Should I Fear the "Wall of Worry"?

LONDON -- The Motley Fool's Sonia Rehill trawls through her inbox for more of your investing queries in this week's Ask A Foolish Question podcast. Sonia is joined by David Kuo, who explains what commentators mean when they say that "the market likes to climb a wall of worry." They also look at why Aviva's dividend yield is high, what are "fund of funds," the simplest way to invest in bonds, how to calculate dividend cover, interest-rate swaps, and how to diversify if you are in a company pension scheme.

In this episode, they also tackle the tricky question of how to track all your investments when money is flowing in and out of your portfolio.

If there is a question about investing that you would like answered, please email Sonia at foolishquestions@fool.co.uk. If you would like to listen to previous episodes of Ask A Foolish Question, you can find them here:

You can download or listen to this podcast here.

EDITOR'S NOTE: What follows is a lightly edited transcript of Sonia and David's conversation.

Sonia Rehill: Welcome to Ask A Foolish Question, The Motley Fool's podcast dedicated to help answer all your investing questions. I'm Sonia Rehill, and joining me is The Motley Fool's investing guru, David Kuo. Welcome, David.

David Kuo: Hello, Sonia.

Sonia: How are you?

David: I'm very, very good.

Sonia: OK, so let's see what we have in our inbox this week. Shall I just kick off with the first question?

David: Yep -- I can't wait.

Sonia: OK, so first up is a question from someone wishes to remain anonymous. What is meant by the phrase "the market likes to climb a wall of worry"?

David: You know, this confuses a lot of people, "the market likes to climb a wall of worry." Essentially, what it's saying is that the stock market doesn't really sort of mind bad news, but what it hates is uncertainty. When you have got bad news, the stock market will have two types of people, those people who are selling shares and those people who are buying shares. There is a lot of worrying news that is coming up that is spooking investors, and those investors who are worried by that will be selling those shares, but then on the other hand, you have people like myself who enjoy the "wall of worry" because we are buying into the market. So what we're actually doing is if there are more people who are buying into the market, and at the same time there are people who are relinquishing their shares and selling it, then you will actually find the stock market starts to rise gradually. That is what you really want to see. Now if you have a look back at some of the stock market charts. Take the FTSE 100 (INDEX: ^FTSE  ) , for instance, and go back five or seven years, and have a look at where the FTSE was and where it is today, you will find it is higher today than it was at the depth of the depression, at the depth of the depressing news that people were getting. So what you're actually finding is that the stock market is climbing this wall of worry. We are getting worrying news about what is going on in the eurozone. We're getting worrying news about what is happening in China. And the more worrying the news, the higher the stock market goes, and that is exactly what you want to see. Then again, there are many private investors who are so terrified by this wall of worry they're getting rid of their shares. And who's buying it? The institutions are buying it, professional investors are buying it, and people like myself are buying it. So the more worrying it gets, the higher the wall of worry will be.

Sonia: Next is a question about earnings cover from Stephen. In a previous podcast, David, you said that one of the key areas to look at when investing in a share is the number of times earnings cover the dividend. Stephen would like to know what earnings figure he should be looking at and what do basic, diluted, and adjusted earnings mean.

David: OK, right. This is a little confusing for some people, but essentially, when you have a look at the profit-loss accounts, there are different ways in which they can calculate the earnings figure, and Stephen is absolutely right. First of all, let's have a look at the dividend cover before we go any further. The dividend cover is your earnings per share divided by the dividends per share -- and what you want to find is that the earnings per share is significantly greater than the dividends per share, which therefore means that there is enough cover from the earnings to pay the dividends. So the figure we're looking for is something like twice the dividends per share. So earnings per share should be around sort of two times greater than the dividends per share. Then we come onto this figure, the earnings per share and there are different types of earnings that are reported by the company. You have something like a basic EPS, which simply just takes the profits divided by the number of shares in circulation. That gives you the basic EPS. Then you have diluted EPS, which is the number of shares that are available including, of course, options, some of the options that the managers might be entitled to. So then you have a diluted EPS. But I think the figure you need to be focusing on is just simply the basic EPS, which is the net profit that the company makes divided by the number of shares in circulation.

Sonia: OK, so what about the adjusted, David?

David: Well, that is also adjusted for options as well so as far as most investors are concerned, have a look at the company's profit-loss accounts and they will report for you the basic EPS, the adjusted EPS and also the diluted EPS. The one you should be looking for is just simply the basic EPS.

