218. There is hope yet for UK equities!

TRANSCRIPT: EPISODE 218
20 October 2022 (pre-recorded 11 October 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]

Sam Slator (SS):

I’m Sam Slator from FundCalibre, and today I’ve been joined by Alexandra Jackson, manager of the Rathbone UK Opportunities fund. Hi Alexandra.

Alexandra Jackson (AJ):

Hi Sam.

(SS):

So, we spoke to you back in February last, and you said that you thought the dominance of growth stocks was probably over, and a more balanced approach was needed. How’s that played out over the last six months or so?

(AJ):

Mm, well how far we’ve come! I think like most predictions, we got a little bit right and a lot wrong. What we got right, was that growth stocks definitely have not dominated – that is for sure this year. But it’s cold comfort really. Balance – having that extra balance – that wouldn’t really have helped either. Because so far this year there’s really only been one trade: energy. It’s the only sector in Europe with positive returns still.

Our view was – back in February – was that yields were going up and that’s why growth wouldn’t be the only ticket in town anymore. But we thought that, within a few months or a reasonable timeframe, inflation would start edging back down again. So, we got that pretty wrong.

The war in Ukraine, it’s led to major supply issues with energy, it’s exposed – among other things – years of under-investment in energy security in the West. And quite a naive assumption, I think, that we could move seamlessly from fossil fuels to renewables without interruption, without investment. So, these issues… we’ve had these issues with energy supply, plus supply of other soft commodities, wheat, things like that, that’s helped to push inflation, which might otherwise have been transitory, but it’s now been pushed into a much stickier state.

And then you add in that kind of tightness in labour markets, that have been trying to readjust after the whipsaws of Covid, and that’s also led to wage inflation being a bit stickier than otherwise.

So, rates have had to rise a lot more than we – and probably most others – expected. That’s had a huge knock- on impact particularly on stocks with premium valuations. They tend to be the winners of the last few years, these sort of longer duration growth names.

And obviously a lot’s happened, especially in the UK market, which has been interesting – using one word – over the past couple of weeks! Have you made any changes in the portfolio to deal with all of this?

(AJ):

Yes, it certainly has been interesting! Basically, we try and make as few changes as possible to the portfolio, particularly during times of market stress. And that’s because, in our area [of] small and mid-cap UK stocks, the spreads can get quite wide when the market is stressed. So, we try not to make too many changes.

But broadly we own a selection of the 50 or so what we think are the highest quality names listed in the UK. So, we’re looking at factors like stable gross margin, high return on capital, low leverage, clean accounts, strong cash generation, those kind of quality factors.

On a three-to-five-year view, those are the companies that history tells us are most likely to outperform, [have the] least reliance on the economic cycle. And, as we’ve talked about before, Sam, during bear markets, we really kind of double down on that focus on quality. So, the changes that we do make, are to exit the weakest links. And this year that’s been a lot of consumer-facing names, unsurprisingly. We don’t have many, but we’ve reduced that exposure even further. Margins haven’t proved to be as resilient as we’d like. Ocado, for example, we’ve exited. A small house builder called MJ Gleeson, where we worry about margins and consumer demand as well.

We’ve been worrying about companies who’ve built up a lot of inventory, which seemed like a good thing to do at the beginning of this year – to build up inventory, maybe if you’re a manufacturing business, in order to guard against supply chain issues. But now, potentially the projected growth that that inventory has been built up for, might not happen. So, you might have some balance sheet risks there. So, we sold a little semiconductor name on that basis, and then we recycled that cash into the highest quality names out there, the ones that we couldn’t afford previously because of their premium rating.

(SS):

And you also mentioned previously about M&A activity, and that you thought it’d be quite strong this year. Has that also come to fruition or are especially foreign investors just not touching us with a barge pole at the moment?

(AJ):

<Laughs> Yes and no. It’s definitely starting up again. So, a year ago, there was a lot of M&A in the mid-cap space, but it was mainly focused around companies that maybe already had some issues of vulnerability of some sort, already trading, you know, on a slightly distressed multiple. So, that was supportive to mid-cap valuations in general, but hopefully, as you would expect, we wouldn’t own those in this quality fund.

This year, actually the stocks that have been targeted, are the higher quality trophy assets, which is really interesting. So, more likely to be the names that we would own in this fund. Aveva, for example, the FTSE 100 software business that’s been bought out – or trying to be bought out – by its European minority owner, a slightly opportunistic bid maybe. But, what I think it’s reflecting, is weak sterling, [for] one, so much more attractive to foreign buyers, but also this huge sell-off in the kind of quality growth tech names, the recent winners. Those names have outperformed and, you know, maybe like us, foreign buyers felt like they couldn’t afford the multiple back then. Now that multiple has compressed.

