Tilting towards the storm
Last month’s column (‘Darkest before the dawn?’) suggested that, after a difficult period for investment trusts as discounts widened, we were approaching a turning point. Discounts may be close to their nadir. But what of the market more generally? Here too the omens are beginning to look better despite the many hurdles. While one will seldom buy at the bottom, attractive company valuations will continue to provide helpful entry points for the long-term.
The rationale
As regular readers know, our portfolios have been more defensively positioned in recent years and this has helped to mitigate against the investment trust index falling 17.8% over the last 15 months to 31 March, when the UK market is up 3.4% and overseas markets are down 3.4%. The logic is well rehearsed. More volatile and ‘stickier’ inflation, higher interest and discount rates, and elevated growth valuations after a long period of outperformance, have helped to create a difficult market environment and concomitant volatility. Other geo-political and economic factors including the hardening of strategic alliances and shortening of supply chains, and continuing high debt levels and poor growth, have contributed.
Such factors have also helped to usher in a new market regime. This new investment landscape will favour ‘value’ over ‘growth’ as an investment style. As such, our portfolios have been increasing exposure to value-focused companies. Portfolio balance will continue to be maintained in part through exposure to key long-term secular growth themes. The column ‘The ending of an era’ (23 September 2022) explains the reasoning in some detail.
However, in part because of the attractive ratings of some markets, enticing company discounts, and the fact that much bad news is reflected in prices after a prolonged period of uncertainty, recent months have seen the beginning of a gradual shift in the portfolios’ asset allocation in favour of equities. This is ongoing. But this shift also reflects long-felt scepticism about global policymakers’ grasp of the situation. There cannot be many other such periods when forecasts have been so awry.
As has been highlighted many times in this column, their track record on inflation is lamentable – even now, central banks are raising interest rates which, given their lag effect on the economy of 6-9 months, clearly suggest they are not confident of their low year-end forecasts. Again, in contrast to forecasts, budget deficits are better than expected and G7 economies are not in recession. As such corporate earnings have not collapsed, defaults have remained relatively low, company finances are in good shape given they took early action to maintain margins, and the markets are steady if not making modest headway.
Meanwhile, with so much bad news baked into prices, some sector and market valuations are looking very attractive. Many good quality private equity companies are trading at discounts of 35-40%. Commercial property companies have also probably overly discounted expected falls in asset values. At a market level, asian and emerging markets are beginning to look attractive after a lacklustre period. And then there’s the unfashionable UK market which trades near to an historically wide discount to other markets despite nearly 75% of FTSE 100 earnings and over 50% of FTSE 250 earnings being sourced from overseas, coupled with the fastest economic growth rate among the G7 since 2010.
Of course, the challenges will remain – sticky inflation, geopolitical tensions, erroneous forecasts, high debt and pedestrian growth being among them. But these are known. The market has largely factored them into the equation. Market ratings, at least in part, reflect the uncertainty. In buying when the consensus is cautious, it is accepted one is sailing into the storm. The waters will continue to be choppy. But history suggests it is usually wise to invest when sentiment trails the fundamentals, when investors are sitting on the sidelines. And although this process will be gradual, seeking to take advantage of market dips, there is nothing to suggest it will be different this time. Indeed, quite the contrary.
Our preferred equity assets giving expression to this transition continue to be those focused on the UK market and private equity globally. The Commentary pieces ‘Trade of the decade?‘ (14 May 2021) and ‘Crises and opportunities’ (24 June 2022) set out the reasoning in some detail.
UK equities
Our view that the UK market looks attractive relative to many others on a variety of metrics including yield, comparative rating and outlook will come as no surprise. The increased focus on value as an investment theme in this new market regime will also provide a modest tailwind given the market’s composition. Recent outperformance of global markets is encouraging but one senses we could still be in the foothills of this journey. Such are the opportunities the best may be yet to come.
Fidelity Special Values (FSV) seeks exposure to businesses which stand on significant valuation discounts while possessing the potential for material price appreciation. The portfolio’s prospective PER stands on a 15-20% discount to the broader UK market – which itself stands on a significant discount to most developed international markets. Alex Wright, the manager, believes the portfolio is well positioned with significant holdings in financials, energy, industrials and high-quality consumer staples. The focus is on companies with possess attractive growth potential and low levels of debt.
