FUND COMMENTARY THREADNEEDLE UK EXTENDED ALPHA FUND

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1 COVERING MAY 2018 FUND COMMENTARY THREADNEEDLE UK EXTENDED ALPHA FUND Summary UK equities enjoyed gains in May, with the FTSE All-Share index outperforming global averages for the second successive month. Gross of fees, the fund underperformed its benchmark; this was largely due to detraction from the short book. The long book also detracted, albeit to a lesser extent. However, our holdings in Wood Group and Rio Tinto added some value. Chris Kinder Portfolio Manager Market Background UK equities performed well in May, with both the large-cap FTSE 100 and the mid-cap FTSE 250 scaling new peaks during the month. In total-return terms, the FTSE All-Share rose 2.8% and outperformed global averages for the second month in a row. The FTSE 100 led the market higher over much of the month as oil prices rallied and sterling weakened the index has a large weighting in energy companies as well as exporters and overseas earners. However, due to its relatively greater global exposure, the FTSE 100 was more impacted than the FTSE 250 by trade-war concerns in the second half of the month. These were particularly prevalent at month-end, when President Trump announced the US would press ahead with import tariffs against key allies, and threatened China with additional measures. UK stocks were also caught up in global selling pressure triggered by a political crisis in Italy, which investors feared could ultimately hand an even stronger mandate to eurosceptic parties there. Over the month as a whole, the FTSE 100 performed in line with the broader market and underperformed the FTSE 250, which posted a total return of 3.1%. In the broader market, technology stocks benefited from optimism around the strong earnings released by their US peers over the month. Materials and energy stocks also outperformed as the prices of Brent crude and other commodities trended higher. Banking stocks lagged amid concerns over potential knock-on effects from the events in Italy; falling sovereign yields were another headwind for the sector. Telecoms also underperformed, due in part to some disappointing earnings news. Sterling weakened over the month, pressured by uncertainties around the Brexit negotiations, dovish commentary from the Bank of England, and a steeper-thanexpected fall in inflation (the annual rate eased to 2.4% in April) all of which increased scepticism about the likelihood of an interest-rate rise this year. In other economic news, an uptick in consumer borrowing in April and a strongerthan-expected jump in retail sales suggested that the UK economy was gradually recovering from the weather-induced hit in the first quarter (Q1) of the year. Other data showed that wage growth outstripped inflation in Q1, while the employment rate in the same period was the highest on record. Performance In May, the fund generated a return of 2.0% and underperformed its benchmark. FOR INVESTMENT PROFESSIONAL USE ONLY 1 Issued June 2018 Valid to end September 2018