Actually there’s, there’s quite a lot of opportunities combined with weak sterling. So, I think we’ll see more of these types of bids as the year closes. We need to be a bit careful in the UK that we don’t let too many of these really high quality, world-class assets go on the cheap. Especially because the IPO market is still shut. I can’t see many IPOs happening before year-end.

(SS):

And you have quite high weighting to FTSE 250 stocks – mid-cap companies. Why is that? And could you perhaps give us a couple of examples?

(AJ):

Yeah, so over 50% of the fund is invested in mid-caps, so in FTSE 250 businesses. That’s a lot more than the benchmark, which is only about 16% mid-caps. And the reason we do this, is because we have observed that mid-caps outperform large caps.

So, if you go back many decades, but actually particularly since 2000, we can see that the alpha in UK assets comes from mid-caps. The FTSE 250’s outperformed the FTSE 100 by over 80%. And it’s not a fluke or a kind of quirk in time. The actual reason for the outperformance, is because the characteristics that the market prizes most highly through cycles, are more prevalent in the FTSE 250, than in the FTSE100. So mid-caps in the UK – they have better growth, lower leverage, higher margins, and better cash generation than their large- cap cousins.

So, that’s why we like to focus the fund on mid-cap names. Those businesses that can be multiple times the size on a three-to-five-year view, hopefully they become FTSE 100, you know, large-cap businesses over time and then we’re not, you know, we’re not forced to sell them when that happens. We can still own them then.

Kainos is a good example actually. We’ve owned it in the fund, since it was a small cap. Now it’s a kind of classic £1.5 billion market cap business. Sits in the FTSE 250, I’m sure that will go into the FTSE 100 one day. [The] stock has fallen 30% this year, so it’s been vulnerable to that derating of high premium valuation tech company, recent winners basket. But we’ve trebled our money since owning it, despite this fall this year. It’s a software business. They are charged with putting various government processes online, for example, customs forms, driving license applications, things like that. So, there’s a lot of structural growth in there. The profit margins are high in the twenties, tons of cash on the balance sheet, clean accounts, no jiggery pokery in the accounts, and a really good corporate culture.

Those are, you know, those are kind of some of the hallmarks of quality midcaps that we like to see. And that give us comfort in buying those names and holding them for a long period of time.

Another one that’s had a great year this year, is Beazley, it’s an insurance company. It’s not life insurance or motor insurance. Beazley is known for insuring companies against cyber-attacks. So, again, massive structural growth. A market where they are the leader. Not many people have leadership and expertise in this market because it’s very new, but it’s increasingly important. Beazley will tell you that their conversations with customers used to be with, you know, kind of division heads or whatever, about the necessity of having cyber insurance. Now it’s with the CEO, the CTO, COO. So, that tells you the change in view towards cyber insurance and the risk around cyber-attacks, and it’s filtering into pricing. So, now for the first time in a long time, pricing is better than cost and that’s what we’re all hunting for in this market. And then for insurers, that means that premiums are going up more than claims. So, that’s really powerful for a stock like Beazley.

So, I said that mid-caps outperform and yes, they do <laughs> over the long term, but in times of macro stress, they don’t outperform. And that’s what we’ve seen this year. And I think that makes sense. You know, investors naturally kind of want to hide in more diversified, more liquid names. I guess that makes sense this year, but again, if you look at the data, the historical data going back, typically smaller mid-caps are the ones that come out of the blocks quickest in any recovery.

(SS):

And you mentioned energy prices at the beginning of this chat. I believe you’ve been testing your company resilience against the rise in energy prices. Can you tell us exactly how you’ve done that? And you know, we

were warned just last week that we could face gas shortages this winter and blackouts and all sorts of things. So, does your testing cover that kind of thing as well?

(AJ):

Mm, yes, it’s one of our current projects. There’s always a new project, isn’t there? Last year we were supply chain analysts, you know, we were assessing how many ships were moored off the coast of LA. We were looking at blockages and freight rates. We’re not doing that anymore this year. We’ve been looking at, you know, how energy intensive our holdings are and then, importantly, to what extent are they hedged? So, we’ll ask company management teams, we’ll go through their results to work out how much energy they use, how big a part of their ‘cost of goods sold’ energy is. But really importantly is the hedging. And this is going to be game changing, maybe not for 2022 numbers, not for this year, because we haven’t, you know, we haven’t really seen the energy price spike embedded itself yet. But for 2023 numbers… and I think expectations are all over the place still.

But we don’t own tons of commodity companies, you know, which are the most energy intense businesses on the listed market. So, actually the energy intensity of the portfolio is quite low. Melrose would probably be the highest – they make engine parts for cars and planes.