Sonia: So in the case of Scottish & Southern Electric  (LSE: SSE.L  ) , it's paying a dividend of 80 pence per share, the basic EPS are 21 pence, the diluted earnings are 21 pence, and the adjusted earnings are 112 pence per share. Taking the adjusted earnings, the dividend is covered, but taking the basic earnings, it is not. What can you read into these figures for Stephen, David?

David: OK, now in this particular case you were referring to the profit and loss accounts for the year 2010 to 2011 and so, therefore, you had all of these figures, the basic, the adjusted and also the diluted EPS. Now, if you have a look at the current year, what you will find is that the basic EPS is significantly higher than the 21 pence per share, so the figure you should be using is the basic EPS for this current year -- the prospective basic EPS for this current year and you will find that the dividend is well covered by the EPS of the company.

Sonia: My next question, David, is about Interest Rate Swaps. Can you explain what they are?

David: They are very, very complicated, much more complicated than I think we have time for, but I will try and do my level best to try and explain how they work. Essentially, what happens is that, let's say I had borrowed money from a bank at a particular rate of interest -- and at the same time, you had borrowed money from the bank at a different rate of interest to me -- but the two of us have these slightly different views about what is going to be happening to interest rates over the long term. What we're referring to here is that both of us are borrowing money on a flexible interest rate, not fixed. Now, if I think that interest rates are going to go down and you think that interest rates are going to go up, but at the current time your interest rate is actually lower than mine, we could actually swap. You and I could actually swap our borrowings. So essentially, you will take mine, I will take yours and if you are right then, of course, if interest rates were to come down, then you would win. If interest rates were to go up, then I would also be right. So it's just a very complex way in which two people who have slightly different views about what is going to be happening to interest rates and who also have flexible interest rate loans, we can actually swap our loans. There is some intermediary who will do it for us. They will try and find you in the market, they'll find me in the market and say, here we have two people who have slightly different views about interest rates -- they have slightly different products that they've actually sort of borrowed from the bank and we can actually swap our two borrowings.

Sonia: We have a question now about combining pensions with company share schemes from Ollie. He is fortunate to work for one of the big oil companies and has a great pension scheme and share options in the company, but he understands the importance of diversifying. He hopes to pick up quite a few shares in his company before he retires and his pension is 60% oil and 40% global, U.S., Europe and Asia -- so it seems reasonably diverse. However, four of the funds' Top Ten holdings are U.K. oil and gas companies, and he asks if his pension is diversified enough considering the company shares he receives, or should he be looking at schemes with less oil exposure in order to spread the risk?

David: That's a great question but Ollie, you haven't actually said whether you are on a final salary scheme or whether you are on a defined contributions scheme. There is a big different between the two. If it was based on a final salary scheme, then you don't really have to care because ultimately when you retire, your pension will be based on your final salary, so what exactly happens in that pension fund is of no interest to you whatsoever. Then on the other hand, if it isn't but the fact that you are investing through a defined contributions scheme, then of course you would be very concerned about what your pension is going to be invested in. As you pointed out, quite a bit chunk of it is actually in the oil sector, the oil and gas sector, so it doesn't hurt to actually have some money outside as well. So, if you are a little concerned, Ollie, and if you are following the pension scheme that you are invested in at the moment and you're not entirely happy about that, there's nothing to stop you from investing in something separate from that. So you could open up a stocks and shares ISA if you wanted and you could invest in something completely different. Just make sure you don't invest in a tracker because within the tracker, a big chunk will be BP, Shell, and also BG Group, so you want to try and avoid that and maybe invest in something that is completely different to what you're already investing in. It's a very, very good point, Ollie.

Sonia: On to another great question. This is one about keeping track of all your investments, from Ryan. He has searched far and wide and still cannot find a suitable spreadsheet or method in which to properly track and record how his investments are growing based on dividend payouts on the stocks he owns. He includes all the basic information on his spreadsheet on when he bought the stock, how much he paid for it and how many shares he bought along with the last dividend yield, but it starts to get complicated when different stocks pay out dividends at different times. Then it gets difficult to keep a track of your ongoing yields and also how much your stocks are growing if you automatically invest your dividends back into buying shares of the same companies. It gets even more complicated when you take into account the compounding effects of the dividend reinvestment alongside the growth or decline in the dividend payout. He wants to know if you have any suggestions on the best way to track the status of your dividend-paying stocks so that he can see total dividend returns including compound, across the entire portfolio but also for individual stocks.