2 Much of the fund s relative underperformance was driven by the short book, which rose 6.4% and detracted 48 basis points (bps) from relative returns. The biggest detractor was our position in an online supermarket chain, which rallied sharply after announcing a large licensing deal with a US grocer. We learnt from previous experience and closed the bulk of our short position within a couple of hours of the market opening and thus minimised the damage, as the stock subsequently rallied a further 30%. Our risk management process, and the fact that we try to be emotionless with our investments as much as we can, helps us close positions ruthlessly when our investment thesis is proved to be incorrect. Thus, we lose the least amount of money when we are wrong. Our short position in a defence manufacturer also detracted; however, those in a bakery chain and a variety retailer proved beneficial. The long book, on average, was up by 2.6% and detracted 27 bps from relative returns. The zero weight in BP detracted most, due to the rally in energy stocks. Other detractors included our positions in BT and Crest Nicholson. BT s full-year revenues and profits undershot expectations. Although challenges remain, the company s ongoing efforts to improve the clarity on areas of market concern should position BT for a better year ahead. Though Crest Nicholson reported that revenue growth had been buoyant in the first half of the year, investors reacted unfavourably to the company s caution on full-year margins. As commodity prices had a buoyant month, not holding BHP Billiton weighed on relative returns. However, the detraction from this was partly offset by a favourable contribution from our position in Rio Tinto. We believe that Rio Tinto s focus on financial discipline and capital returns is a major differentiator in its sector. Our holding in Wood Group also added value in May, as did the absence of Vodafone. Oil-services company Wood Group said that trading had been good in Q1 and that the integration of Amec Foster Wheeler, acquired last year, was going well. We feel the acquisition should result in significant cost synergies. Furthermore, Wood Group should benefit from an uptick in capital expenditure by oil majors. Vodafone s shares fell sharply after the telecom major s CEO unexpectedly announced his retirement. Excluding certain banks, such as HSBC, also supported relative returns in a difficult month for the sector. Overall, the performance of both books has validated our view that it is far easier to find successful longs than shorts in the current environment. Activity In the long book, we took advantage of a dramatic share-price fall in technology firm Micro Focus to initiate a position in the stock. We believe its shares have de-rated too far and offer an attractive yield; the company enjoys high margins, strong cash flow and has the option to break-up if trading deteriorates further. We also topped up some existing positions, notably in British American Tobacco (BAT), Shire, Cobham and Carnival. BAT is trading at a material discount to its overseas peers, despite being a globally diversified business. We see considerable upside to its intrinsic value. We feel Shire offers a sensible, low-risk means of making uncorrelated double-digit returns over the next year or so as the takeover process is completed. Cobham has a resilient underlying business, offering multiple opportunities for value creation, which the new management team should be able to unlock. Carnival is among the dominant players in a solidly growing, supply-constrained oligopoly with significant barriers to entry. The new management are focused on cost control and enhancing revenues; this has resulted in a significant, sustained multi-year uplift in profitability despite the many challenges across the core regions in which the company operates. We envisage solid profit growth and the potential for Carnival s stock to re-rate to higher-valuation multiples which better reflect the firm s strong market position and growth prospects. We closed our position in inter-dealer broker TP ICAP as trading volumes remain subdued given the flattening of the US yield curve. In the short book, we significantly reduced our position in the aforementioned online supermarket. We also closed our position in a credit scoring company. We initiated new shorts in a water utility, an engineering company and a property developer. FOR INVESTMENT PROFESSIONAL USE ONLY 2 Issued June 2018 Valid to end September 2018

3 Outlook This month, our focus is on global market valuations and in particular, the US stock market, given that there is much debate as to how far through the economic cycle we are. The forward price-earnings (PE) multiple and cyclically adjusted (Shiller/CAPE) PE multiples for global equities are currently slightly below their longterm averages as shown below: Source: Exane BNP Paribas, June A fundamental premise is that the price you pay for an asset is by far the biggest determinant of future returns. The chart below shows that historically, when the market has traded at today s Shiller PE multiple of 20x, the global stock market has never declined over the subsequent three years: Source: Exane BNP Paribas, June However, if we look specifically at the US Shiller PE, then we find that the US has only been this expensive twice a month before the Great Depression in 1929 and during the TMT bubble in 2000: FOR INVESTMENT PROFESSIONAL USE ONLY 3 Issued June 2018 Valid to end September 2018

4 Source: Exane BNP Paribas, June It should be noted that there have been many changes to GAAP accounting standards which have reduced the earnings numbers used in calculating the Shiller PE. If we use national income and product account (NIPA) earnings where accounting regulations haven t changed at all over the last 50 years, then the US market valuation doesn t look nearly as stretched: Source: Exane BNP Paribas estimates, Datastream, NIPA US earnings have increased dramatically since 1990: Source: Exane BNP Paribas estimates, Robert Shiller s data, June FOR INVESTMENT PROFESSIONAL USE ONLY 4 Issued June 2018 Valid to end September 2018

5 While share buyback programmes have boosted earnings per share, the main driver has been rising pre-tax operating margins: Source: Exane BNP Paribas estimates, Datastream, NIPA, June Looking back through history shows very clearly that higher margin businesses should rationally trade on higher valuation multiples: Source: Exane BNP Paribas estimates, NIPA, June Interestingly, Exane hasn t factored in a further imminent rise in profit margins due to President Trump s corporate tax cuts; any such increase should justify a further increase in price-to-sales ratios. Although declining interest and tax rates have helped, Exane estimates that almost 80% of the improvement in US profit margins has been due to declining wage costs: Source: Exane BNP Paribas estimates, NIPA, Datastream, June FOR INVESTMENT PROFESSIONAL USE ONLY 5 Issued June 2018 Valid to end September 2018