But yes, this point about hedging is really interesting. One of our property holdings, Sirius Real Estate, they rent out space to commercial tenants in Germany and the UK, so office space, light industrial, self-storage, things like that. And they actually, in 2020, they secured fixed gas supplies, not just for them as a company for their personal use, but for their tenants. So, the whole business model is around renting out space to their tenants. If you are a Sirius tenant, you get the fixed gas supply that they organised in 2020 – fixed until December 2023. So, it makes taking space in a Sirius building, you know, incredibly appealing. And that’s one of the reasons why we would be excited about Sirius. They had very strong results this week. It’s an interesting sign-post. If they’re doing things like that in the business, then, you know, what else could they be doing? In what other ways are they making the business more resilient? It’s a great sign-post.

The other thing we’ve put back on the list, thinking about resilience is debt, of course. You know, we’ve had such low interest rates for many, many years now. Lots of analysts, I think, have probably given up looking at looking at debt levels. So, we’ve been going through the portfolio again, looking at debt levels, but also who’s fixed their costs and who is exposed to rising interest costs.

I don’t know about you, but every time I talk to friends at the moment, we talk about who’s got a fixed or floating mortgage and when people roll off. So, it’s the same with our companies. We need to work out who’s fixed and who’s floating. Again, the debt intensity of our holdings is quite low, so half of our positions are actually in net cash. So, that’s very comforting to us.

You asked about gas shortages. Yes, I mean, never say never, but the warnings around those shortages made last week, it felt kind of more like doom mongering, this doom mongering rhetoric that we seem to have become a little bit addicted to in the UK. And maybe a warning, you know, warning shot across the bows for government.

But actually, our French suppliers, our French partners, made some very soothing comments over the weekend. We’ve seen a lot less air time kind of devoted to those over the weekend. So, you know, again, we’ll be looking at that, at the possibility of energy rationing. But the UK doesn’t have a huge manufacturing base in this country anymore. It’s not, you know, it’s not Germany or similar.

(SS):

And as you pointed out there, there is a lot of doom and gloom at the moment. There doesn’t seem to be a lot positive to talk about. Can you give us anything positive about the UK market as we wrap up?

(AJ):

Yes, I think it’s really important not to get into this doom spiral. Maybe it’s, sort of in a weird way, it feels good somehow? But it risks that we lose the kind of nuance and the detail. When I look at valuations – so, that’s where I would start – UK markets have now fallen below the typical PE ratio [price earnings ratio – a way of valuing a company] that you see during periods of macro distress.

So, the UK is now trading cheaper than it was during Covid, during the Eurozone sovereign debt crisis, during the China trade wars, you know, a bunch of scenarios, a bunch of issues, macro stress, bear markets that we’ve been through; the UK is now trading cheaper than it was then, so on under 10 times. And so, even if you cut earnings by a kind of round number – 25% that feels kind of chunky enough – even if you did that, then valuations would still be below their 10-year average.

You can’t say that about the US. So, the UK is sitting on a massive valuation cushion already. And actually, in the UK, buying UK businesses on sub 10 times PE, has historically proved to be a really good entry point into this market.

So yes, there’s a lot of noisy headlines. I worry that we’re, that we’re kind of, you know, it’s easier to focus on all this negativity, not much scope for the nuance and the detail. And I think the market’s time horizon gets compressed each time we have another one of these disastrous kind of news cycles. So, when this happens, the best thing we can do, I think, is to extend our time horizon out even longer.

And so I think, for all the noise, UK shares do look very cheap as we’ve just mentioned. But what’s piqued my interest specifically, is that the premium that we normally have to pay for top quality businesses, that’s been eroded this year.

So, I can now buy structurally growing, net cash retailers say, on nine times, but I could also buy over spaced, over leveraged yesteryear retailers for nine times as well. So, I mean, for me, there’s not much of a choice there, but it’s really interesting to see how that premium that you typically have to pay for quality has disappeared.

I’m still avoiding most retailers by the way. I think we’ve, you know, we’ve got a bit more of this consumer squeeze to go. I’m avoiding banks, house builders. I like specialty finance, insurance, lots of parts of tech, but not all, healthcare… So, I think, you know, we’re going to have more mood swings to work through, more news flow, uncomfortable headlines for sure. But the opportunity to upgrade portfolios, to access the best of the UK market on these multiples right now, that feels too good to pass up.

(SS):

That seems a very good sentence to end our conversation on! Thank you. It’s always a pleasure to talk to you, Alexandra. Thank you very much.

(AJ):

You too, Sam. Thank you.

(SS):

And if you’d like to find out more about the Rathbone UK Opportunities fund, please go to fundcalibre.com. And don’t forget to subscribe to the ‘Investing on the Go’ podcast via your usual channel.

(Outro)

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.