354. What makes a great income investment?

10 April 2025 (pre-recorded 2 April 2025)

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[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. We’re focusing on global equity income today and how dividend-paying companies can provide both resilience and long-term returns for investors. I’m Staci West and today I’m joined by Nick Clay, manager of the TM Redwheel Global Equity Income fund. Thanks for joining me today.

Nick Clay (NC): Thanks for having me.

[INTERVIEW]

SW: So this is a global fund, as the name suggests but your fund is significantly underweight in the US. A few of our listeners might know, because we have talked about it before, the US is about 70% of MSCI World index and you are significantly underweight, which is rare. So I just want to start there. Can you walk us through the reasoning behind this kind of stance or view on the US and maybe, you know, why that you believe this US exceptionalism that we’re seeing isn’t likely to continue?

NC: Yeah, so I mean the US as you said, 75% or so of the MSCI World, historically, that’s as high as it’s ever got. And that has got there following a couple of years now where the S&P has been able to deliver 24% return each year for the last two years. And, and that is incredibly rare when you look back to about the 1950s that’s only happened on six occasions. And to think about whether or not that can just continue going. Does the America weighting in the MSCI World end up going to 85%, 95% of the MSCI World, the global market simply becomes the US. Does American exceptionalism go on forever or do things start to change?

And given that the valuation in the US market had become so stretched, you know, we weren’t being able to find any decent ideas there. More importantly, we were being forced to sell out of American ideas that were becoming too expensive. And that has led us to our biggest underweight in America that this strategy has seen since its inception at Newton back in November 2005. But that isn’t any surprise given how extreme the American market’s been in its performance over the last few years.

SW: But when we had talked previously, you kind of mentioned that if this US exceptionalism does persist, then it would signal the end of capitalism as we know it. And so I just want, I want to elaborate on that. What do you mean?

NC: So there’s been good reasons why the US has outperformed the rest of the world over the last few years. And that is predominantly to do with far better margins and the increase in margins of the companies, of the US in the US and the earnings growth that’s come with that. And some of the margins that some of the companies are making, particularly in the most popular investments, the Magnificent Seven and the like of, you know, for example, Nvidia generating about an 80% gross margin. If American exceptionalism is going to continue, you are effectively saying that those margin improvements, that earnings growth differential between America and the rest of the world will continue pretty much for the foreseeable future. And it were you to say that you are effectively saying that mean reversion is going to fail that mean reversion has stopped working.

And why that’s such an important assumption to have to make is that at the heart of capitalism is mean reversion, you know, the whole point of capitalism is it attracts capital to where returns are high and therefore that increased competition brings those margins and returns down over time. And it starves capital where where margins are terribly low and you get rid of unproductive capital and move it on. And that’s how we evolve and that’s how capitalism works.

But if mean reversion were to fail, ie America can just continually persist and ever higher margins than anyone else at growth levels that are higher than anyone else, well then you are effectively saying capitalism is broken. Now, what’s interesting about that assumption brave though it may be is that were it to be true in areas where of the world where capitalism is not the economic model were that to be true and mean reversion would be broken.

What you are really creating is state sponsored monopolies or some kind of regulatory environment around them in order to protect those returns over time. And what’s interesting about other countries and economic models where that is the case is when you look at the performance of those those economies is they don’t tend to be in innovative. They don’t tend to sustain great margins over long times because they become lazy. The competition normally keeps you hungry, you remove competition, companies become lazy, they don’t innovate, and eventually the growth diminishes. That’s why capitalism is a model that a lot of the democratic western economies want to follow.

And so if mean reversion really still holds true and capitalism is still very much our economic model, then the assumption that a American companies are gonna continue to persist with record high margins, the Nvidia is gonna continue to sell all its GPUs at 80% gross margin seems highly unlikely. And therefore, if that’s the case, the fact there we’re at these extreme concentration in the US at the, with regards to its weight in MSCI World, at some extreme valuations for some of those companies, mean reversion would tend to tell you that that doesn’t go on forever. Trees don’t grow to the sky and that will start to revert and therefore you want to be facing somewhere else in your portfolio and not finding yourself part of that crowded trade.

SW: You mentioned being a kind of forced seller of US, and I want to come back to that because it is a unique aspect of this fund and your kind of disciplined philosophy really sets your fund apart in this sector as well. So maybe just give us a brief overview of why, what caused you to be a forced seller and then how that discipline actually plays out in practice either with the US as an example or maybe with something else.

