Market panic puts spanner in the works

One of the good things about running a mechanical portfolio such as the Nifty Thrifty is you don't have to worry when confidence evaporates from the market, as it did in August.

The algorithm is completely indifferent to market panics, and will keep on churning out its recommendations regardless. While other investors react to the market's gyrations, you remain the computer's slave.

Sadly, the shares still go down in price. Having struggled to a £3,000 profit in July, the Nifty Thrifty portfolio was, at the beginning of September, worth £29,185, nearly £1,000 less than its £30,000 starting value in June 2010. An investment in a FTSE All-Share exchange traded fund, which would have required little thought, and, bar reinvesting the dividends, little effort, has done considerably better. It's worth £33,000 now.

August panic

The performance of the portfolio and its benchmark during the August panic were almost identical. From their July peaks to their August troughs, the ETF fell 20% and the Nifty Thrifty fell 19%. Although the Nifty Thrifty beat the market by a small margin, it's still lagging severely overall, because of its performance in its first year.

It's at times like this, when performance is poor, I must remind you that when we started this project I expected the Nifty Thrifty to win over the long term, and if we give up on it because of a short-term setback, we will never get to the long term.

If a year's performance doesn't tell us much, three months is even less revealing, but three months ago I made a decision to deviate from the algorithm slightly. I replaced three highly-ranked companies with alternatives from slightly lower down the table. The algorithm had recommended five mining companies in addition to two already in the Nifty Thrifty. I felt that was a risky degree of concentration.

Although commodities are in a long-term bull market, the shares of the companies that mine them are highly sensitive to changes in investors' confidence in the global economy. If the economy deteriorates we consume less metal and prices drop, and since mining companies can't cut costs as quickly, the outlook for profits changes suddenly. During the credit crunch miners crashed precipitously.

That scenario repeated itself in miniature in August, which is one of the reasons the portfolio and its benchmark did so badly. There are a lot of giant mining companies listed in London, and two of the three I left out fell by considerably more between their July peaks and August troughs than the Nifty Thrifty. Kazakhmys (KAZ) fell 35% and Vedanta Resources (VED) fell 41%, although Hochschild Mining (HOC) matched the portfolio average with a fall of about 18%.

I don't know what will happen to the market in the one-year timespan that shareholdings contribute to the Nifty Thrifty. August could have been the beginning of a longer period of uncertainty, or the market could recover just as dramatically, and those companies that fell furthest bounce back strongest.

But I think the events of August may have vindicated the decision to deviate from the strictest interpretation of the algorithm and seek diversification.

Within the portfolio, miners aren't causing most concern though. A glance at the performance table, which looks like a battlefield as there's so much red in it, reveals Halfords (HFD) and Logica (LOG) as the big losers.

The big losers

Halfords published a positive year's results in June, which seemed to halt a decline in its share price that started almost the day I added the company to the Nifty Thrifty in September last year. But the blow-out in the market and a first-quarter statement in July revealing lower sales in the retailer's car maintenance division combined to knock the price again.

Investors are struggling to determine how much high street retailers are likely to suffer because of the prolonged economic torpor, and how much competition from supermarkets and internet adversaries has permanently diminished their prospects.

To add to the conundrum, the forces of debt and global competition laying siege to the economy this time seem significant and intractable, so the current downturn, which by some measures is already three years old, could have years more to run.

All this makes investing in retailers, many of which negotiated expensive leases on their high street premises in buoyant times but must pay the rent when their profits are under threat, a nervy proposition for investors. Even so, two of the four retailers in the Nifty Thrifty, WH Smith (SMWH) and Next (NXT), are making a positive contribution.

In identifying cheap retailers when investor sentiment is negative, the algorithm is doing precisely what it should do; buying value. The problem this time is Halfords got even cheaper.

Logica's fall was more sudden. The IT services company had promised profit margins would be higher this year than last, but revealed in its half-year results in August that it could no longer be sure of that. It's been hit by austerity, not so much in the UK as in the Netherlands.

Although Logica's business with the private sector, which earns the firm almost two thirds of revenues, is doing better, it seems neither sector is a reliable source of growth, so some investors have given up on Logica.

Defensive companies such as Unilever (ULVR) and Imperial Tobacco (IMT) survived August. But it didn't make up for cyclical companies like Halfords and Logica and, to a lesser extent Spirax-Sarco Engineering (SPX).

As the algorithm grinds on finding good companies at cheap prices, we trust that every month ahead won't be like the last one.

Spotlight on Spirax-Sarco

More baffling is the fate of companies such as Spirax-Sarco, where the fundamentals are strong and sentiment alone seems to have driven the share price down.

Spirax-Sarco manufactures, designs, and installs steam systems used for heating and sterilisation in industrial plants producing necessities such as food, pharmaceuticals, petrochemicals, paper and plastic. It also provides services: system audits, customer training, and spare parts.

In Teesside a Spirax-Sarco system takes steam from a neighbouring chemical plant and uses it to heat a 23-acre greenhouse site growing 360,000 tomatoes. A Texas oil refinery relies on steam-traps (valves) from Spirax-Sarco and heat exchangers in a factory in Barnard Castle heat the water used in pharmaceutical production.

Businesses such as Spirax-Sarco, that bundle specialist products up with service or training contracts, can often earn high-profit margins because their customers value the relationship as well as the product the company is supplying. They're prepared to pay more and stay loyal for convenience and peace of mind.

When a company can transplant its expertise globally (only about 10% of Spirax-Sarco's sales come from the UK), it can become a growth engine that keeps on growing because the market is so big.

Multiple niches are even better, and Spirax-Sarco also owns US-based Watson-Marlow, which manufactures pumps. Last year it earned the company just under 20% of total revenues.

The proof of all these positives is consistent profitability and inexorably rising profits and dividends, yet the company's share price fell 19% between its July peak and August trough.

Reshuffle introduces Micro Focus

The quarterly reshuffle in September is relatively relaxed. Few companies report their annual results in the summer, so I make a higher proportion of portfolio additions and ejections in the first half of the year. This quarter, four companies have been in the portfolio for a full year and are up for eviction if they do not feature at the top of the rankings.

Remarkably three do: BHP Billiton (BLT), British Sky Broadcasting (BSY), and Halfords. I'm quite pleased as instinct tells me Halfords, particularly, is being unfairly punished. WS Atkins (ATK) goes, though, raising £780.79.

Thanks to dividends collected in the portfolio, there's £1,209 to fund a replacement and the associated broker fee and stamp duty. Because the top three are already in the Nifty Thrifty, I've added the fourth-ranked share, Micro Focus International (MCRO), a software company.

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