Marketing material for professional investors and advisers only Schroder Income Fund Quarterly Fund Update First Quarter 2018 Cumulative returns to 31 March 2018 (%) Z accumulation shares 80 60 40 20 0-20 3 months 1 year 3 years 5 years Portfolio Index Schroder Income Fund FTSE All Share TR Sector average* 3 mths 1 yr 3 yrs 5 yrs -1.3 5.8 20.0 56.9-6.9 1.2 18.6 37.6-6.1 0.4 14.3 41.2 Discrete yearly performance (%) Fund Benchmark 2017 9.3 13.1 Summary The FTSE All-Share index delivered a total return of -6.9% over the first quarter. The portfolio delivered an absolute return of -1.3% and outperformed the index. Our UK portfolios relative outperformance over the first quarter was characterised by not owning typical bond proxy businesses, which performed poorly. This should serve as a reminder that safety stems from the price you pay, and not the underlying dynamics of the businesses you buy. There are no equities that are always safe or always risky. There are only equities that are too cheap or too expensive. Portfolio characteristics Fund manager Managed fund since 18/05/2010 Fund launch date 13/05/1987 Fund benchmark Fund size Ongoing charge 0.91% 1 Kevin Murphy & Nick Kirrage FTSE All-Share Total Return 2,065 million Source: Schroders, as at 31 December 2017. 1 Based on the last year s expenses for the year ending December 2017. 2016 25.3 16.8 2015-6.6 1.0 2014 4.9 1.2 2013 33.5 20.8 Source: Schroders, net of fees, bid-bid, with net income reinvested. Z Acc share class as at 31 December 2017. Sector: InvAssoc UK All Companies. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested. Schroder Income Fund First Quarter 2018 1
What happened in the market The FTSE All-Share Index delivered a total return of -6.9% over the first quarter. The portfolio delivered an absolute return of -1.3% and outperformed the index. Performance attribution (%) Allocation effect Selection effect Sector Total effect -1.4 2.6 Technology 1.2 0.1 0.7 Consumer Services 0.8 0.0 Consumer Goods 0.1 0.7 Financials 0.7 0.8 0.8 0.1 0.5 Utilities 0.6 0.1 0.3 Basic Materials 0.4 0.1 0.1 Healthcare 0.2 0.0 Telecommunications 0.1 0.0 Oil & Gas 0.1 0.2 0.2-0.3 0.0 Industrials -0.3 Source: FactSet, average positions over the quarter by ICB Industry. Anglo American, the UK listed miner was the largest contributor to outperformance, enjoying a strong start to 2018. The market reacted favourably to the business reporting excellent full year results, including the declaration of its highest dividend for a decade. Pre-tax profits rose to $5.5 billion and the business generated almost $5 billion of free cash flow while halving its net debt to $4.5 billion ($8.5 billion in 16). Anglo American has been a real turnaround story since its dark days of 2015. The key protagonists have been a heavy reduction in leverage, and the disposal of non-productive, low margin assets. Capital spending is also still being constrained, with management stating they will only take on one project at a time. This is in stark contrast to the heady days of 2012-2014 where the business was ploughing billions into multiple projects at the end of the commodities boom. Spending on these projects sat at $2.2 billion in 2017 in comparison to $6.1 billion in 2013. We support this prudence and the continuation in the reduction of its debts. Those firms with less leverage will be better prepared to weather the storms should trade suffer in the future. We still see significant upside further upside for Anglo American from today s levels. Financial infrastructure specialist NEX Group was another top-performing holding following a robust third-quarter trading update and recommended bid approach from US-listed derivative exchange operator CME Group. The company s cautiously optimistic outlook for the current financial year was taken well by the market, as was news that the transformation programme is on track to deliver annualised cost savings of 40 million over the next three years. As a consequence of the bid we have reduced our holding, although retain a position given the potential for a counter offer in light of NEX s portfolio of unique and strategically attractive financial market infrastructure assets. Despite posting losses of nearly 2 billion, Barclays shares rose in the first quarter as the market enjoyed the announcement to restore its dividend to the same levels before it was cut in 2016. While revenues fell 2%, profit before tax was 10% higher year on year. Barclays fits into the portfolio as part of a wider UK banking recovery that we have supported. Our view, and for some time, has been that both share prices and dividends would return to higher levels from these businesses as legacy issues subside and key capital ratios improve. Barclays reported their common equity tier one ratio rose from 12.4% to 13.3% over the year, which represents a far better capitalised balance sheet today than in the build up to the financial crisis in 2007. We believe the derisking of Barclays (and the portfolio s other banking positions) business continues to be under appreciated by the wider market, justifying its position in the portfolio. Schroder Income Fund First Quarter 2018 2
GlaxoSmithKline was another key contributor to outperformance. The pharmaceutical major maintained its dividend for 2018 and revenues were slightly ahead of market expectations. While there is uncertainty about the future of the company s flagship asthma medicine, Advair, we feel this is well understood by the market and anything other than a significant decline in sales would be taken positively. We therefore feel comfortably protected on the downside. As ever, we focus our time and energy on assessing the risk and return of each company on a case-by-case basis. Here we are confident that Glaxosmithkline offers adequate upside for the associated level of risk. While we usually prefer to comment on the stocks that we do hold rather than those that we don t, this quarter s outperformance has also been characterised by not owning bond proxy tobacco businesses such as British American Tobacco and Imperial Brands on which we have repeatedly aired our concerns on valuation grounds. However, it is worth