NC: So we, you know, the disciplines that we have imposed upon us in the strategy, so we’re, you know, we’re forced to only buy stuff that yields 25% above the market, the world market. And we’re forced to sell everything that yields less than the world market. I think that those disciplines become the most important when markets go to extremes, you know, in the markets that we were seeing, particularly at the end of 2024.

And the reason why they’re the most important at those stages is it’s at those appear at those times when the pressure is greatest upon you as a manager to want to conform, to want to join the herd, to want to get closer to a benchmark. Because the difficulty of standing aside from that is that it’s painful. It can lead to under performance. It creates pressure upon you, a pressure on your own career. It creates pressure from your risk systems that are telling you you need to get closer to the benchmark. A benchmark which has become very expensive. And you need those disciplines to stop us as human beings. And we are just as weak as every other human being out there to not go and just join the herd and end up in the expensive parts of the market.

And it’s that sell discipline that was kicking in last year. And what I think is a really good example of that over last year was in about the late summer we were forced to start selling our TSMC holding and our Qualcomm holdings. So Qualcomm, an American stock, TSMC was loved by everybody at the time because it makes the GPUs for Nvidia and of course therefore it was going to take over the world. And that had led to incredibly strong performance in both of those stocks.

Qualcomm puts all those GPUs or makes AI happen at devices that you’re holding your hands at what’s called the edge of society. And that pushed up the share prices to valuations which had become very extreme and were discounting an incredible future for those companies and also pushed their yields to below that of the market. And we were a force seller.

Now that felt very uncomfortable at the time because everybody wanted to own these stocks, particularly TSMC. And it felt uncomfortable at the time because our risk systems were telling us we’re selling more tech and we were already underweight tech and we shouldn’t go even more underweight tech and we were selling more us through Qualcomm and we shouldn’t go even more underweight in the US. And yet what’s interesting is with hindsight, however bad and felt uncomfortable, it felt at the time when you look back now over time, the semiconductor index peaked at around the summer of last year, I was telling us to do the right thing at the right time, even though it felt uncomfortable.

And what’s important about that is left to our own devices as individuals, the chances of us setting those stocks would’ve been very low because it would’ve just been too difficult and too uncomfortable. So it’s at these extremes where the disciplines I think come in from the sell side and also the buy side to encourage you in two areas which have been forgotten about.

I think that’s what’s so important about this strategy, that encourages you to do the right thing at the right time just a bit more than 50% of the time. You know, not all the time obviously, but just a bit more than 50% of the time, quite frankly, that’s all we need to achieve.

SW: So let’s look on that buy side then for a second because I saw that you recently added LVMH to your universe, so potentially not all doom and gloom in luxury. What’s your view then on the kind of, I guess, luxury discretionary spending even kind of maybe the Chinese consumer a little bit and the story behind LVMH?

NC: So I mean that’s another really good example of those disciplines. So we were able to buy LVMH just before Christmas last year in 2024. Because it had been so weak that it was now yielding 25% above that of the world market. This year will be the 20 year anniversary of the process and philosophy of this strategy. And over that period, this is the first time ever we’ve been allowed to buy LVMH, the first time ever. It’s become cheap enough and obviously it became cheap enough because of the woes hanging over the luxury sector particularly resound surrounding the Chinese consumer where everybody believed that the Chinese were never gonna buy a handbag again. And of course that’s what made it difficult wanting to buy luxury at the time because everyone was telling us were forms for doing so. But actually what has come through so far this year is that maybe it isn’t all doom and gloom.

And again, sort of harking back to one of the answers to the earlier questions about mean reversion is that it would assume that the Chinese government do absolutely nothing to try and save their economy. And also to try and get their consumer to spending again having been basically in a savings mode since the pandemic and the Chinese consumer are not in financial ruin. So yeah, that would be one of the big structural problems you could face if the property demise in China led to financial ruin for the consumer out there. But that has not been the case. They have saved so much that they’ve offset the decline in their property wealth to still see their net wealth increase. And so we feel it’s just a confidence thing, not a financial ruin thing for the Chinese consumer. And that eventually the Chinese government will do something to encourage spending, which they are now starting to do.

