137. Obsessing about growth stocks and reappraising inequalities in society

17 June 2021 (pre-recorded 15 June 2021)

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]

Ryan Lightfoot-Brown (RLB): Hello and welcome to the Investing on the go podcast brought to you by FundCalibre. I’m Ryan Lightfoot-Brown and today I’m joined by Nick Clay, the Elite Rated manager of the TM RWC Global Equity Income fund. Nick, thank you very much for your time today.

Nick Clay (NC): Thank you very much.

[INTERVIEW]

[0:16]

RLB: Now this is a very new fund. It was only launched in November of 2020, but many investors will know you and know the process from a previous fund you ran, the Newton Global Equity Income fund, that became the BNY Global Income fund. And can you just remind us what type of company are you looking to invest in with this mandate?

NC: Yeah, sure, so, I mean, the quick and easy description is ‘quality at a reasonable yield’. As people will remember, we’ve got a yield discipline imposed on us, buy and sell discipline, which means that all our companies yield more than the market, but equally we look for companies which sustain and have a durable cash flow. So obviously they can keep paying us that dividend, i.e., a quality element to them. And we’re looking for an asymmetric valuation skew in our favour, i.e., they’re looking cheap. And you only get those three things – a high yield, quality and cheap – when something’s going wrong. When there’s some kind of controversy surrounding those good companies. And over the years, you know, we built up sort of five buckets of controversy where we continually fish: troubled compounding machines, ex-growth cash generators, profit transformation, capital intensity, and special situations. And so what this process ultimately gets us to do is buy those good companies when the controversy is front and centre, and then have to sell them, forced to sell them, in fact, when everybody now has that as their consensus, and like or are in favour of the company.

[1:43]

RLB: And does this sort of buying the controversy and selling the consensus, does it lead to the funds being risky than its peers?

NC: Well, I would argue I guess – but why wouldn’t I, but I would argue that it’s the opposite actually. And the reason why I say that is that, you know, probably the problem with all of us is we’re human beings. And, you know, we tend to fall in love with things. And we also tend to want to seek comfort in herds and following the consensus and the majority of people. The problem with that is that ultimately valuation matters. In the short-term it doesn’t really, but in the longer term, and that is our holding period, around five years, it does matter with regards to what your likely future returns are going to be. So having a disciplined process that forces us to buy things when they’re out of favour and then forced to sell things when they become very much in love with everybody and are overvalued, actually starts to mitigate the risk in your portfolio because your expectations in your stocks are much lower. The chance of them meeting those expectations are higher. And it leaves you with a more stable and antifragile type portfolio rather than one that is exposed to any kind of shock, which could come in the future, which you weren’t aware of.

[2:58]

RLB: And now many of our investors will know you as a manager. Is there anything that you’re doing differently on this fund that you haven’t done with the old fund? Have you tweaked the process in any way, or is it the same?

NC: It’s exactly the same. So we’ve changed nothing. You know, we believe in it, we’d done it 15 years. We know it works. There’s a process and a philosophy. The whole team came over to RWC. So the whole knowledge base came with us. We’re obviously going to leverage off that knowledge base. So, we’re not going to change anything to make that knowledge base defunct in any way. And the process will evolve through time, as you learn from your mistakes and you put in extra checklists, et cetera, but no we’ve changed absolutely nothing in the way we do things.

[3:41]

RLB: And therefore in the portfolio, have you invested in any sort of old favorites or have you sort of reset things so to speak?

NC: So we haven’t reset things, we have we’ve sort of launched again basically as if we’d never stopped running the fund. So it’s just a continuation of where it would have been had we continued running the fund over the last over the summer of last year. And so it looks very familiar. But what the pandemic did do was allow us actually the opportunity to add back some stocks we had invested in before, which had performed really well. We then ended up having to sell them, but they underperformed again, during the pandemic. And so we got a chance to reinvest in them. So things like the Diageo, things like TSMC and things like Lockheed Martin, all of those, we were able to add back to the portfolio because it drifted back into those buckets. But it really looks very similar to how it would’ve looked before. And also it’s exactly how it would have looked had we carried on running it anyway.