noting that these companies are merely the tip of the iceberg when it comes to the market s love affair with bond proxies. We unapologetically maintain our belief that owning shares in these types of businesses, is putting our clients money at unnecessary risk. When the market snaps back to its typical function as an arbiter of value, these heavily traded, highly levered bond proxy positions are likely to see significant share price declines. Debenhams was the largest detractor of returns in the quarter. The UK retailer s shares suffered as it communicated a post-christmas profit warning due to difficult seasonal trading. While its balance sheet is currently viable, there is no doubt that Debenhams requires an improvement in sales to drive the share price higher. Another high street retailer, Marks and Spencer suffered a poor quarter. We added to the position to take advantage of the share price weakness. Top stock contributors (%) Top stock detractors (%) Stock contributor Relative weight Total return Stock contributor Relative weight Total return Anglo American +4.1 +9.6 Marks & Spencer +2.5-14.2 Cisco Systems +3.7 +8.8 South32 +4.5-10.7 NEX Group +0.8 +61.7 Sky -0.5 +30.8 BATS -4.4-16.6 Debenhams +0.4-39.9 Centrica +3.6 +3.6 GKN -0.3 +45.0 Source: FactSet, average positions over the quarter. Portfolio positioning as at 31 March 2018 (%) Sector Relative weighting (%) Consumer Services 9.5 Technology 6.1 Basic Materials Utilities Financials 3.7 3.6 3.4 Healthcare 1.2 Telecommunications Oil & Gas Industrials -10.8-2.9-1.8 Source: FactSet. Consumer Goods -14.8 Schroder Income Fund First Quarter 2018 3
Key portfolio activity We established a position in ENI, the Italian oil and gas business. We feel the firm has a strong balance sheet, after going through a process of de-gearing via a number of asset disposals which allowed the firm to pay down nearly 4 billion of debt in 2017. The business is also able to generate free cash flow, nearly entirely covering its dividend despite the depressed price of oil. As value investors, balance sheet strength, prudent leverage and positive cash flow generation will always sit as positive points on our ledger, providing these coincide with an attractive valuation of course. We added to some portfolio holdings that we believe offer significant value, including Marks and Spencer and Wm Morrison Supermarkets, in both cases taking advantage of share price weakness. Key stock positions (%) Overweights Sector Relative weight Pearson Con Serv +5.0 Centrica Utilities +4.2 Anglo American South32 Basic Materials Basic Materials +4.1 +4.1 Cisco Systems Technology +3.8 Source: FactSet as at 31 March 2018. We continued to reduce our holdings in other positions that have performed well and as a consequence are approaching fair value. Schroder Income Fund First Quarter 2018 4
Outlook and strategy A whole lot of noise It may seem facetious for us to say that there isn t a great deal to talk about since our last quarterly letter. In the first three months of 2018 have brought headlines such as Volatility is back! and US-China Trade wars spook investors, not to mention endless column inches devoted to the ongoing uncertainty about the implications of Brexit. Indeed, UK equities were down 6.9% over the first quarter making it the worst one in over six years, and of the 23 developed markets the UK was the poorest performer (ranked by MSCI). Step away from the hubris, however, and little has changed. Broadly speaking, the stocks and sectors that were both cheap and expensive at the end of last year remain so today. The UK stock market s decline is not insignificant, but it should be viewed through a lens of the steep rise in markets of recent years. Is value defensive? As we mentioned in the performance statement, our UK portfolios relative outperformance over the first quarter was characterised by not owning typical bond proxy businesses, which performed poorly. This should serve as a reminder that safety stems from the price you pay, and not the underlying dynamics of the businesses you buy. There are no equities that are always safe or always risky. There are only equities that are too cheap or too expensive. A business could have the most volatile earnings stream in the world but, if you buy it at a 90% Health care Insurance Industrials Basic materials Utilities Banks Oil and gas Beverages Retail Telecoms Tobacco Technology 38 12 20 discount to fair value, you are giving yourself a very good chance of making money from that investment. In the same way, you could identify the business that boasts the most stable earnings stream in history and yet, if you pay 10 times what it is worth, you are highly unlikely to make money. In fact you are more likely to end up losing money. To us, that is the definition of risk and it has nothing to do with the supposed predictability and stability of an asset only the price you pay for it. What this means is that seemingly safe and stable businesses can become very dangerous investments as their valuations rise. It is our firm view that the downward share price moves of some of the so-called bond proxies in the first quarter were just the tip of the iceberg when it comes to the unwinding of market s love affair with those equities. Conversely, our portfolios are comprised of undervalued, unloved businesses, many of which have had near-death experiences in the recent past and are therefore prudently managed and wellplaced to weather any market on economic disruption, whenever it may come. The chart below shows the absolute sector performances in the first quarter, as well as each sectors Cyclically-adjusted PE (CAPE). Broadly speaking, stocks in the most expensive sectors, such as Tobacco and Beverages, faired the worst, while stocks in cheaper sectors such as banks and basic materials faired better. 36 13 12 11 13 14 21 14 CAPE 14-30% -25% -20% -15% -10% -5% 0% 5% Source: Thomson Reuters Datastream, data to 30 March 2018, CAPE = cyclically adjusted P/E. Warning: When the CAPEs are high, subsequent longterm returns are typically poor. One drawback it is that CAPE is a dreadful predictor short-term returns or of turning points in markets. For example, the US has been expensively valued on this basis for a number of years but that has not been any hindrance to it becoming ever more expensive during this cycle. What does value mean to us? In this letter we have decided to take the opportunity to revisit the tenets of our investment philosophy and process. Just why are we value investors? And what does value mean to us? All investors take value into account to some degree; it is very rare to find an investor that is willing to buy a stock at any price. However, our approach is closely tied to the traditional definitions of value investing. That means investing in the cheapest part of the market, as defined by a metric such as price-to-book or price-to-cyclically-adjusted-profits. Schroder Income Fund First Quarter 2018 5
