195. Why the UK government will find it difficult to resist calls for a windfall tax

26 May 2022 (pre-recorded 23 May 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 episode covers an array of topics in the UK market, from the potential windfall tax for BP and Shell to currency risk and continued supply chain disruptions. 

James Yardley (JY): Today I’m joined by Simon Brazier, the Elite Rated manager of Ninety One UK Alpha. Simon, thanks very much for joining us today. 

Simon Brazier (SB): It’s great to be here. Hi James. 

[INTERVIEW]

JY: Simon, every single fund manager pretty much says they like to buy quality companies, but what does that really mean to you?

SB: That is a fair point. I mean, we have been doing this for a long time and what we are trying to find is, ultimately, companies that – over the long term – can compound their profits, their cash flows, and deliver better returns than the markets. And we do that by looking at companies’ business models – can they grow their profits over time? That’s often because they have barriers to entry or they’re a sustainable growth environment. Do they turn… secondly, their financial model, do they turn its profits into cash? You know, very clearly looking at balance sheets as well, making sure the companies are well financed. And then the valuations we look at are very much cash flow based. 

But for us, you asked maybe where we differentiate ourselves from others, is that we really focus on what we call capital allocation, is how do companies reallocate their capital? How do they reinvest their cash flow? And to us often the difference between a good and a great company is not often the chief exec or the business itself, but actually what they do with their financial model. Do they, are they able to reinvest in, you know, good M&A, or good research and development, which enables them to grow their profits over time and compound. And that’s what we’re really looking for.

JY: And how are you positioning your portfolio at the moment? I mean, a lot’s going on, the UK’s done quite well year to date. I believe you’ve added in a bit of cyclical exposure. What are your views on everything? I mean, there’s talk about recession and everything else. 

SB: Yeah. 

JY: How are you positioned?

SB: Well, we have been taking quite a cautious approach for some time in the portfolio and I mean that is bearing some fruit this year. But the reality is that, you know, the economic outlook for us remains very, very uncertain. And we want to own companies that can perform in a difficult world with structural change going on. And so, typically, we have been focused on those more international, globally diversified cash generative businesses. You know, the likes of Unilever, Reckitt Benckiser, Diageo, which ultimately can grow in a low growth world. 

But on top of that, you are right, we have got cyclicality, but we’re quite specific about where we have cyclicality, i.e. those companies that are more exposed to economic cycle. We want companies that actually will have higher revenues in 2022, 2023 than the last two years, no matter what. And they’re often ones that are coming out of the COVID sort of normalisation trade. So there are like the airlines, you know, JD Weatherspoon in the pub sector, and other companies exposed to, for example, commercial aerospace or events, where actually as the economy opens up, we know they will have higher revenues. And quite often in this space, they’re facing less competition than they did a year or two ago. So if you are Ryanair, you are certainly facing less competition because many of your competitors went bust in the downturn. If your JD Weatherspoon, many of your competitor pubs went bust in the downturn, and hence you’re in a better position. 

And the final point to mate James is many of these companies are actually at the value end. So in a more difficult environment, people maybe will trade down to the likes of Ryanair, EasyJet Weatherspoon, in that type of environment. So again, we feel we have some protection and we are somewhat ignoring those companies, which, you know, had great 2020, 2021 maybe because they make kitchens or because they’re exposed to residential refurbishment where actually we think people were going to cut back on that in a more difficult environment.

JY: Very good points. And BP and Shell are two of your top holdings. What are your thoughts on the current calls for a windfall tax? How will this potentially impact these companies?

SB: I mean, I would like to say I would leave that to the politicians, but I am an investor and one has to take a view. I think governments are loath to intervene in the sort of normal workings of business and also the tax structure. But having said that, I think the political narrative here is one where I think they’re going to find it increasingly difficult to resist the calls here. And also if we do see sustained higher oil prices, which we believe we’re going to see, then it is true that these companies, the likes of BP and Shell do have quite elevated levels of cash flow. And not only that, they still trade at relatively attractive valuations. So I can see why that may be the case. It may be tempered by the fact that it will be linked to their investment, particularly into UK assets. And hence if they’re able to invest that will reduce that tax. But I have to say in our analysis, we are now starting to factor that in as a very likely event.

JY: Now, your fund invests across the market cap spectrum. So you could combine large, mid and small caps. I mean, we’ve seen a big difference in performance year to date with, you know, the mid and small caps doing a lot worse than the large caps. Have you been repositioned at all there? Are you seeing any value or are you preferring the large caps still?

SB: I very much prefer the large cap area. I mean, I basically went zero in small caps at the end of 2019 because we were seeing a bit better value in the larger area of the market. That’s clearly helped us in 2020 when the markets fell and the more defensive areas of the markets performed well. 2021 was a more difficult year for that reason, but it’s certainly coming back to help us right now. And you know, if you are, well let’s be frank year to date, if you haven’t had exposure to large cap oil, mining, healthcare, then you would’ve really struggled to perform. And these sectors still look incredibly cheap, and they have liquidity. And I do think liquidity is one of the key factors in the market today that is undervalued. And we like companies where we have liquidity.

