206. We’re now operating in a financial world we’ve not seen for decades

11 August 2022 (pre-recorded 9 August 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This week we’re discussing abnormal markets, overlooked opportunities and unloved European companies.

Ryan Lightfoot-Aminoff (RLA): I’m Ryan Lightfoot-Aminoff and today I’m joined by Ben Leyland, the Elite Rated manager of the JOHCM Global Opportunities fund. Ben, thank you for your time today.

Ben Leyland (BL): Thanks for having me.

[INTERVIEW]

RLA: Your recent commentary says that you don’t believe that markets have been normal for a while, not just since COVID a couple of years ago, but since sort of 2017 or even the great financial crisis in 2008. Can you sort of elaborate on this statement please?

BY: Yeah, I think there are two important points to make here. The first is really the degree to which financial and equity markets have been influenced, supported, manipulated by central banks and very loose monetary policy and how long that’s been in place for.

So we mean both in terms of interest rates being held below the level of inflation, which has been pretty consistent since the global financial crisis in 2008. And then on top of that, in terms of more unconventional tools like quantitative easing you know, having such an amount of excess liquidity in the system must have had all sorts of distorting effects, both on the real world and also the financial world, and to have it there for so long means that a lot of investors have forgotten what it’s like to invest when it isn’t there. You know, people have quite short memories and anything before the last five years, let alone 10 years, is regarded as ancient history and not necessarily relevant. And we think that’s incorrect.

I think the second point is more about investor psychology in a period of equity market volatility because equity markets typically go up over the long term. It’s common for people to see periods of volatility as the kind of aberrations, abnormal interruptions in this longer term normal path of steadily rising equity markets. And so whenever we are in a period of volatility, as we are now, people look back to whatever preceded that volatile period and assume that that was some sort of normal baseline. And you can see it, how people talk, journalists, for example, talk about you know, how far things have fallen from their peak as if the peak is some sort of normal level from which we should use as a reference point.

And ultimately we just think that’s a dangerous assumption. The world doesn’t kind of oscillate from normal to volatile back to normal again. And we don’t go back to the old normal, we tend to transition towards a new normal and that was a phrase that we used an awful lot in the post global financial crisis era. But I think it’s more relevant to understand how the world evolves and changes. And we never go back to the old set of circumstances. We always move into a new regime; and certainly now given how significant and wide ranging the changes that we’re all seeing and serving. Investors and governments and companies are having to operate in a set of circumstances, which most haven’t experienced before because we haven’t new set them for a number of decades.

RLA: Now maybe you can expand on that then please. I mean you mentioned you’re in a transition period. It’s difficult world to invest in when geopolitics is fragmenting and capital controls are being imposed. You’ve got inflation for the first time, significantly in years, correlations are changing things like this. So how are you investing through this period and what do you expect the world to look like when we do come out the other side?

BL: I’ll pass on the second part of your question. I think it’s very difficult to predict what the world will look like when we come out to the other side. But let’s talk about how we manage money through a transition, a potentially volatile transition period. I think the key is to recognise that some of the old heuristics and the mental shortcuts that have worked well for investors in recent years may not work so well anymore. And so maybe this is what we always do is we try to stick to some fairly basic and time honored battle, hardened investment principles whilst remaining flexible in how we apply them, given the current circumstances.

So to take an example, we believe that quality is a very important characteristic when investing and what we mean by quality is the strength and the durability of a company’s franchise. And within that concept is as important as ever. And so we are still in our due diligence focused on understanding a company’s sustainable competitor advantages, you know, the source of their pricing power for example, but where you find those quality characteristics may change as the world evolves. And so some areas of the equity market that previously were regarded as high quality may lose that those characteristics and others, which traditionally, or more recently haven’t been regarded as quality may evolve towards more quality; and in terms of basic principles, you know, we focus on quality and we focus on value.

And so the second core principle within our process is value in an absolute sense. And I think it’s very important there just as it was in the early 2000s coming out of the technology bubble to emphasise that thinking about value absolute rather than relative terms, whether that’s relative to other equities or other asset classes such as bonds is important. And so we spend a lot of time thinking about the margin of safety in an investment. We have the risk adjusted return expectations. So we have an explicit downside analysis as part of our due diligence. And what that allows us to do is to assess and debate and challenge ourselves about how vulnerable a company might be as this environment changes.

