141. Brazil and European real estate dominate the second quarter of 2021

6 July 2021 (pre-recorded 8 July 2021)

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[INTRODUCTION]

Sam Slator (SS): I’m Sam Slator from FundCalibre and today I’ve been joined by Juliet Schooling Latter and Darius McDermott. We’re going to discuss the big themes of the second quarter of this year.

[INTERVIEW]

[0:12]

SS: So perhaps we can start looking at the best performing funds over the past three months, we had a quick look and it’s actually been Brazilian equities and European real estate that have been the best performers. Any ideas why that is?

Darius McDermott (DM): Well, I have to say when you posed this question to me, I had to scratch my head a little bit because Brazilian equities wouldn’t have jumped off the page at me… But then taxing my brain a little as I have to occasionally, I try to think about it a little bit, and one of the dominating themes in markets at the moment is inflation, and Brazil is.. tends to do well in inflationary periods. The other factor is oil has been quite strong. It’s now in the mid $70 per barrel and Brazil is an oil producer, but also it produces lots of other commodities like paper and packaging and chickens and, with a broad reopening trade, maybe that’s what’s driving Brazil in the short term. It’s still in a bit of a mess with COVID. Their leader has had some interesting Trump-esque type policies, but I think this, it looks like an inflation play to me.

Juliet Schooling Latter (JSL): I think, I think it is an area that is very risky and, you know, investors need to be aware of that. I mean, you know, the politics as Darius mentioned, isn’t great there and, you know, there’s, there’s quite a lot of social discontent and this is not being aided by the fact that they’re in the grip of a really bad drought which is causing water shortages and power blackouts. And obviously this sort of coming on top of COVID has not helped. And obviously doesn’t help with the, with the sort of social discontent aspect either.

[2:20]

DM: Yeah. And the other area that you mentioned, Sam, is European real estate, and this is quite niche, but actually a really interesting way of playing property as a broad theme. So the fund I know we looked at was the BMO European Real Estate fund that invests primarily in Europe, but the UK as well in listed property companies. There’s a huge debate going on about the liability matching between illiquid assets like property and open-ended funds and whilst I don’t wish to send our listeners to sleep with any great depth on the subject, one way to play property, particularly in UK and Europe is via the BMO European Property Real Estate. It invests a big chunk in things like German residential. On the continent there’s far less property ownership and far more property renting as a culture. And you get these fixed rate increases often linked to inflation. And it’s the ‘I’ word for the second time. And I think with the reopening feeling that, you know, this is just one of those sectors, which property did poorly in the pandemic and it is coming back and, you know, this is a fine way of playing an illiquid asset in an open-ended fund.

[3:43]

SS: We’re also halfway through the year now. So we also had a look at the figures for the first six months of the year. So slightly longer timeframe, although pretty short term still, and energy funds were the top performers there as well, which I’m presuming is a similar story to what you just talked about with Brazil. But UK smaller companies are up there too. What’s the story behind our small caps?

JSL: Well, I think smaller companies have been, you know, the UK in general and UK smaller companies have been unloved really since 2016 due to Brexit, you know, markets hate uncertainty and obviously, you know, the, the UK with a deal, no deal, et cetera, has, has been in a state of, of, of uncertainty. And we were actually quite positive on them sort of towards the end of 2019, you know, as the negotiations came to an end and there was more clarity for businesses, but then of course the pandemic hit. But fast forward and, you know, our vaccine rollout’s been really, really good. And, you know, we’ve, we’ve got rid of the Brexit uncertainty, and I think investors are returning to the, to the UK market.

DM: Yeah, I think just to finish off on UK smaller companies, this is one of the world’s least guarded secrets, particularly here at FundCalibre. We bang on about small companies all the time and Sam, you and I did some work three years after the referendum, before the sort of Boris you know, heavy victory in December 19. And even then, when the UK market was totally unloved, UK smaller companies had well and truly performed better than UK larger companies, which was counter intuitive to us. So UK smaller companies, whilst clearly having the liquidity risk that you get, but you also get paid for the liquidity premium.

And I think particularly in the UK, but many other regions, smaller companies should be a decent portion of your weighting in an individual geography. Oil, I think is slightly easier. Oil in Q1 of 2020 for two reasons, there was a bit of a, a scrap between the Saudis and the Russians on oil and supply. Then we had the pandemic, all of a sudden nobody’s doing anything. There’s no travel. So you see the supply and demand and the demand for oil went through the floor. So oil just went to like, long-term record lows, $10-$20. And here we are a year later, it’s $70 and it’s that slight lag of that increased oil price, fixed filtering through its oil companies and the supply chain within oil that, that are seeing energy funds do so well.

[6:36]

SS: And you’ve mentioned inflation a couple of times now, we’ve seen it continue to rise in the US it’s now 5%, what’s your view on it? Do you think it’s going to be something that’s going to stick around for the long term, or is it just this transitory period on sort of looking back on this time last year when nothing was happening?

JSL: Well I think I mean, inflation was always going to tick up as you say, because it was such a low base a year ago and, and we were relatively relaxed because we, we thought it was a temporary blip. I’m becoming a little concerned that the blip might be slightly more drawn out, you know, because you’ve got this sort of dramatic rise in the cost of shipping, sort of brought about due to the pandemic and ships being in the wrong place. And this is going to take quite a long time to sort of iron out. And that’s obviously adding cost into businesses and also we’ve got sort of wages tipping up, tick ticking up, you know, the hospitality industry struggling to find staff when they reopen…

DM: That I do think is a little more short term. I think there is seasonal issues. And, you know, there are a decent percentage of people in the hospitality industry on furlough, which still hasn’t ended. And universities are just finishing for the summer. I guess there will be some student labour enter the market over the period. But yeah, you’re absolutely right, hospitality is struggling to get full employment, to deal with the July 19th three opening day when you know, venues can be at fuller capacities.