JY: And I see you had some overseas stocks, but you seem to have sold them all. So, I mean, is that just a view that the UK is just screamingly cheap at the moment and now is really a great time for it, despite the fact it’s already outperformed year to date?

SB: Yeah, we do have the ability to buy overseas stocks. We typically say, we go up to sort of 10% in overseas and they have delivered, you know, strong performance for us in recent years. But Anna Farmbrough, who’s sort of my number two on the fund, and I were sitting there looking at the stocks at the end of last year. And to be honest with you, we couldn’t justify – no matter how high quality the businesses  like Visa, you know, Bookings Holdings, Beton Dickinson are, which were some of the names we held at the end of last year – the valuation disconnect we were seeing in the US when we could buy British American Tobacco, BP, HSBC, and some other names in our portfolios on less than half the multiples often, you know, 20% of the multiple of those businesses. We just did not feel that valuations allowed us to continue to own them. 

So you are right. It was the valuation opportunity in the UK. And that switch has been good. I mean, the one holding we still own is Charles Schwab, it’s a US, it’s a bit like a very large Hargreaves Landsown the US, but it does perform well in steeping yield environment when interest rates are going up and it has been performing well for us. So we kept that one, but otherwise you are right. We found more value in the UK and we continue to do so right now.

JY: And are you starting to see more sort of global money come into the UK market? I mean, the UK’s sort of famously been unloved for so long. I mean, I think it’s been called the Jurassic Park of stock markets, but I mean, I guess that when the sentiment is that negative, that’s usually a time to buy isn’t it? Are you seeing any of that money come in?

SM: Yes, you’re right. I do sometimes feel like a dinosaur wandering around looking for…

JY: Not a comment on you Simon. 

SB: But do you know what? We definitely started to see interest at the end of 2019 because the sort of Brexit, you know, the pain had started to sort of dissipate and obviously the pandemic hit and the UK performed poorly. I do meet a lot of overseas clients. And the reality is they’re still holding off. I’ll be honest with you, partly because they just worry about currency risk and the uncertainty around the economics means they just do not know where the UK currency is going, which is important for them depending on in which country they’re investing from. 

But having said that, often outperformance breeds interest and, you know, the significant relative performance of the UK this year, which could easily continue if that pain trade for a lot of people who don’t own the likes of the oil stocks continues, then we may see more interest, but I’ll be frank with you, James, they’re somewhat holding off still.

JY: And is the currency anything, you know, we should be worrying about? Or, I mean, is that actually, I mean, the lower pound should be boosting a lot of your multinationals, are you seeing that come through in the earnings?

SB: Yeah, I mean, I’ve always said that most multinationals are very good at managing their currency risks. So you don’t actually see what we call, you see translational risk at the end of the year where your profits are, if you report in dollars where they are in pounds, but actually in terms of your actual operational risk, most of these companies have put their debt into the same currency as where their operations are. They put their cost bases in the same jurisdiction. So they have less of that type of risk in their companies. So they are pretty good at managing that currency risk. Having said that the biggest strain really is not currency. It is dislocation in supply chains, whether it’s around Brexit, the pandemic, China, and that is what is really causing the more hassle, rather than actually managing currency risk, which I think they’re pretty good at.

JY: Are we going to finally see an end to these supply chain difficulties in the next year or so, or is it just never ending at the moment?

SB: Well, I’ll be honest with you. I meet tens of companies every week, month, and I was expecting by now, you would’ve seen a few of them coming and saying, do you know what Simon, the margin, we’re starting to see some improvements here. And it’s just not the case. I mean, and also, you know, I was reading a recent report just saying, Shanghai is about to open up again, the port there, which has been on basically in lockdown for the last few months. And suddenly that’s going to command a lot more resource into Shanghai, which again, people feel is going to put pressure on freight rates, on container rates, on all of that supply chain dynamic. And so the companies right now are seeing no let up. So this is something I think is going to continue through. The only thing that really could do something, but it would not be a positive, is demand destruction. Slower economic growth means there’s less demand and puts less pressure on that, but again, that’s a sort of lose/lose scenario. So I have to be honest with you, we’re in a very difficult position right now from that perspective.

JY: Well, thank you very much, Simon, always good to get your insights, and thanks for joining us today.

SB: And thank you.

SW: The Ninety One UK Alpha fund is a well-diversified core UK equity fund. The majority of the portfolio will be invested in companies with attractive quality characteristics as described by Simon. And at least 50% of the fund’s holdings will be in the FTSE 100. To learn more about the Ninety One UK Alpha 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. It’s not a recommendation to buy or sell. 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.