How market volatility creates investment opportunities

James Yardley 22/06/2022

Hugh Sergeant, manager of ES R&M UK Recovery, joins us this week to talk about all the uncertainty in the market and how that impacts investment opportunities for recovery funds. Hugh gives his views on why he believes some inflationary pressures are cyclical and how volatility creates opportunities with examples in real estate and Close Brothers Group.

Hugh Sergeant has managed the R&M UK Recovery fund since its launch in 2008. The fund holds approximately 200 out of favour or undervalued companies, where Hugh believes the management has the capability to turn performance around. In this interview, James Yardley catches up with Hugh to discuss inflation, market volatility and opportunities in the fund.

Please Note: Below is a transcript of the video, modified for your reading pleasure. Please check the corresponding video before quoting in print, as it may contain small errors.

Video Transcript

It’s very interesting times at the moment, volatile markets. I believe that’s a sort of environment you like. Have you been very active with the portfolio recently?

[0:12] I mean, volatility often creates opportunities and those are our bread and butter, recovery, PVT opportunities and this sort of environment is providing more opportunities. The market is obviously volatile in the context of moving away from this deflation, and low interest rate environment, to a more reflationary, inflationary, higher interest rate environment, and that’s creating a lot of uncertainty.

Uncertainty equals volatility, equals opportunities.

But we’re being gradualist, so, key areas that we’re looking to add more capital would be some of the consumer cyclicals that have derated aggressively, industrial cyclicals that have derated aggressively. So, from our perspective, that equals an opportunity. In general, UK equities and many global equities have amazing value at the moment. So, this portfolio, R&M UK Recovery, is trading on nearly 10 times earnings. So, I do see it as an exciting time in terms of buying stocks cheaply.

You’ve added Close Brothers recently to the portfolio, what is it about that stock which you like?

[1:36] We have been gradually building a position – that’s in the context of us putting more capital to work into the lenders, the banks, the UK banks, the domestic banks and also the Asian banks. UK banks we see as very attractively valued – interest rates are going up, so their net interest margin should be able to improve in that environment.

Despite a more favourable background, the banks have actually derated because the market is worried about the credit cycle. We actually think the credit cycle will be relatively benign compared to previous economic downturn, so we see that as a real opportunity.

Close Brothers, though it’s not just a lender, it’s obviously got the wealth management business and Winterflood [Securities]. But it’s been derated I think in the context of worries about the UK lending environment. And we do see that as a big opportunity. And actually, if you look at the Close Brothers valuation, it trades at just around one times tangible book value. You have to go back to the depth of the global financial crisis for that kind of low valuation. So, when things were particularly bad, Close Brothers has, over the years, been able to generate attractive return on capital and be far less cyclical than other lenders. And we really don’t think that’s reflected in the very low valuation of only one times book.

And what gives you that confidence that the credit cycle’s going to be benign because everyone’s gone quite negative at the moment, the consumer’s supposed to be struggling with inflation, higher energy prices, et cetera. So, there’s quite a lot of nervousness out there.

[3:24] I think that the nervousness is understandable in the context of a different regime, a clearly more inflationary regime. Our own view would be for two to three years, we’ve been in the reflation camp and the low interest rates weren’t going to be around forever more. We’re not in the camp of inflation getting out of control. So, we do think some of the current inflationary pressures will prove to be a little bit cyclical so those will start to peak.

Our key observation on the credit cycle with respect to banks is that they haven’t really been aggressive lenders over the last 10 plus years. Ever since the global financial crisis, the banks have essentially been pretty cautious, often they’ve been required to delever. And, as a result of that, they should have pretty strong credit. Their balance sheets are very strong. They’ve got excess capital. If you look at the Lloyds, a lot of its lending is against housing assets and obviously house prices have been very strong. So, it’s those reasons that we think the credit cycle will be relatively benign and understand the short-term pressures on the consumer and understand why some of those consumer stocks have been derated.

But we do think the actual consumers are probably in a better position than the current real fears think, and the reasons for that is that the consumer balance sheet is strong. So, it’s been quite a significant wealth effect from house prices moving up and employment prospects have remained very robust. And actually there is a positive of wage inflation in that there is a little more cash going into the consumer’s pockets, and then they obviously saved a lot during lockdown and not all that saving has been spent. So, I think they’re in just a little bit better position than the current very gloomy consensus assumes.

