UK EQUITIES: ALPHA OPPORTUNITIES

Transcription

1 INFORMATION FOR INVESTMENT PROFESSIONALS UK EQUITIES: ALPHA OPPORTUNITIES DECEMBER 2016 Chris Kinder Portfolio Manager, UK Fund and UK Extended Alpha Fund The UK equity market is an unloved asset class, yet it contains a number of strong global companies that are attractively valued. Amid the spectre of rising inflation, it is entirely possible that the long-term flows into bonds may slow, and potentially even reverse, bursting the bond bubble, making equities more compelling in comparison. Valuations of stocks exposed to the UK domestic economy now look relatively cheap, driven largely by market fears about Brexit rather than the strength of individual companies. Over time we feel that any confusion will create opportunities for pragmatic active managers. The UK market: reasons to be cheerful UK equities have been something of an unloved asset class for some time now, and especially during the last year. According to the Global Fund Manager Survey of September 2016, outflows from UK equities resulted in allocations to the asset class reaching multi-year lows in the run-up to Brexit. Yet we believe the UK equity market is resilient, with attractive valuations in comparison to bonds (which are displaying bubble-like characteristics) and other regional equity markets. With a strong yield, UK equities also offer a degree of protection against inflation, which is forecast to rise in the UK in With a good number of large, quality global companies on reasonable valuations, the UK market remains attractive amid the choppy waters and volatility that will no doubt characterise markets in One driver of volatility will be the ongoing rhetoric around Brexit, not to mention the uncertainty surrounding Article 50. Page 1 of 6

2 Brexit aside, in truth the market has had to cope with a lot of noise including but not limited to Trump, QE and rate rises in the US, various flash crashes in equities and currencies, an existential crisis within OPEC and a very significant Chinese stimulus package. But the one constant within this has been the spectre of rising inflation and the sense that monetary policy has maxed out, and the next spur to growth must now come from increased government spending. This has led markets to the conclusion that there will be an increase in nominal GDP across the globe and that government fiscal positions will actually now deteriorate from here. These two conclusions which we broadly agree with have rocked the global sovereign bond market and been supportive to equity markets and inflation proxies while undermining so-called bond proxies in the equity market. From a UK perspective this impact was notable as these companies had performed particularly well in the post-brexit flight to safety and dollar earners (see Figure 1). We have been very clear in our minds that investing in securities with a zero, or negative initial yield could be extremely damaging, yet the flows into such securities have been very significant for several years. Inevitably one never knows when or how these trends end, but the biggest threat to bonds has always been a rise in inflation which now seems upon us, albeit in a limited way. It is therefore entirely possible that the long-term flows into these assets may slow, and potentially even reverse, arguably making equity valuations more compelling against bonds. The UK equity market has been notably resilient since June, in part due to the particular makeup of its constituents. Indeed the UK stock market has little to do with the UK economy, with the FTSE 100 in particular containing a significant number of companies that generate overseas earnings. Figure 1: Relative performance of domestic vs. international earners Source: Liberum & Datastream, 7/12/16. Note: Domestic earner = >85% of revenue from UK, International = <40% of revenue from UK. Page 2 of 6

3 After the referendum result, UK domestic earners capitulated (Figure 1) but rebounded after that dramatic initial fall yet valuations remain well below long-term averages. While we think it is likely that the Brexit vote will induce a slowdown in UK economic growth in , more recent GDP figures suggest that, so far, the performance of the domestic economy may have defied worst case expectations, with a less severe slowdown in the rate of growth in the three months immediately after the referendum than was first anticipated. Even taking into account lower expectations for growth, valuations of stocks exposed to the UK domestic economy look relatively cheap (Figure 2). These valuations are being driven largely by market fears about Brexit, rather than the strength of individual companies. If previous experience is anything to go by, UK consumers may yet surprise us and support the economy through a trying period. Figure 2: Domestic cyclical P/E premium now versus 20-year average 40% 30% Domestic cyclical +12m P/E premium (vs. FTSE 350) 20% 10% 0% -10% -20% -30% '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 20yr avg. Source: Liberum, Datastream and Bloomberg, as at 7 December As a result, and from bottom up research of company fundamentals, we have modestly increased exposure to domestic stocks in growth-oriented portfolios as we believe they have been overly punished since the Brexit vote, and that value and growth potential remain in this subset of the asset class. Moreover, from a short selling point of view it is times like these (where the market may have over-valued certain stocks), that create interesting opportunities for investors. Confusion and capitulation will create opportunities for pragmatic active managers with a longer-term focus. Why Columbia Threadneedle Investments? Our UK equities team is one of the largest and most experienced in the City, with an average of 16 years experience and 11 investment professionals. We manage a wide range of strategies, from growth portfolios to long/short and small/mid-cap portfolios. Although our fund managers Page 3 of 6

