For individual investors in the UK

Price & prejudice – not all cyclicals will struggle

In this article, Laura Foll, Portfolio Manager of Henderson Opportunities Trust and Lowland Investment Company discusses the current landscape for cyclical companies.

Close-Up Of Water Drops On Blue Sky At Night
Laura Foll, CFA

Laura Foll, CFA

Portfolio Manager


James Henderson

James Henderson

Director of UK Investment Trusts | Portfolio Manager


21 Oct 2022
5 minute read

In the current economic climate markets are not taking kindly to cyclicals. If solid companies are being pummelled it is because the consumer is too. But in pricing these shares down, are investors being unduly prejudiced?

A simple definition of a cyclical company is one whose sales and earnings are sensitive to the economic backdrop. Examples include financials, industrials and consumer discretionary – all of which are now out of favour.

The prospect of reduced spending has caused the share prices of consumer-facing companies to drop dramatically. We can see this in the performance of FTSE 100 companies. As at the end of August the top 20 largest holdings have delivered a total return of 12.4%.1 Six of those are natural resources companies, while others, including British American Tobacco and Vodafone, are companies whose services consumers are unlikely to give up even when the budget is tight. The remaining 80 companies, on the other hand, have returned -19.3%.2 Detractors in this list include consumer stocks Next and Ocado and industrials Ashtead and Halma.

But it is dangerous to assume that all cyclical stocks will be equally hurt by consumers tightening their belts in the face of recession, increased food costs and astronomical energy prices. Not all cyclicals are equal. A consumer-facing company like Halfords, for example, has a large non-discretionary offering. If my car’s windscreen-wiper is broken, the cost of a replacement is not something I can easily avoid. Yet, YTD, Halford’s share price is down nearly 58%.3

An area which may also be undervalued is industrials. While many industrial companies have been derated, we are seeing little evidence of a demand slowdown in the sector. Management teams are reporting strong order books and are largely confident in their ability to meet, if not exceed, expectations. There are several companies that we believe are in stable enough positions to survive the impending recession – and potentially come out the other side stronger.

Engineering firm IMI is a good example. The company has divisions for precision engineering, critical engineering and hydronic engineering. It manufactures equipment required to facilitate incredibly precise movement – such as the valves for liquified natural gas (LNG) terminals. In recent months, the general attitude towards gas has changed significantly, as its role in the transition to alternative energies has become clearer. The need for the terminals that store and transmit LNG is unlikely to dwindle anytime soon.

Within its hydronic division, IMI builds equipment used for climate control in buildings. The EU is under such huge pressure to reduce emissions – thus the demand for solutions to make buildings more energy efficient remains high.

IMI also serves the food processing industry and healthcare – sectors that should be more resilient to a recession. There are large areas of this business which are likely less sensitive to GDP movement than many people realise.

Additionally, IMI is still going through a cost-saving programme; its most cyclical division will face significant restructuring next year. The cost savings the company will have at a time that cyclical businesses might enter more of a downturn could be a significant benefit. Despite all of this, its share price is down 37% YTD.4

Another company that has the potential to benefit from the move towards a more sustainable world is Morgan Advanced Materials (MGAM), a provider of advanced carbon and ceramic materials. It has many niches and serves several different end markets, including energy, defence and healthcare. Its products are technically complex – but the company itself has actually become less complex in recent years. MGAM has decreased its number of operating companies, is well invested and is conservatively managed.

The approach of the new generation of managers is not yet reflected in the way the company is viewed – MGAM’s share price is nearly 20% below where it was five years ago, but in that time the management team have made great progress.5

One of its other strengths has previously been a source of criticism. MGAM has around 70 facilities, which is a large number for the size of the company. However, these facilities tend to be in (or close to) the end market – close to where they are making sales. This means that, by luck, MGAM is not greatly exposed to freight costs at a time when they have increased dramatically.

A final company to mention is Surface Transforms – down over 23% in the past year. It operates within the automotive industry, a classic cyclical sector. Surface Transforms is the UK’s sole manufacturer of carbon-ceramic brakes for use in automation and is an industry leader in the development of next-generation carbon-ceramic materials. They have just signed a new contract with a major US manufacturer to export these brakes to the USA. Regardless of the state of the UK economy, this technology is being adopted and Surface Transforms is leading the way. Within industrials we look for innovators, each with qualities likely to help them survive a downturn.

There is little doubt that the next year will be difficult for many cyclical companies, but not all of them will suffer from a recession. As investors, we have to be careful that prejudice does not blind us to opportunities.

 

Laura Foll is co-manager of the Henderson Opportunities Trust and the Lowland Investment Company.

 

1Bloomberg as at 31 August 2022

2Bloomberg as at 31 August 2022

3https://www.google.com/finance/quote/HFD:LONsa=X&ved=2ahUKEwiP6bevu_H5AhVRS0EAHYl7BSAQ3ecFegQIKBAYwindow=YTD As at 21 Sept 2022

4https://www.google.com/finance/quote/IMI:LON?window=YTD As at 21 Sept 2022

5https://www.google.com/finance/quote/MGAM:LON?window=5Y as at 31 August 2022

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

 

Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

 

The information in this article does not qualify as an investment recommendation.

 

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Please read the following important information regarding funds related to this article.

Before investing in an investment trust referred to in this document, you should satisfy yourself as to its suitability and the risks involved, you may wish to consult a financial adviser. This is a marketing communication. Please refer to the AIFMD Disclosure document and Annual Report of the AIF before making any final investment decisions.
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  • Some of the investments in this portfolio are in smaller companies shares. They may be more difficult to buy and sell and their share price may fluctuate more than that of larger companies.
  • This Company is suitable to be used as one component in several in a diversified investment portfolio. Investors should consider carefully the proportion of their portfolio invested into this Company.
  • Active management techniques that have worked well in normal market conditions could prove ineffective or detrimental at other times.
  • The Company could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the Company.
  • Shares can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
  • The return on your investment is directly related to the prevailing market price of the Company's shares, which will trade at a varying discount (or premium) relative to the value of the underlying assets of the Company. As a result losses (or gains) may be higher or lower than those of the Company's assets.
  • The Company may use gearing as part of its investment strategy. If the Company utilises its ability to gear, the profits and losses incured by the Company can be greater than those of a Company that does not use gearing.
Before investing in an investment trust referred to in this document, you should satisfy yourself as to its suitability and the risks involved, you may wish to consult a financial adviser. This is a marketing communication. Please refer to the AIFMD Disclosure document and Annual Report of the AIF before making any final investment decisions.
    Specific risks
  • If a Company's portfolio is concentrated towards a particular country or geographical region, the investment carries greater risk than a portfolio diversified across more countries.
  • Some of the investments in this portfolio are in smaller companies shares. They may be more difficult to buy and sell and their share price may fluctuate more than that of larger companies.
  • This Company is suitable to be used as one component in several in a diversified investment portfolio. Investors should consider carefully the proportion of their portfolio invested into this Company.
  • Active management techniques that have worked well in normal market conditions could prove ineffective or detrimental at other times.
  • The Company could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the Company.
  • Shares can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
  • The return on your investment is directly related to the prevailing market price of the Company's shares, which will trade at a varying discount (or premium) relative to the value of the underlying assets of the Company. As a result losses (or gains) may be higher or lower than those of the Company's assets.
  • The Company may use gearing as part of its investment strategy. If the Company utilises its ability to gear, the profits and losses incured by the Company can be greater than those of a Company that does not use gearing.