The global macroeconomic background remains broadly beneficial for equities and, although the direction of travel for interest rates points north, there has – with the notable exception of the US – been more pointing than progress. For what it’s worth, we don’t view the move to higher interest rates as an insurmountable obstacle for markets: monetary tightening is likely to be gradual and not material. Meanwhile, politics oscillate between the entertaining and the worrying. Donald Trump continues to make the occasional comment with which not everybody agrees. Nevertheless, stockmarkets remain sanguine about such matters.
About 18 months ago, much was being made of the fact that the UK market appeared to have weak dividend cover. But this ignored the depressing impact from the oil and mining shares. Today, with earnings in these areas having recovered, the picture looks more comfortable. It is worth mentioning that the dividend cover on some of our holdings will look low on the basis that some are able to pay out nearly all of their earnings in dividends. Some banks and insurance companies, for instance, having reached a capital position in excess of regulatory requirements, are able to do this. Here, a low dividend cover is more a symptom of strength than of stress.
The recent performance of the UK market has little to do with international investors looking beyond the troubled waters that presently surround these islands and abandoning their longstanding antipathy. Rather, it owes a lot to its status as the home of oil and mining shares in a period when rising commodity prices have provided a roaring tailwind. When some 20% of the market by value is serving aces, it takes a lot of double faults from the remainder of the market to hold it back.
While macroeconomics and politics do of course concern us, they have little influence on the shape or day-to-day running of the portfolio. Some of our clients ask us how we are positioned for: Brexit; trade wars; stronger sterling; weaker sterling; higher interest rates; a Labour government… the list goes on. Although we are flattered to be accorded such visionary status, we are (as our adverts suggest) ‘profit hunters’ rather than prophets. Not only do we lack a process or forecasting mechanism that would help us in such speculations but, were we to have a view, positioning for these outcomes would incur significant effects on the portfolio. Instead, we concentrate on finding the stocks where we feel we have the knowledge and insight to postulate and predict. We then back these views with your capital.
In terms of the fund’s performance, the strength of the commodity sector has recently presented a headwind. These stocks are less well-represented in our portfolio than in the UK market. Having the same exposure to these areas as the All-Share would, in our opinion, mean that an uncomfortably high proportion (25%) of our income would depend on oil stocks and miners. Things look rosy here today but these areas are cyclical (at a conference just two years ago I was asked whether Shell would go bust…); and we aim to provide a steady, growing income for our investors.
Other parts of the portfolio provide a more-than-adequate offset against our underweight in commodities. Reassuringly, they have tended to be the stocks that are long standing holdings, such as 3i, Segro and SSP. All continue to make progress (in some cases more than we expected) and, while valuations may precipitate sales at some juncture, they illustrate some themes common across the greater part of the portfolio.
First, like much of the portfolio, we can see the rationale for the underlying cashflows of these stocks proving sustainable, if we take a farsighted view. This is, if you will, ‘horizon investing’. This is in contrast to what we might term ‘lily pad’ investing – hopping from one stock to the next as the long-term security of their underlying cashflows makes the notion of staying (afloat) on the lily pad questionable. But before we become too high-minded about these things, we should acknowledge that we are pragmatic: some lily pads are more robust than others, and so if we see a shorter-term opportunity where a company’s cashflows are clearly being mispriced, we will contemplate acting.
Second, our investors seem, on occasion, a little dismayed by the fact that we are not bursting with new ideas. They believe that we should be, and rotating from stock to stock to generate performance. This ignores the basic tenet of why a company has management and what it gets paid for. Paying managers to put their effort into delivering future share price performance while at the same time flitting from one lily pad to the next looks irrational to us.
Outlook – reaping the benefits of technology
For us, thinking about – and working on – the themes that will determine the future composition of the portfolio plays a much more significant role in our day-to-day work than hyperventilating over unpredictable macro and political events. Although of boundless interest, ultimately these will have less bearing on the long-term value that accrues to unitholders.
More pertinent is our view that technology will reap better returns for many companies as they are able to replace their ageing myriad of legacy systems with something sleeker and more modern, giving customers a better service while costing less to administer. For many companies with large numbers of customers, interfacing through apps and emails yields convenience. Today, many are navigating IT systems that are analogous to spaghetti junction. But – pushing the metaphor to its limit – they will in due course be cruising down the M6 toll road.
For some companies, the impact of technology is already being felt. For example, that BP could produce as much cashflow when oil prices are $60 per barrel as it could when they were $100 per barrel (despite having paid out $60 billion for the Macondo spill) is in no small part due to its use of technology, which is enabling some of its wells to run at higher rates of production than would have otherwise been the case. Tui, the travel company with 20 million customers, told us it used to take 36 hours and no small amount of manual input (which is to say cost) to reset its flight schedules. Today, it takes just 90 seconds and costs £4. That looks like progress to us.
From the world of stocks to the wider world. Notwithstanding its recent rally, the UK is still seen as the hermit of global equity markets. Understandably, international investors continue to view a potion blending Brexit uncertainty with political stasis as more akin to hemlock than Horlicks. A drumroll followed by a sudden Brexit deal seems unlikely. Instead, a prolonged process that obliges the equity market to inch its way towards certainty seems more probable. In the meantime, while conventional investors hesitate, corporate buyers are more eager: by our calculation, some 13 of the UK’s top 350 companies have either succumbed to takeovers or received approaches in the year to date. Little did investment bankers realise that the Brexit uncertainty would lead to such a bonanza of M&A. We suspect that they, along with the sommeliers of most good West End restaurants, will have a spring in their step for a while yet.
If there is one change in the macro-environment that does concern us, it is labour costs in the US and UK. In both economies, employment is full and labour is in short supply which suggests that its price must rise. In addition, the UK government has stipulated rises in the living wage. Added to which is the realisation that for all its modernity the so-called ‘gig economy’ – delivery drivers, parcel companies, food delivery by Deliveroo and transportation by Uber – is a voracious user of labour. Governments are increasingly interested in the terms and conditions of contracts (holiday entitlement, employment rights and pensions) in these areas. Any subsequent legislation will likely add to the upward pressure on labour costs. For many companies, offsetting this through higher prices is not an option. This ultimately represents a threat to profits and makes us cautious about certain segments of the market.
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The value of any investment, and any income from it, can rise and fall with movements in stockmarkets, currencies and interest rates. These can move irrationally and can be affected unpredictably by diverse factors, including political and economic events. This could mean that you won’t get back the amount you originally invested. A fund’s past performance should not be considered a guide to future returns.
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