And then I guess two other kind of core principles to abide by in this kind of environment would be firstly to operate within your circle of competence, to stick to what you know now is not the time to be going off on exciting adventures into more esoteric areas of any financial market that you don’t understand so well and also stay liquid. And so if you recognise that you understanding your analysis has changed, or your expectations need to change, then you can take your appropriate action to your portfolio.

RLA: And your portfolio itself does look very different to many other global equity funds. Why is this, what is it that you do differently to get you outcome?

BL: I think one reason is we try not to be too heroic and we tend to stay away from the extremes. And the reason for that is that we think timing markets is too difficult. You know, we try to play often some defence at the same time, rather than forming a view about where markets are going, whether they’re going up or down and then trying to behave aggressively or defensively on the basis of that forecast.

And so what that means is that when markets are running hot, as they did for a few years before this year started we tend to stay quite balanced in some senses, quite conservative. Whereas I think many other funds would’ve felt pressured to keep up with relentlessly rising market. I mean, doing so sacrificed certain important investment disciplines whether that’s in terms of the quality of the companies they invested in, or maybe the valuations they were prepared to pay for the most well-known and widely recognised areas of quality and growth, specifically the technology sector.

And I guess, related to that, and this is more fundamental rather than a comment on current positioning. We have our own definitions of concepts, like quality and growth and value. And also now we’re finding sustainability, which are a bit different from other peoples or different from kind of conventional definitions. And so for example, we believe you can find quality and growth in sectors like utilities, regulated utilities, or healthcare, even some financial companies maybe not mainstream ones, but certainly within that sector. Whereas I think it’s been common or become common in recent years to argue that the only place you can find quality and growth is in the technology sector. And as a result, it doesn’t matter what you pay for those companies.

RLA: And as a result of that, you’ve got around quarter of your portfolio in Europe. Again, very different to peer group, can you maybe give us an example of a stock from there, sort of perhaps maybe in the renewables or defence space which has been very much in the news of late.

BL: Yeah, it’s a fair observation. These, I mean, the fund is now 10 years old and we’ve had a long standing bias towards, you know, pan Europe. So Europe and the UK I think the average weight over the last 10 years is around 40%. And that’s because typically we focus more on economic exposure. So where a company does its business means we can do on where something is listed. And actually we find that there can be a difference between how companies are perceived based on those two lenses. And we’ve often found high quality multinational companies or companies with US biases in their businesses, which are listed in Europe have become quite cheap or have at times in the last 10 years been cheap because they’re listed in the European Union or the UK and they’re misperceived as European companies.

You know, so historically that would include companies like Wolters Kluwer, which is a Dutch media company with big US exposure at Woosley, which is now Ferguson, which is a US builders merchant listed in London, Experian would be another UK company meeting that definition. And then within the current portfolio names like CRH, the Irish construction company infrastructure company with big us exposure or Sanofi or, you know, any pharma company would work or the energy sector. For example, Shell and gal are primarily exposed to the oil price, which is a global exposure rather than European economic exposure. So I think it’s worth emphasising, although in certain sectors – in fact we effectively evaluate each sector on its own merits and there will be certain circumstances where we prefer us exposure.

So regulated utilities, for example, we prefer US names. The same is true of healthcare, but when it comes to sectors like energy and defence , we actually prefer the European names in energy because we think there’s quite a loss of under-appreciated value, particularly in a decarbonising world with their downstream assets and defence, because the likely growth trajectory of European defence budgets from here as a result of the Russian invasion of Ukraine and the recognition that defence is an important thing to invest in has been neglected for a lot longer in Europe than it has in the US. So I think the growth prospects for European defence businesses are maybe even stronger than they are for European names.

But I think the final point and this is almost an acknowledgement of others’ concerns about Europe is our European exposure is it is a quarter of the portfolio, but it’s a lot lower than it has been at that 40% average for the last 10 years, because we do recognise that Europe faces some quite unique challenges in the current environment specifically, and including being an energy importer and maybe the tensions that current circumstances could create within the European Union. So we don’t have very much exposure to Europe in economic terms or to be honest in currency terms with regard to the Euro.