[4:41]

RLB: Okay. And it’s been quite a difficult year for income investors. The pandemic led to many dividend cuts. How easy has it been to find opportunities when so many companies have gone through that process?

NC: Yeah, you’re right, an awful lot of companies certainly cut their dividend. But luckily you know, our process and that ability, that durability of cash flows means we tend not to ever look or get invested in those companies which are ultimately fragile, and unable to suffer difficult times. The pandemic, you know, probably the most difficult of all admittedly. And so many of those companies that cut their dividend were not things that we were invested in, nor would we want to invest in at any point, things like banks, et cetera. And so our companies are able to suffer quite quickly and even the companies which had to just suspend things in the short-term, just because the utter uncertainty, have all returned very quickly to paying dividends again. So we’re not finding that our opportunity set has been curtailed in any way. And in fact, the way that the dividend style fell out of favor so dramatically last year, obviously because of the headline cuts that were going on, means that quite a few stocks, which, you know, are known for paying good stable, sustainable dividends, you know, underperformed and therefore offers us good entry points and good opportunities. And some of those stocks we talked about just earlier.

[6:02]

RLB: And you have mentioned that you’ve got a very disciplined process. You target a yield of at least 25% higher than the market. Does that mean you’re looking for higher yield today rather than growing yields for the future, or you’ve got a balance?

NC: It’s a balance. About 25% above the market is not stretching for yield. And certainly not in today’s market with the yield on the market so incredibly low at 1.7% and going lower. And so we only need to get 2% or mop or above in order to be able to qualify.

But over the 15 years, the fund’s averaged a yield of around 4% and that historically plus all the evidence that’s ever been done on this sector shows that this is a sustainable level of dividend income, that companies can keep paying you. And when you start to stretch higher than that, that’s when you get into trouble. They’re the ones which are more fragile. So in today’s environment, 25% above today’s yield is perfectly reachable and attainable and sustainable level of yield to generate on the fund.

[7:03]

RLB: And you can omit certain sectors if you don’t like them for the fund. I noticed you’re underweight energy and financials at the moment, we touched on this a little bit earlier, but those are two areas that usually have quite high yields. Why are you able to omit them and still get quite a decent yield for the fund?

NC: I mean, we have been overweight and underweight every sector at some point over the 15 years. So it’s not that we have a bias in any way towards sectors. It is you know, an investment decision to not bother piling into the financials area, particularly the banks, basically in the financials area. And that really is because we feel this knee-jerk vaccine bounce that we’ve seen since November of last year and the salivating over the infrastructure plans that have been announced by governments here, there, and everywhere is going to be quite short term. And in fact, when you sort of drill into the detail, we think that a lot of that stimulus that’s been spent by governments, this is more consumer-facing, than it is the beginning of yet another fixed asset investment super cycle that we saw coming out of China back in 2010. So we’re not buying, we are out of materials completely, we’re underweight energy.

And in the bank sector, you know, we are not a believer therefore, that we’re resuming a path of inflation coming back meaningfully and sustainably, that therefore interest rates have to steepen and yield curves steepen and all that is great for banks. It improves their profitability and the like, but we just don’t think that’s going to happen. The government’s got way too much debt. In fact, government debt went on steroids over the pandemic and let’s face it governments set interest rates, they can’t afford interest rates to be high. They just can’t afford the credit bill charge at the end of every month. So they’re going to keep interest rates low, which is bad for banks.

And you need to, as we talked about, we’re buying companies, these good quality companies, when there’s a controversy. Well, there isn’t much of a controversy with banks these days. No one’s defaulting because there’s so much cheap debt around. And when you really want to buy banks is when everybody’s defaulting, that’s your controversy and that’s the time to get in. So we’re much more favoring the consumers in the portfolio – that had a good pandemic – consumers that came out of it the other side, more savings than historically has been the case, a lot of them furloughed in America, again, a lot of support.

And ultimately we think the one lasting change, and there aren’t many lasting changes from crises, but the one lasting change from this pandemic is a trying to level up of society – to reappraise the inequality that the global financial crisis and the pandemic has pushed to extremes. And that ultimately favours the consumer who most of the people are the consumer and that’s most of society. And that’s where most of the stimulus we think is going to get spent.