There s a very good reason we follow this approach to value investing the significant amounts of academic research into the value factor have all focused on the cheapest part of the market based on a defined valuation method. And those studies show value has worked over long timeframes and over pretty much every stock market. Why does value investing continue to work? We believe a lot of the reason is psychological. When you look at companies in the cheapest bracket in the market, there is usually a reason why they are there. There is often a problem which means they are disliked by the market. When things go wrong, people s natural reaction is to get scared and want to distance themselves from those companies. Psychologically, that means fear is driving the decision-making process and when people are scared and fearful, they make bad judgements and bad decisions. By contrast, being a value investor requires having a strong analytical framework to make good decisions. That framework helps us identify companies where the problems are temporary and there is scope for earnings to recover and for the market to reappraise the quality of the business. It also helps us avoid those companies where the reverse is true. In short, it means overcoming the emotions that contribute to poor decision-making. How do we overcome emotions in our investment process? Every active manager needs to have an edge to stand a chance of outperforming. At its heart, an edge is something to distinguish between skill and luck in an investment process. We have four elements to our process which help us set emotions aside and give us our investment edge. Firstly, there is the informational edge. For us, this is the use of data screens to ensure our focus is only on the very cheapest parts of the market. Then, we have an analytical edge. This is the deep analysis we do for every stock we look at. The next step is a behavioural edge which is our use of a risk and reward framework to help make good portfolio decisions. Finally, we have our organisational edge; the storage of all the work we do which enables us to revisit companies that may become interesting at a later point in time. The Value Team Edges In a competitive investment world, you have to have an edge Source: Schroders, March 2018. The Schroders Value Team: we are purpose built for value We believe that a great investment process is one with a high probability of superior outcomes over time. Our process is focused on producing the best possible long-term results with minimum risk. High risk does not equal high return; low risk equals high return in the long run. Real investment risk is the chance of permanently losing some or all of the money that you have invested. Buying stocks at a discount to their intrinsic value greatly reduces the risk of capital loss. Overpaying for stocks, however it is justified, will ultimately destroy capital. Value investing s major strength is the disciplined focus on buying out-of-favour companies at all stages of the investment cycle. Only by being disciplined and consistent can we deliver its long-term performance advantage. Moreover, given a history of relatively long value cycles, your investment in a true deep-value portfolio should deliver significant outperformance on a 10- year view. Schroder Income Fund First Quarter 2018 6
Schroder Income: Risk factors The fund may be concentrated in a limited number of geographical regions, industry sectors, markets and/or individual positions. This may result in large changes in the value of the fund, both up or down, which may adversely impact the performance of the fund. As a result of fees being charged to capital, the distributable income of the fund may be higher but there is the potential that performance or capital value may be eroded. The fund can be exposed to different currencies. Changes in foreign exchange rates could create losses. Equity prices fluctuate daily, based on many factors including general, economic, industry or company news. In difficult market conditions, the fund may not be able to sell a security for full value or at all. This could affect performance and could cause the fund to defer or suspend redemptions of its shares. Failures at service providers could lead to disruptions of fund operations or losses. Important Information: For professional investors or advisers only. This material is not suitable for retail clients. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested. Nick Kirrage and Kevin Murphy have expressed their own views and these may change. The data contained in this document has been sourced by Schroders and should be independently verified before further publication or use. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The information provided is not intended to constitute investment advice, an investment recommendation or investment research and does not take into account specific circumstances of any recipient. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Information herein is believed to be reliable but Schroder Unit Trusts Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for error of fact or opinion. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Unit Trusts Limited, 31 Gresham Street, London EC2V 7QA. Registered No: 4191730 England. Authorised and regulated by the Financial Conduct Authority. Schroder Income Fund First Quarter 2018 7