David: Right, there are a couple of ways in which you can do this. The simplest way would be to try and ignore the fact that you are given dividends at different times during the year. So, what you have is you have a starting value and a final value for your portfolio, and you can actually work out how much that portfolio has either grown or shrunk over that period of time. That would be one way of doing it. If you are interested in trying to work out what your total return is for your portfolio, there is a function on Excel and it's called the "IRR Function." It stands for the Internal Rate of Return. So essentially what you do is, on the downwards column you have the months, so you divide it into the 12 months for the year and then for the various years after that. In the next column alongside the month in which you either invest money or you were paid dividends, you would put a figure -- and the Excel spreadsheet, if you use the IRR Function, it will calculate for you what the internal rate of return for your portfolio is. When are you investing money, you need to use a negative sign; when you are paid a dividend, you have to enter it as a positive sign -- and then you need the final value of your portfolio. Highlight that entire column and ask it to work out what the internal rate of return is. Like I say, Excel has a function -- it's called the "IRR Function." Play around with that and if you have any problems, get back to me but otherwise, it is very obvious how the IRR Function actually works. Sonia, you look a little perplexed with regards to the IRR Function.

Sonia: No actually, I'm just thinking that I need to go away and try this out for myself.

David: I think you should. I think everybody should and everybody should be keeping track of their portfolio, but if you have got any problems, look at the "Help" function on Excel with regards to IRR and you'll wonder why you never used it.

Sonia: You're making it sound far too easy, David, and I don't think it really is.

David: It is quite easy. What you have to do is to watch for the signs. When money goes in, it's a negative sign. When money comes out, either in the form of dividends or you're taking the money out totally, you need to keep that as a plus sign.

Sonia: OK. Well, I will definitely go away and try that IRR function. OK, we have a question about investing in bonds from WH in South Africa. He has been investing in his local share market in a Top 40 and Top Dividend Yield ETF. The growth he's had during the last three years was quite exceptional. On the Top 40 ETF, he averaged about 20% per annum and on the dividend yield, about 30%. If he'd picked his own stocks for his portfolio, he doesn't think he would have been able to beat these returns. However, he knows he needs to diversify and is looking for some exposure to bonds. Is it wise to buy a government bond ETF or should he look for a bond fund. He finds unit trust funds rather expensive, especially buying into these funds on a monthly basis. What would you suggest is the best way for him to get exposure to bonds?

David: Now, this is one of my pet subjects at the moment because I am actually quite terrified about bonds, particularly government bonds because I do think there is a bubble forming in the government bond sector. That doesn't exactly apply to the corporate bond sector which is still looking quite healthy at the moment, but if you want to buy corporate bonds, there are a couple of ways in which you can do it quite cheaply without having to go down the route of a fund manager. There are two tracker funds that I've come up with and both of them are iShares. One of them is the iShares Markit iBoxx Dollar Corporate Bond ETF -- bit of a mouthful. Its ticker code is (LSE: LQDE.L  ) . It is available on the London Stock Exchange and it behaves exactly like a share. What the iBoxx Dollar Corporate Bond ETF does, it attracts 30 of the biggest U.S. dollar bonds, and that is the iBoxx Dollar Bond Fund. Then, of course, you also have the iShares Markit iBoxx Corporate Bond Fund based in Sterling, and its ticker code is (LSE: SLXX.L  ) . That one tracks 40 of the largest Sterling bonds, so one you have in U.S. dollar, one you have in Sterling. So there you have it -- two different tracker funds -- one tracks the dollar, the other tracks the pound bonds.

Sonia: Well, I hope that answers your question, WH. Our next question is about Aviva  (LSE: AV.L  ) , and it's from Mark. He would like to know why Aviva is currently trading at a very favorable dividend yield compared to the rest of the market.

