What lessons have you learned from 2017?
Trends can continue for a long time, therefore go slowly with any buy/sell decisions: We have been surprised by the ratings that some of our holdings have reached this year, as companies that have good management teams and positive earnings momentum have continued to perform well almost independent of their valuation level. Our inclination as moderate value investors is to reduce companies that look highly rated relative to their own history, but that would have been the wrong decision. We need to stick with our valuation disciplines, but do so slowly.
Be wary of companies that look cheap on valuation metrics: We are currently eight years into a market upturn, therefore any companies that look cheap on metrics such as the price/earnings (P/E) ratio are likely to have question marks around them. We need to be wary at this point in the cycle not to enter into value traps.
What are the key themes likely to shape the markets in which you invest in 2018, and how is this likely to impact portfolio positioning?
The level of global economic growth, particularly in the US and China: 2017 has been a year in which global economic growth has, on the whole, surpassed expectations and this has meant the best performing sectors have tended to be cyclically exposed, such as materials, industrials and technology. As we move into 2018, the valuations of these companies are higher, and therefore whether they can sustain these ratings will be dependent on whether the current momentum in economic growth can continue. We have been modestly reducing our holdings in more expensive cyclical stocks, as we have concerns that some areas of the market are trading on elevated multiples on top of what are high operating margins relative to history.
The gradual unwinding of quantitative easing and the effect this has on equity and bond markets: Quantitative easing (QE) programs have been a huge experiment in monetary policy since the financial crisis. It is very difficult to know how much of a distortive effect this has had on equity and bond market valuations. What we do know is that within the bond market there has been some very low recent issuance; for example, Land Securities recently issued a 40-year bond at 2.75%. In this context the equity market looks better value (Land Securities has a 4% dividend yield), however it will also have been distorted and therefore the disruptive effect as QE unwinds is unknown.
The progression of Brexit and UK politics more broadly, and how this impacts the level of sterling, consumer confidence (and spending), and business investment: While the companies we hold are often highly international (with ~60% of sales deriving from overseas), the UK economic backdrop is still material for how the companies in the portfolio perform. For example even if a company is selling predominantly overseas, if they are buying overseas inputs in sterling and the value of sterling falls, they will need to pass on these higher input costs to the end consumer. If they cannot fully manage to pass on the higher costs, their margins will fall.
Where do you currently see the most compelling opportunities within your asset class?
Our strategy does not follow a high conviction style – we maintain what we consider a long (~100) and diverse list of stocks and avoid being overly exposed to any one theme or sector. What we are trying to do is pick a broad range companies that we think, on balance, look cheap. This diversity in the portfolio is particularly important at a late stage in the cycle when pockets of the market look modestly expensive, and companies that miss on earnings forecasts are being marked down harshly.
These are the managers’ views at the time of writing. References made to sectors or asset classes do not constitute or form part of any offer or solicitation to issue, sell, subscribe or purchase them.
Ratings / valuation: The price of shares in a company.
Value investors: Value investors search for companies that they believe are undervalued by the market, and therefore expect their share price to increase.
Price/earnings (PE) ratio: A popular ratio used to value a company’s shares. It is calculated by dividing the current share price by its earnings per share. In general, a high P/E ratio indicates that investors expect strong earnings growth in the future, although a (temporary) collapse in earnings can also lead to a high P/E ratio (also known as a ‘high or elevated multiple’).
Cyclical: Companies that sell discretionary consumer items, such as cars, or industries highly sensitive to changes in the economy, such as miners. The prices of equities and bonds issued by cyclical companies tend to be strongly affected by ups and downs in the overall economy, when compared to non-cyclical companies.
Value trap: An equity that appears to be cheap due to an attractive valuation metric (such as a low P/E ratio) may attract investors who are looking for a bargain. However, this may turn out to be a ‘trap’ if the share price does not improve or falls, which may happen if the company or its sector is in trouble, or if there is strong competition, lack of earnings growth or ineffective management.
Operating margins: The proportion of a company’s earnings that remain after paying for all costs of production, such as wages, utility bills, transportation costs and raw materials. Commonly used to understand a company’s pricing strategy or operating efficiency.
Quantitative easing: A measure whereby a central bank creates large sums of money to purchase government bonds or other securities, in order to stimulate the economy.
Monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money.
Low recent issuance: Meaning bonds where the coupon (or interest rate) is low relative to history.
Dividend yield: A payment made by a company to its shareholders. The amount is variable, and is paid as a portion of the company’s profits.