RLA: And one other thing I’ve notice in the portfolio, you still have quite a reasonable holding in cash. Is that a call on those concerns? Is it a call on market valuations still? What are you waiting for to deploy that money?

BL: Yeah, again, a little like Europe, I wouldn’t overstate the cash balance now. You know, it’s been broadly in the mid-single digits for some time, you know, best part 12, 18 months and it’s significantly lower than it was during the 2015 to 2020 period when it was fairly consistently in the high teens level. I’d say a mid-single digit cash balance is much less of an impeded to our ability to capture a good proportion of market upside, if, and when markets turn upwards you know, as illustrated by our performance during the recent market rally.

Now, as we’ve always said, cash is just an outcome of our bottom up stock picking at work, so how much value we can find in the investible universe of high quality companies on a risk adjusted basis will deploy cash when we see opportunities to do so. And those opportunities can either come from a share price falling, or it can come from fundamentals improving. So over time as companies reinvest in themselves they will, their intrinsic value will grow. And so a share price will look more attractive than it did maybe one or two years ago. And the beauty of working in large cap, liquid equity markets with a concentrated fund, 25 to 40 stocks, is that we can move and deploy quite a lot of cash quite quickly. When we see those opportunities, you know, it only takes two names to move 5% of cash into the market. And certainly we can either deploy cash into new names or increasing weights in existing positions.

So if you take the evolution of the cash balance over the last, let’s say two years, the longer term trajectory is downwards because we’ve perceived there to be a greater number of opportunities in what we’ve been calling the forgotten middle. So, you know, good growing high quality companies, typically outside of the technology sector, which were increasingly overlooked by a market obsessed by the extremes during 2020. And and then more recently, obviously markets have been weak and we’ve had the number of existing, for example, in the utilities sector, GXO Logistics is particularly interesting, exciting situation.

RLA: Now we talked about a lot of industries that you do like and we’ve touched on a couple that you are perhaps not so keen on at the moment the particular focus on maybe those technology names. Do you think there’ll be a time that you’ll be interested again, or do you think there’s just so much already in the well away from that forgotten middle and very much that the very conscious stuff ends. Do you think there’s a time that you you’d be adding to those names into the portfolio? It was not really your sort of area.

BL: No, we’ve always said throughout the period of markets increasingly dominated by well-known household name technology companies then becoming a bigger pass of benchmark indices and then appearing to be very expensive that we don’t own them purely on valuation grounds. So now that’s a selective comment. So enterprise software companies are typically very much within our quality universe, you know, recurring revenues, sticky customers, brilliant flywheel of reinvesting R&D to create intellectual property and monetising that through global customer bases. So these are all good companies, which are on our watch list of investible companies we’ve been put off by valuation. We have started to dip our toe into names like Microsoft and Adobe over the course of the year on weakness. So we’ve established smaller position two-ish percent position sizes in those names. But as ever it’s selective.

So as I say, we much prefer enterprise software to consumer exposure. We tend to prefer software and services to hardware. And in particular, we struggle with the barriers to entry in the social media space. So we never really paid much attention to Facebook. We still don’t. I think the stickiness for consumer facing businesses like Netflix is not something that we feel we understand well enough. So as with any other sector, we’re selective, we do think there are quality names in there. We have evaluation discipline, which over the last five years has meant that we haven’t been involved in that sector very much. But the first five years of the fund from 2012 to 2016, we had good exposure to a number of software names. And we’re starting to build that exposure back up, but again, selectively, patiently, and we’ll wait for valuations to come to us rather than chasing them purely because they’re large component of the index.

RLA: Well that’s been really interesting Ben, thank you very much for your time today.

BL: Thank you.

SW: JOHCM Global Opportunities can invest in any company around the globe, but has a strong bias towards larger and medium-sized multi-national businesses whose revenues are generated from all over the world. To learn more about the JOHCM Global Opportunities fund, visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.

Please remember, we’ve been discussing individual companies to bring investing to life for you. The information contained within this podcast including any expression of opinion is for information purpose only and is given on the understanding that it is not a recommendation. Views are as of date of recording and are subject to change. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.