And you’re getting interested in real estate stocks at the moment, is that the real estate investment trust or building companies or both?

[5:44] A little bit of both. We’re interested in real estate, we’ve been adding to it because we see it as a good inflation hedge. So, you should have good inflation protection there in terms of the value of real estate. And then valuations are quite attractive because a lot of the stocks have come back, because of the same concerns about the UK domestic outlook in terms of the economic background.

So, there’s been that element of uncertainty, which has led the shares to be relatively weak, so good inflation hedge plus an attractive entry point in terms of valuations. Key stocks that we like would be Capital and Counties, which owns Covent Garden, and actually Shaftesbury [Plc] as well. We’ve got a decent position and there is a proposed merger on the table of those two businesses. Shaftesbury being the operator of much of Carnaby Street and parts of Soho. And we do see the combination of those two would make a very attractive real estate franchise.

If they don’t combine, then separately, they’re also very attractive, the likes of Covent Garden actually seeing foot fall which is higher than pre pandemic. So, the fundamentals are actually very strong at the moment, despite that the shares have been laggards, they trade a big discount to NAV and that NAV’s had to be hair cut over the last couple of years, as valuers have taken more cautious assumptions during the lockdown period. So, we see that as really attractive.

British Land is also attractive and that we have been adding capital to, it’s got some interesting development projects and an interesting pipeline with respect to being able to create value from development and also trades cheap versus its NAV.

Shell and BP are two of your biggest holdings, they’ve obviously done very well for you recently. What are your thoughts on the whole windfall tax? Is that material at all or is that well in the price now? And what are your thoughts for those stocks going forward?

[7:58] It’s not really material for the big oil majors for BP and Shell. The North Sea is not a huge part of their asset base. Obviously, it won’t encourage them to make the North Sea a larger part of their asset base. So, we are not very supportive of the windfall tax, it was clearly largely a political statement. It will probably discourage investment, just at a time when the UK needs to be more self-sufficient in carbon production. So not supportive of it, but it doesn’t have a major impact on Shell and BP.

We do actually have quite material positions in Harbour [Energy plc] and some other E&P [energy and power] stocks, which have been more impacted. Harbour’s share price is down over 20%, since the announcement. We see that as an overreaction, because there are things that Harbour can do. It has got an investment program lined up and that would be able to offset some of the tax hit. As well as organic investment, there’s probably an opportunity for further inorganic [investment]. So, consolidation of the producers in the North Sea to offset some of those tax pressures. So, we do see this as an opportunity – that significant draw down in the Harbour share price to add to our positions.

And what are your thoughts on the overall market outlook from here?

[9:36] We are bullish because starting valuations are very modest in the UK market, trading on less than 11 times earnings, and our portfolio is trading at a discount to that. So, we’re trading on probably 10 times earnings, we’re trading on a price to book of 1.3 times high free cash flow yield, so attractive starting valuations. And then the portfolio we have should be able to grow profits and cash flow at a robust pace over the next two to five years, so low starting valuation and attractive medium-term growth. We were exposed to a lot of recovery, classic recovery type stocks where profitability is not at peak, it’s still quite depressed and recovering. So that was that element to come through.

This is an uncertain time, and that uncertainty is not going to go away tomorrow. I would see probably the key catalyst to reduce – to temper – some of that uncertainty in the short-term, would be inflation numbers peaking. I don’t quite know when that would be, probably some point in through the second half of the year, we’ll see a peaking in short term inflation numbers. And I think that would act as a catalyst for some reduced uncertainty and for equities to rally in that context.

As a value and recovery manager, we’ve been relatively defensive in this drawdown period, clearly longer duration type investments, growth investments, have been more aggressively impacted. Small and mid-cap have also been weak. There are some quality stocks that may have been derated too aggressively. So, we’ve been looking to add capital for some of those, likewise small and mid-caps have been very weak and we see that as an opportunity to add capital. We’re pretty optimistic about attractive equity returns over the medium term from here.

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