6 History shows that company profits begin to decline once wage costs accelerate to the extent that companies are unable to pass them on to customers: Source: Exane BNP Paribas estimates, NIPA, Datastream, June Thus US wage growth versus corporate pricing growth is something to keep a close eye on. Indeed as we write, there are now more job vacancies in the US than unemployed workers to fill them! Data just released by the Labor Department shows a record 6.7 million job openings in the US in April but only 6.35 million people are currently categorised as unemployed. We will have to wait and see if this tight labour market finally triggers significant wage growth. Historically, the US profit cycle has only turned once average hourly earnings growth has hit 4%; this number is currently only at 2.7%: Source: Exane BNP Paribas estimates. June There has been a lot of debate around the flattening of the US yield curve. The key point is that equities have tended to peak only after the yield curve inverts: FOR INVESTMENT PROFESSIONAL USE ONLY 6 Issued June 2018 Valid to end September 2018

7 Source: Datastream, NBER, June The chart above shows clearly that the US yield curve has inverted before each of the last seven US recessions. Exane has estimated that if the Federal Reserve follows its current projected rate hiking path without any corresponding increase in the US 10-year yield from today s level, then the yield curve is likely to near inversion only in late 2019: Source: Exane BNP Paribas estimates, Datastream, June Finally, buybacks in the US should continue to underpin the market. In May, companies announced the largest ever volume of share buybacks, at $173.6bn, though this was largely due to Apple s mammoth $100bn stock repurchase plan: Source: Wolfstreet.com, June 2018 FOR INVESTMENT PROFESSIONAL USE ONLY 7 Issued June 2018 Valid to end September 2018

8 Conclusion We can t control economies, we can t control monetary policies and we certainly can t control politics. All we can do is control what we buy and sell, and the prices at which we transact. With that in mind, we see numerous opportunities to deliver solid returns in the long book while the travails and challenges in global markets should give us decent opportunities to monetise the downside via our short book. Our long-term track record in doing this has been very strong and we look forward to another year of alpha generation. FOR INVESTMENT PROFESSIONAL USE ONLY 8 Issued June 2018 Valid to end September 2018

9 Important information: For internal use and for Professional and/or Qualified Investors only (not to be used with or passed on to retail clients). 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. Threadneedle Specialist Investment Funds ICVC ( TSIF ) is an open-ended investment company structured as an umbrella company, incorporated in England and Wales, authorised and regulated in the UK by the Financial Conduct Authority (FCA) as a UCITS scheme. TSIF is registered for public offer in Austria, Belgium, Denmark, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Singapore, Spain, Sweden and the UK. 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For Institutional Clients: 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 or Market Counterparty and no other Person should act upon it. The mention of any specific shares or bonds should not be taken as a recommendation to deal. This document is a marketing communication. The research and analysis included in this document have not been prepared in accordance with the legal requirements designed to promote its independence and have 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. All source information used in the preparation of this document is available on request. This document should be read in conjunction with the appropriate fund factsheet for the same fund. The mention of any specific shares or bonds should not be taken as a recommendation to deal. Issued by Threadneedle Investment Services Limited. Registered in England and Wales, Registered No Registered Office: Cannon Place, 78 Cannon Street, London EC4N 6AG United Kingdom. Authorised and regulated in the UK by the Financial Conduct Authority. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies. Benchmark Index is the FTSE All Share. Performance attribution source FactSet, calculated using a daily time-weighted methodology based on gross returns as at global close on the last working day of the month. columbiathreadneedle.com FOR INVESTMENT PROFESSIONAL USE ONLY 9 Issued June 2018 Valid to end September 2018