell, HSBC, Vodafone and Diageo.

There is also a lot of debate about the current market bounce. The reversal of sentiment is incredible. Two months ago fear was everywhere. Today, even the threat of a global pandemic is shrugged off. If swine flu had of surfaced in February, when market sentiment was distraught, it could have driven the market down 30 percent. Amazing what 9 weeks and a bit of buying momentum can do.

Most people I talked to remain concerned about the underlying fundamentals and see this bounce as a ‘trash rally’. Others though, admittedly a minority, see this as the beginning of a major recovery in sharemarkets that could last a decade. Their rationale is that valuations are cheap, interest rates are basically zero and given that the past decade has been terrible for shares, the next 10 years could be their time.

All agree on how investors should approach current markets. The past 9 weeks has underlined how stupid it is to try and time the market. With interest rates at close to zero, many investors are sitting on their cash wondering when they should jump into the market now or wait for a pull back that may or may not come.

Without exception, every money manager I talked to believed that any investment into shares should be done in instalments. Money to be allocated to shares should be broken into five or more portions. One portion should be invested now, just in case this is the beginning of something bigger, and the others should be held back and invested at regular intervals over the next year or two.

UK shares also provide good dividends. The average gross dividend yield across the top 100 companies is around 5 percent. While this yield is much lower than the 7.5% gross yield available from the top New Zealand companies, a key issue that needs to be considered is the relative payout ratios from each market.

The payout ratio is simply a measure of how much of a company’s profit is paid out as the dividend and how much is retained by the company to reinvest into growth.

Across the New Zealand market the average payout ratio is 80 percent – companies are paying out 80 percent of their profits as dividends, leaving only 20 percent of profits available to be reinvested into the business.

In the UK the average payout ratio across the top 100 companies is only 45 to 50 percent. Some companies are notably higher, such as the oil companies and banks, but most companies distribute only a modest proportion of their profits as dividends. The remainder is used to reinvest in the company to drive future growth.

The higher payout ratios in New Zealand are understandable. Our economy is small, growth opportunities are limited and it makes sense to distribute a higher proportion of profits to shareholders. But as a result, share price growth potential is lower.

The UK market provides a decent dividend yield, access to global multinationals, exposure to sterling and, via the underlying companies, a range of other currencies as well. The lower payout ratio means that this market also offers the potential for higher dividend growth over the long term.

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