And then you sort of step back and look at the luxury industry as a whole and you look back over its history is that as an industry it tends to benefit well in difficult times simply because of the nature of the cohort of the population they’re selling to. They tend to be the wealthier part of the population, therefore in a better able to suffer economic volatility and turmoil. And also that it continues to be the case that the growth in the wealth of the middle classes leads to an aspirational desire of human beings to want to demonstrate that success by buying luxury. And we see very little evidence around the world to suggest that that’s come to an end.

And so given that we know that the growth in the middle classes continues particularly across the developing nations, we know that the top part of society within the developed areas of the world continue to be financially very well off. They’ve been a big beneficiary of the asset price bubbles that we’ve seen since the financial crisis in 2008. Therefore we think that the industry is fairly healthy now. There’s definitely gonna be problems and short term volatility in their sales and that gives you the opportunity to get into these companies. But when they get to valuations, which are telling you that they’re probably never gonna sell their goods ever again, well that’s the time you wanna be buying them. Yeah, we think that that’s very much the case across most of luxury, LVMH included, and that’s why we were able to buy it and very happy to be doing so.

SW: Alright, I’m gonna jump around slightly from LVMH and the China consumer to, we’re seeing governments around the world including Germany, for example, continuing to spend despite already high levels of debt. So do you think that we are headed for a prolonged period of inflation and either kind of yes or no, how is that shaping your approach to this fund and what you’re trying to do?

NC: So I think the answer has to be yes. I mean I think we can see across the world, whether it’s US government, Europeans now, China, wherever you look, governments continue to want to spend and they see it is almost imperative that they continue spending in order to try and support their economy. You know, you look at what Trump’s doing with regards to wanting to renew his tax act that he bought in the first time round. That’s anything between a $5 trillion to $11 trillion increase in spending or foregone revenue for for the government. And then of course what we’ve just seen with Germany tearing up a constitutional debt restriction in order to allow ’em to start spending, you know, and talking of anything up to 12% of GDP that’s pretty historic what’s going on in Germany and what is what Europe are being forced to do with regards to the actions of America particularly.

And then China too seemed to finally be sort of deciding, okay, well maybe we need to have our global financial moment and start to pump a lot of liquidity into our economy. And if you’ve got a situation where governments are spending a lot of money and they’re doing it from a starting position where their debt to GDP is already very high and we are basically a debt to GDP levels that we haven’t really seen since the end of World War II, there are limited options that governments have to their disposal to try and resolve that situation. It is obviously not something that could go on forever because eventually you get a debt panic and so you have to do something, you either gotta stop spending or no government as we just said that wants to do that at the moment you could default on the debt. And quite frankly, we wouldn’t even wanna go there or even consider that as an option.

And so by far the most easiest and equally most sort of palatable solution to all of this is inflation. And that is how governments around the world post World War II managed to rectify or recorrect the debt situation to GDP. You do nothing about the debt. You grow the GDP and you grow it in phenomenal fashion and you grow it through very high levels of inflation. And so for example, back in the 1970s, the average level of inflation in the US over that period for 6.6%, you need that kind of levels of inflation in order to take a debt to GDP ratio, which hit about 120% post the war back down to below 40 by the time we got to the beginning of the 1980s. And that’s how you solve your problem. And it is quite frankly, the only way to solve a problem in developed nations, which is seen as acceptable.

Now it has big consequences for how you invest big consequences for real returns for investors and our clients. But it seems to us an inevitable outcome to the situation we find ourselves in and the fact that governments wanna carry on spending. So we think inflation is returning. We think inflation is something that governments require. We don’t think 3% inflation that we’re sort of seeing globally at the moment is anywhere near high enough. And a lot of government’s actions will be to try and stimulate that level of inflation. Now they’re never gonna openly say this and they will continue to put pressure on their central bankers to to do the opposite and increasing treasury rates to try and hold that inflation down. They want it to run hot.

So we think we think we get to a situation where nominal GDP will grow quite fast over the next few years. But that doesn’t necessarily mean everyone’s gonna make wealth outta that. It just means that things could go up in a nominal sense.

SW: So how do you invest then through this type of environment? Are there specific companies or qualities that you’re looking for to combat this?

NC: Yeah, so you do need to go back in history a bit. So we obviously haven’t had an inflationary environment quite frankly since the middle of the 1980s. And so you need to go back to a period where we had it, which was during the 1970s. And what you see during that period is that inflation doesn’t just go high and stay high, it goes in these waves and it’s those waves of inflation that cause the volatility in asset markets around the world. And when you look back at what worked in those environments, well real commodities, real assets worked. So things like gold, things like commodities, but within equity markets themselves, what worked was income and value and the reason why income worked was threefold. And what’s encouraging is that these three things still exist today. I these attributes can be repeated today.