[9:53]

RLB: Okay. And when we speak to global income investors, they say that they are often underweight things like US, India, IT, because it’s not the areas that pay dividends. It’s an area that you’ve got quite a bit in. What’s different there that you think you can add an edge in?

NC: So, I mean, we are underweight the US as per sort of an arbitrary benchmark, but we do have the most of our portfolio in the US you’re correct. And we have a bit in India too, and we are overweight even against our arbitrary benchmark in technology. And the reason for that is that over the years, particularly in developing and emerging markets, the dividend culture has grown. And they now represent you know almost half of all the dividends that you can achieve collect around the world, come out of that area. But secondly, we think that a lot of the US companies because when the market got so narrow in the US with this obsession with the sex and violence growth stocks, it allowed a lot of the other stocks in the US marketplace to become decent yielders and therefore give us an opportunity to buy into them.

And then equally we do think that the tax changes, which are coming down the pipeline in the US particularly with regards to capital and income tax means that the incentive for US companies to just keep buying their shares, which is normally just to the benefit of the CEO and the CFO, is going to revert back to looking more, as we should try and do a dividend instead. And so even more companies in the US are going to start paying a decent yield and giving us a even greater opportunity set.

In IT what’s really interesting about that is that, you know, we can’t because of our disciplines own those really big as we call them sex and violence stocks which just gone to the moon. However, what we can do is own what we would consider to be much more reasonably valued technology stocks like Cisco and Infosys and TSMC and Qualcomm, but are still exposed to some of those structural growth dynamics that we know are very prevalent in the IT sector. And we think that’s a much better risk reward for our clients.

[11:59]

RLB: Now I know you are a stock picker first and foremost, but we’ve discussed sort of a couple of macro issues you think that aren’t going to happen with interest rates and we’re now sort of approaching the halfway point of the year. So perhaps could I push you on your outlook for the second half of this year? And what do you think that’s going to do for your portfolio?

NC: Well I think we’re going to get to the realisation stage in the second half of the year where we see that, or particularly towards the end of the year, the lacking effect of the inflation numbers, which are just obviously so high simply because everything was so low last year, starts to wane. People start to remind themselves of the bigger structural factors, which were at play before the pandemic and are still in existence today, which bring down prices, which is an aging population, too much debt, which has obviously gone through the roof now. And obviously disruption from technology, which has also gone on accelerated period during the pandemic. And those big factors, I think will keep the lid on prices. And so I think the second half of this year, you continue to get this realisation that interest rates aren’t really going to normalise that quickly. There’s no much appetite for it.

And that then we will start to sort out in the market between the ones who are actually coming out of this man-made economic recession stronger than they were when they went into it, because in certain industries, there has been capacity coming out. And retail is a really good example, there have genuinely been companies that have failed during this pandemic. Where in other industries, government support, cheap debt, et cetera, has kept capacity high. And therefore you’re not going to come out of this with pricing power and a stronger economic position as a company. And I think that’s the realisation it’s going to dawn on markets. Coupled with the continued direction of travel with regards to taxation, and who’s going to pay for this debt. And I think that corporates are front and centre in that. And so companies with very low tax charges, which are almost ironically tend to be the large tech companies, will be the ones which will have to start to step up to the plate and start paying a fairer share.

And of course that would be fine if we weren’t on record valuations, but if we’re on record valuations, that might cause a few problems for some of those share prices. So, you know, that’s the way I sort of see the outlook and therefore trying to concentrate the fund on those companies, which are coming out stronger, which are exposed to where the genuine help is coming, which is consumer-facing. And at least been stopped from investing in companies with massive expectations in their valuations, I think leaves the portfolio in a good position for the rest of this year and forward looking.

RLB: Well on that note Nick we’re going to have to leave it there so thank you very much for your time today that’s been really interesting.

NC: Thank you Ryan. Thanks for having me.

RLB: And for more from the Elite Rated TM RWC Global Equity Income fund please visit the website fundcalibre.com and for more from the Investing on the go podcast, please subscribe via your usual channels.