But yeah, inflation is, I think the subject we discuss the most and what implication it has on other assets. We were recently talking with Steve Snowden, who’s the manager of the Elite Rated Artemis Corporate Bond fund. And he was very much of it. Yes, it may be sticky for six or 12 more months, but actually, given that he’s a bond manager and bonds generally do bad in rising inflation, the Fed have pointed to raising rates in 2023. And as he rightly pointed out, if we get to rate raises in the US, it will go to a whole lot 0.75 interest rates. It’s still at record lows. And whilst you two are both far too young to remember, inflation above 10% in the seventies and eighties was actually quite common. And even in the noughties and the early 2010s,  inflation in the UK at three, four and five, whilst above the 2% target, was absolutely the norm. So certainly something to be watched, certainly something to be mindful of, but we are broadly not in a, it’s going to 5%-10% and it’s going to stay there. That’s the way the evidence looks to us I think today, and to a lot of fund managers, we talked to actually take the counter view. I might add, I think it’s fair to say. Some of them are very bearish on what inflation might mean for both equities and bonds. So we’re not being ignorant of it. We’re certainly being mindful of it. But as we stand today, I think it, you know, it’s a bit more stubborn than we thought six, eight months ago, but yeah, not, not endemic long-term hyperinflation, I don’t think.

JSL: And don’t forget. I mean, you know, actually for governments is a bit of a sweet spot at the moment because they’ve got low interest rates for, for their, for their debt. But a bit of inflation because they’re, they’re, you know, governments post COVID are up to their ears in debt. And having it sort of inflated away is what they need really.

[10:16]

SS: One of the other things you guys have been talking about in the investment committee is big tech. Now, the consensus seems to be that, you know, the big Amazons all those types of stocks have got pretty expensive, but actually there’s been some discussion that their earnings are okay and they could continue to do well. What, what have you been talking about there?

DM: Technology again, has just been such a dominant sector. Both pre and post pandemic. Like lots of sectors technology is also a very broad sector. It’s not just even Amazon actually, isn’t qualified as a technology company. It’s qualified as a consumer company. When I think most feel it, it is a technology business – technology is changing the world. It is what disruption is all about. And who’s to say that some of these businesses can’t disrupt for longer. What’s more, their earning power is phenomenal. They sell more computers and more chips and more platform space and Zoom and advertising. And all that means is they keep building up more and more cash. So if anybody is clever and comes along with some technology to just to disrupt them, they just buy them, you know, bring it into their own sort of sphere. So again, another subject we do debate, Juliet, I know has always been a long term tech bull.

JSL: Yes, I bought, I bought tech in Junior ISAs many years ago, which has done quite well actually. And you know, you have to look beneath the surface to see if a company’s actually expensive. You know, as Darius said, you know, big tech’s got excellent sort of long term secular growth trends and it’s got much faster growth and it’s just sort of slightly more expensive than the market, but with those sort of strong balance sheets and you know, with valuations that are likely overstated given they’re based on sort of quite conservative analyst estimates.

DM: So the earnings part, isn’t it of the, the PE equation.

JSL: Yeah.

DM: The earnings is the bit that keeps surprising. And certainly in Q1, the big tech company earnings were far bigger than, than the Wall Street had predicted. And hence they sit nicely on those slightly elevated, slightly elevated valuations, but with huge cash generation and huge cash conversion. And you’ve gotta be, if you’re…how do you disrupt Microsoft? I mean, they’re in part of everybody’s IT life, even if you use a different computer brand or whatever, you’ve probably still got some Microsoft cloud. It’s everywhere, it’s a bit like Apple, they’re just part of people’s lives. And it doesn’t look likely to change. Now, that’s where the, as I say, if, if newer technologies and devices come along, the likes of Apple or Amazon with these massive cash, I mean, tens and tens of billions of US dollars sitting there, somebody’s going to go, they’re just going to buy them and incorporate it into their own space. So it is a bit of a monopoly, some of these businesses, but they are huge. Apple’s bigger than the whole of the European stock market by market cap or something like that. It’s phenomenal.

[13:31]

SS: And going maybe from expensive to cheap. One of the things that we’ve seen here in the UK is an increase in merger and acquisitions with some foreign buyers actually looking to pick up some UK companies at some very good prices. We had Morrison’s takeover bid recently. We’ve also had companies coming to market with IPOs like Moonpig, what’s your thoughts around that area?

DM: Well, I’ll have a word on IPO’s and then maybe, sorry, on M&A and then let Juliet talk about IPO’s. But the interesting thing about M&A is it’s coming from three channels. It’s coming from overseas buyers, it’s coming from private equity and it’s also coming from other UK companies buying their rivals. So it really is hotting up. I think, companies that were looking to buy each other maybe in the last year when the pandemic or overseas are accelerating that trend. And I think that’s visible in the IPO market as well.

JSL: Yes. I mean, I think, I think it’s likewise for IPOs is basically there’s, there’s just been a sort of a backlog. You know last year was such, such a write-off for companies and, and I think they’ve they’ve taken advantage this year and are coming to the market and with sort of renewed investor confidence and optimism as things open up. They’re doing quite and I know a number of our managers have taken advantage of some of them. We were talking earlier today to James Baker at Chelverton who has been investing in some. So I think that’s again positive for the UK market.

SS: That’s great, thank you very much. And if you’d like to listen to more of our podcasts please go to fundcalibre.com and subscribe via your usual channels.