And those three things are, one is that companies are nominal too, so they can grow their dividends. And that helps you suffer in a real sense keep up with the inflation. So we saw during the 1970s that for example, dividend growth of the S&P 500 kept up with US CPI over that period because companies are nominal, they can increase their prices, they can grow their cash flow and they can grow their dividends. We’re seeing a similar thing happening over the last couple of years with our own companies in the strategy, which is that in 2023 in sterling terms, the distribution on the fund grew 11% in 2024 sterling terms in grew 5% both times keeping up with core inflation. And that is the way we’re gonna be able to cope. Now that obviously means you need to invest in companies that can increase their prices and you need those characteristics, but if you can find those companies, then you can suffer.

The second characteristic is that you need to, in a volatile environment, when your series of returns are volatile, you need to keep your volatility lower than that at the market. Mathematically your downside numbers matter more than your upside numbers. And that is a big sea change from how everybody has thought in the last few years, which has all been about markets just go up and up and up and we just need to keep up with markets, ie upside capture’s most important. Now your downside capture is most important. You mustn’t lose as much money now if you generate the majority of your turn through the compounding of a dividend. Dividends are less volatile than earnings compounding dividends is less volatile than the capital returns on markets and therefore you can dampen down the volatility of your portfolio to suffer in that environment.

And then the final thing is valuation suddenly matters again. And this links to volatility, which is when everything just goes up and keeps going to the sky, no one cares about valuation. Everyone buys passive vehicles valuation agnostic and you march things up to city valuations when things become more volatile, when economies become more cyclical, it is far harder for companies to deliver on those expectations, the very high valuations demand of them. And therefore you need to have a valuation discipline again in what you are investing in and not to get sucked into those very high early rated companies.

And for example, at the beginning of the 1970s, you had the Nifty 50, then the equivalent and the Magnificent Seven obviously more of them. And these are the best companies in the world and they could do everything for you as an investor. And then they promptly fell twice as much as the market did when the market had collapsed in the middle of the, in the middle of the 1970s. And that was just purely because the valuations are too high. These are great companies, many of them still exist today, but the valuation was too high and didn’t protect you. So you need those three things, you a grain dividends, you need to keep your volatility lower and you need to have some kind of discipline on the valuation you pay for things. All of that can be found in an income portfolio again today. And I think that’s why it makes it highly appropriate given the environment going into.

SW: And I’m gonna assume it’s fair to say that you don’t think the Magnificent Seven is ticking those boxes for investors?

NC: No, I don’t. I think it’s worth reminding people that 1960, the original Magnificent Seven movie that came out, four of them died in that movie. This idea that these companies, you know, and wherever more certain this time than we’ve ever been in the past, because this time it’s just seven companies that we’ve marched up to a bubble type valuation and they’re all technology companies, so it’s not just, they’ve got breadth, they’re all the same thing. And we are convinced that AI is gonna take over the world and they’re all gonna take over the world. I think that’s just a dangerous assumption and we’ve seen it before, you know, these are, some of these companies are amazing companies. Microsoft is an amazing company. But just because it’s an amazing company and it’s been an amazing company since 2000 that didn’t stop it falling 75% after the tech bubble and there’s no reason why it couldn’t fall greatly again given its valuation. It’s got too high.

Again, we think that again, you know, reversing back to one of our first answers, when mean reversion kicks in you know, if returns cannot be held at such extortion at high margins that they are currently being held at and they start to normalise through competition, et cetera, or they become more capital intense, whatever it might be, then those valuations will start to suffer. And particularly if we go into an economically volatile period, and therefore we do not think that they are by anywhere near the safe place to be investing to weather this kind of environment. And that’s why obviously we hold none of them in the portfolio.

SW: Well, on that note, I think that’s a fantastic way to end it, kind of full circle from the beginning of the conversation, right through to the end. So Nick, thank you very much for joining me and taking the time today.

NC: Thank you very much, it was a good conversation. Thank you.

SW: This fund has a true contrarian approach, backed up by a disciplined philosophy as Nick outlined in today’s episode. This means the fund will be broadly diversified across sectors and likely stray from the benchmark. For more information on the TM Redwheel Global Equity Income fund, please visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.