4 and portfolios vary in style, we do not operate in silos; we have a central research process from which everyone is able to draw on the best ideas of the team. Across the Threadneedle UK Fund and the Threadneedle UK Extended Alpha Fund, we run a well-diversified portfolio, where 50% of our assets are invested in stocks that fall into the following buckets : strong franchises/unique assets (such as London Stock Exchange or Diageo); and defensive growth stocks (BT, Imperial Brands, Reckitt Benckiser, Sage). The remaining 50% will be invested in restructure or recovery stories (Rolls-Royce, Rentokil), quality cyclicals (such as housebuilders, Johnson Matthey, Carnival or Wolseley) and contrarian views/hidden gems (DMGT, Merlin or Greene King). Both the UK Fund and the UK Extended Alpha Fund outperformed their FTSE All Share benchmark over one year, three years and five years to 31 August 2016 (Figure 3). Figure 3: Threadneedle UK portfolio performance Threadneedle UK Fund Threadneedle UK Extended Alpha Fund Source: FactSet and Morningstar, as at 31 October Performance is in GBP, using daily official Global Close valuations and daily cash flows (prior to 1 January 2008 official noon prices were used). Fund data are gross of tax and T.E.R to facilitate comparison with the index. Past performance is not a guide to future returns. Returns are annualised. Importantly, we focus on risk-adjusted returns when managing our funds and, based on tracking error, the UK Fund sits at the very low end of the range, meaning it has offered strong returns for less risk than many of its peers.the UK Extended Alpha Fund is of course more riskseeking, but again has been best in class and better than many of its peers that take on greater risk as defined by tracking error. Our investment process We seek diversification and do not want our core funds to be dominated by any one stock, sector or world view. Indeed, there should be competing opportunities within our portfolios at any one time. We look to identify decent businesses with sustainable, quality growth, and strong market positions. Page 4 of 6

5 We believe long-term compound growth is important, and we are more likely to own businesses that can grow sustainably over time as opposed to, say, a technology company of the day that is growing its top line at 30%. On a price/earnings basis, some of the companies in our portfolio appear to be on high multiples, but looks can be deceiving. The point about some of these companies, such as Diageo, which has a P/E of 20 (and has historically nearly always had a P/E at that level), is that they have the ability to grow their earnings sustainably, convert those earnings into cash, and pay a decent dividend. When we look at these businesses and see the likes of high single-digit earnings growth and a 3% dividend yield, we are comfortable with the multiples because if they can grow at that rate or even slightly less we will make perfectly decent total returns over the next 10 years. After all, Disney traded at a P/E of 81.9 in 1972, yet still made a return of about 8-9% a year for the next 30 years. Return on capital also matters persistently high returns on capital over time and the ability to reinvest cash flows at that same high rate are important factors. We analyse elements such as barriers to entry and exit, and we quiz management on research & development relative to sales. How much are businesses spending on capex too? We want to know how much companies need to spend to maintain their competitive advantage and if we re unconvinced that the competitive advantage is sustainable, we d be less inclined to own it. Also, pricing power is important. We ve had a long standing aversion to commodity stocks quite simply because they do not control the price at which they can sell their products. Although it has been a recent short-term headwind, our long-term underweight in mining and banks has added enormous value. Conclusion Macroeconomic factors are likely to provide further volatility, but any accompanying confusion will create opportunities for active managers. Currently we would note that opportunities are existing in greater numbers among restructure and recovery stories, quality cyclicals and contrarian investments. Nevertheless, we also remain interested in high-quality, large global companies that can help us continue to deliver consistent and strong risk-adjusted returns through the cycle. We will continue to use short-term volatility in the market to exploit the longterm valuation opportunities. Page 5 of 6

6 Important information: For investment professionals only, not to be relied upon by private investors. Important Information: Past performance is not a guide to future performance. The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may not get back the amount invested. This material is for information only and does not constitute an offer or solicitation of an order to buy or sell any securities or other financial instruments, or to provide investment advice or services. The mention of any specific shares or bonds should not be taken as a recommendation to deal. The research and analysis included in this document has been produced by Columbia Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice and should not be seen as investment advice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. This material includes forward-looking statements, including projections of future economic and financial conditions. None of Columbia Threadneedle Investments, its directors, officers or employees make any representation, warranty, guarantee or other assurance that any of these forward looking statements will prove to be accurate. Issued by Threadneedle Asset Management Limited (TAML). Registered in England and Wales, Registered No , Cannon Place, 78 Cannon Street, London EC4N 6AG, United Kingdom. Authorised and regulated in the UK by the Financial Conduct Authority. TAML has a crossborder licence from the Korean Financial Services Commission for Discretionary Investment Management Business. Issued by Threadneedle Portfolio Services Hong Kong Limited 天利投資管理香港有限公司. Unit 3004, Two Exchange Square, 8 Connaught Place, Hong Kong, which is licensed by the Securities and Futures Commission to conduct Type 1 regulated activities (CE:AQA779). Registered in Hong Kong under the Companies Ordinance (Chapter 622), No Issued by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07, Winsland House 1, Singapore , regulated in Singapore by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289). Registration number: W. Issued by Threadneedle Investments Singapore (Pte.) Limited [ TIS ], ARBN TIS is exempt from the requirement to hold an Australian financial services licence under the Corporations Act and relies on Class Order 03/1102 in marketing and providing financial services to Australian wholesale clients. This document should only be distributed in Australia to wholesale clients as defined in Section 761G of the Corporations Act. TIS is regulated in Singapore by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289), Registration number: W which differ from Australian laws. Issued by Threadneedle Asset Management Malaysia Sdn Bhd, Unit 14-1 Level 14, Wisma UOA Damansara II, No 6 Changkat Semantan, Damansara Heights Kuala Lumpur, Malaysia regulated in Malaysia by Securities Commission Malaysia. Registration number: W. This document is distributed by Columbia Threadneedle Investments (ME) Limited which is regulated by the Dubai Financial Services Authority (DFSA). The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client under the DFSA Rules. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies. columbiathreadneedle.com. Page 6 of 6