It is noteworthy that earnings proved resilient in 2020 and bids for portfolio companies have not been found wanting. The company has performed well over the past decade – recent figures suggesting it has delivered a Net Asset Value (NAV) total return of twice its benchmark. As the manager recently suggested, this outperformance may even pick up pace if the rotation into value continues: “The current environment of higher, likely stickier, inflation, rising interest rates and economic volatility means investors need to be value sensitive.”
Finsbury Growth & Income (FGT) possesses an excellent long-term record of delivering market beating returns from a concentrated portfolio of predominately UK equities. Last autumn, Bloomberg data showed the 20-year sterling total returns on £1 invested for FGT to be £8.07 – this compares to £6.36 for the S&P 500 and £3.32 for the FTSE All-Share. Short-term performance has modestly suffered recently, and this has resulted in the company’s discount drifting somewhat. Nick Train, the manager, is well known for his conviction approach – buying high-quality, income generating companies and holding them for the long-term.
A recent discussion with Nick highlighted the many sound UK companies which stand at unjustifiably wide discounts to their international peers, a valuation gap he rightly believes will continue to close over time for various reasons. The UK market’s outperformance last year and year-to-date perhaps marks the beginning of better times ahead. And while already a major shareholder, his recent share purchases certainly suggest conviction. Patient investors will continue to be rewarded. Meanwhile, reflecting the cash-generative nature of the holdings, healthy dividend increases continue to entice.
The Merchants Trust (MRCH) seeks to produce an above average level of income and income growth, together with long-term capital growth, by investing in a diversified portfolio of mainly higher yielding larger UK companies which it believes are undervalued. The company has a very good NAV track record under its respected and long-standing manager, Simon Gergel, who has been managing the trust for 15 years. This record has been assisted by its gearing – the cost of which has fallen in recent years. A focus on good quality businesses and record of having paid increasingly higher dividends to its shareholders year on year for the last 40 years is commendable. The company currently yields 4.8%.
Private equity
The sector looks particularly attractive given the extent of the discounts, which are more than compensating for expectations that NAVs will come under pressure given the wider economic scenario – expectations which tend to downplay the often-conservative valuations attributed to investments by the managers, as seen when investments are realised. This is pertinent when evaluating the sector’s rating.
HarbourVest Global Private Equity (HVPE) is a major independent global private markets manager – a remit supported by its strong connections to top-tier private equity managers. The managers’ disciplined approach and diversified portfolio have achieved strong and consistent returns. A characteristic of the company is the impressive uplift on the carrying value of investments on exit, which reflects the high quality and conservative valuation of its portfolio – since 2012, the average uplift on disposal being c.35-40%. This too has made for excellent long-term returns. Meanwhile, the company stood on a near 48% discount to NAV when bought which is somewhat uncharitable.
CT Private Equity Trust (CTPE) is attractive on various metrics including its investment approach, wide discount, excellent track record and attractive dividend policy which promises to annualise the highest previous quarterly distribution. Speaking recently with Hamish Mair, the company’s manager since 1999, he believes the high degree of diversification across the portfolio, which spans the mid-market sector across its chosen markets, continues to be a positive, while the company’s focus on later-stage profitable technology businesses is now rightly coming more into vogue within the sector. An uplift in value of around 35% when investments have been realised confirms the portfolio’s quality.
Pantheon International (PIN) provides access to an actively managed, good quality and globally diversified portfolio of investments focused on sectors which exhibit strong growth characteristics – mainly information technology, consumer staples/services and healthcare. A recent discussion with Helen Steers, the lead manager, also highlighted conservative valuations and a prudent balance sheet which has helped to produce the excellent long-term returns. Meanwhile, the company retains a competitive advantage courtesy of its depth of resource and the strong relationships with leading private equity managers fostered over many decades and cycles. The discount of 45% when bought again appears excessive.
Disclaimer: The information contained in this article does not constitute investment advice or personal recommendation and it is not an invitation or inducement to engage in investment activity. You should seek independent financial and, if appropriate, legal advice as to the suitability of any investment decision. Past performance is not a guide to future performance. The value of investment company shares, and the income from them, can fall as well as rise. You may not get back the full amount invested and, in some cases, nothing at all.
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