David: OK, right. First of all, the dividend yield is calculated by taking the dividend per share, dividing it by the share price and multiplying by 100. Now in the case of Aviva, the dividend yield is around 8.7%, which is significantly higher than the market average. The market average is round about sort of 3% to 4%, so it is about two to three times higher than the current market average. The reason for that is because the share price is abnormally low; consequently, the dividend yield is abnormally high. The reason why the share price is abnormally low is because people don't want to buy shares in Aviva. If more people started buying shares in Aviva, then of course the dividend yield would start to drop -- and that is essentially what people are saying. There are some people out there who are very concerned about Aviva because they think, oh maybe Aviva has an unusually high exposure to the European debt market, which therefore means that maybe, you know, Aviva might have to at some point cut its dividend, which is why the dividend yield looks abnormally high. But Aviva has shown no indication whatsoever at the moment that it either intends to or will cut its dividend, so therefore it looks as though the spare price is wrong rather than the dividend is wrong. So it depends on your take on Aviva. Some people think that's great -- if it's going to be offering me 8.5% dividend yield, I will just simply buy it at this price until such time that Aviva says I'm going to cut the dividend. But if you are buying shares in Aviva, watch very carefully for the corporate news that comes out from the insurer to see whether it either intends to, or may have to, cut its dividend. If not, then just carry on enjoying that 9% dividend yield.

Sonia: Now for our final question -- it's about "fund of funds." We touched on this in a previous podcast. Can you explain what these are, David, and the charges? What do you think of them?

David: OK, right. Let's say for instance that I am a fund manager, and what I do is I have a fund and I go out and I buy shares or bonds in various different businesses. So I am just a basic fund manager. So are you -- you are a basic fund manager and you also invest in various funds. Now somebody says, which one of our two funds is actually better?

Sonia: Obviously yours, David.

David: Well, not necessarily. So, what we then have is a third person and what that third person will do is to go around and have a look at the various funds, and it will say, Sonia's fund is actually quite good. Then we also have X, Y and Z fund is also quite good, so they will be picking the best of all that there is funds out there, because you have to remember there are literally thousands of funds out there doing all different things -- and the "fund of funds" manager says, I have the knowledge of the various funds and I can actually pick the best of all the funds so that you, as an investor, don't have to decide for yourself whether I want Sonia's or David's, or somebody else's for that matter of fact. So the "fund of funds" manager is somebody who says, I have total knowledge of everything that is going on in the fund market and I can discern, I can differentiate between Sonia's fund and David's fund.

Sonia: Do they just package funds then, so you would buy one financial product that encompasses several funds?

David: That is precisely what happens and there is a guy, for instance, called John Chatfeild-Roberts. He works for Jupiter Investments and he says, I have total knowledge of what is going on and I know that there is a very, very smart fund manager called David Kuo out there, and I want to invest in his fund. I also know that there is a very smart fund manager called Sonia Rehill, so I'm going to have a bit of her fund. And so, he will then sell his "fund of funds" because he's actually bought funds and he's packaged them into his own fund, which is why it's called a "fund of funds."

Sonia: It's exactly what it says on the tin.

David: It is exactly what it says on the tin, but there is one big difference. Remember, you as a fund manager will be charging fees for buying shares. I as a fund manager will be charging fees for buying my shares. So when he is a "fund of funds" manager, he will also charge a fee for picking those funds. So if you are investing in his fund, you will have to pay his fees together with your fees and my fees, and so you're paying two lots of fees.

Sonia: It sounds very expensive, David.

David: It is very expensive, and that is the whole point. Unless of course the "fund of funds" manager can outperform the market significantly, then of course you are paying two lots of fees. Now as we know, eight out of 10 fund managers cannot beat the market. So what this "fund of funds" manager is hoping to do is to try and find those two out of 10 fund managers who can beat the market. Can he do that? Well, that depends on how good his knowledge of all those fund managers out there is, and whether or not he has his finger on the pulse. If he is, then of course he's actually earned his stipend, he's earned his fee -- but if he hasn't, then what effectively will happen is that you as an investor will have had to pay more than one lot of fees and in some cases, two or three or four times the fees.

Sonia: Thanks, David. We've had some very interesting investing questions today and some great answers from you.

David: Yes, and I bet you can't wait to rush off and have a look at those Internal Rate of Returns on the Excel spreadsheet.

Sonia: I am going to play around with that actually this afternoon. How did you guess?

You have been listening to Ask A Foolish Question. If you would like to get a question in for the next episode, please email me at foolishquestions@fool.co.uk, and if you would like to find out how you can make your portfolio grow, download a free report called "10 Steps to Making a Million in the Market" at fool.co.uk/questions. Thanks for listening and happy investing!

David Kuo challenged his Motley Fool analysts to pinpoint the attractive sectors of 2012 -- and they delivered! Discover the industries they selected in this new Motley Fool guide -- "Top Sectors for 2012" -- while it's still free!

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Both David and Sonia own shares in BP. David also owns shares in Shell. Neither owns any other share mentioned. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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