Economic and market background: a bumpy ride down
The UK stock market reached a peak in May 2018. Since the darling buds of May, though, it has taken a bumpy ride downwards, with the FTSE All-Share Total Return index now firmly in negative territory for the year at -5.95%.
Whilst the market remains an irrational beast, we would highlight four influences that have been building during the period:
New politics: it is becoming clear that the shift in the global political environment is not a temporary phenomenon, but that we are experiencing a structural move away from the free market liberal ideology that has dominated Western politics and economics for the last 40 years. In particular, the previous received wisdom of the benefits of tariff-free trade is being challenged. This has led to weakness in capital goods and resources stocks, sectors which have previously benefited from the growth in global trade.
The end of QE: central banks have signalled an end to the quantitative easing experiment that has fuelled and distorted asset prices over the last decade. Cash-consumptive “unicorn” businesses that have surfed this liquidity wave have seen their share prices crash.
The return of inflation: tight labour markets globally and an inflationary UK budget (a 4.9% increase in the National Living Wage from April 2019) have heightened the prospect of further interest rate rises from record low levels. This has predictably hit valuations of cyclical and highly indebted companies.
Risky behaviours: market participants and company managements have travelled further up the risk curve. There has been a surge in M&A (past the previous cyclical peak) while measures of investor optimism indicate a worrying level of complacency. As a result, equity valuations have reached previous cyclical highs and corporate balance sheet gearing has surpassed previous records.
Performance: doing what it says on the tin
Our overriding objective remains to protect and then grow client capital. Over the last six months, the Fund has returned -0.97%, net of fees for the A Accumulation share class. This is in the context of a -7.85% return for its benchmark, the FTSE All-Share Total Return index (12pm adjusted).
Our exposure to high quality businesses has been key to the Fund’s resilience over this period. Diversified businesses with predictable and recurring cash flows, such as Unilever, Diageo, Reckitt Benckiser, WM Morrison and GlaxoSmithKline, all added value during the period. The portfolio also benefited from the takeover of insurance broker Jardine Lloyd Thomson.
In the debit column, shares in distribution business DCC were weak during the period despite a strong operational performance. We still like the diverse conglomerate structure of the business and DCC’s strong balance sheet.
Vodafone was also a laggard. The business has failed to address its oversized dividend, which, together with recent M&A, has led to an increase in debt. However, the business benefits from long-term structural tailwinds, as consumers across the world spend even more time on their mobile phones. Vodafone remains highly cash generative and the ability to reduce leverage remains within management control.
The exhaustiveness of our research process has arguably helped us to avoid the worst stock-specific blow-ups. Nevertheless, experience has taught us that we will not avoid them all. We are prepared for an unpredictable road ahead.
Portfolio activity: increasing resilience, reducing cyclicality
We made a number of changes to the portfolio during the period:
Outlook: the great unwind has barely begun
Whilst there has been a small correction in stock markets this autumn, valuations of most high quality business with strong balance sheets remain unattractive. Cash remains king, giving us the flexibility to sell, be patient and have firepower when opportunities present themselves.
Whilst tighter monetary policy is beginning to be felt by the US economy, we are a long way from the corporate deleveraging that will eventually need to take place. Credit markets are only just starting to wake up to the likely consequences of a decade- long build up in corporate debt. The non-financial BBB debt market has nearly trebled in size from US$655bn in 2009 to US$1,843bn in 2018 (source: Morgan Stanley), credit quality is diminishing and, with BBB being 2.5x the size of the sub- investment grade market, it could mean a severe shortage of buyers.
The signs that flows into passive and ETF funds are slowing are important and also merit concern. These flows have been the dominant source of new money, whose buying, regardless of price or risk, has accelerated market gains. This is especially true in the illiquid area of corporate debt, where passive funds and ETFs have ballooned in size since the last global downturn. The consequences of negative flows as greed turns to fear will be felt across asset classes.
It won’t surprise followers of the Fund to read that we remain defensively positioned. We continue to avoid balance sheet leverage, particularly banks and life insurance companies, which are exposed to rising impairments and dislocation in bond markets respectively. Earlier we flagged political risk as a mounting consideration. Investors have yet to adjust to the structural shift in the political environment. Owning large, diversified international companies will help us navigate these increased potential risks.
Patience and discipline are essential to our process. Through our research efforts we have drawn up a shopping list of high quality businesses. We will deploy our cash when changes in valuations, balance sheets or management behaviour turn these individual risk/reward pay-offs in our favour, but only then.
Finally, a reminder of the portfolio’s attractive yield characteristics. Even with our elevated cash position, the Fund is currently yielding c. 3.1% (based on our unofficial internal yield forecasts).
Past performance is no guarantee of future performance.
Source: JOHCM/Bloomberg unless otherwise stated. Issued by J O Hambro Capital Management Limited authorised and regulated by the Financial Conduct Authority. Past performance is no guarantee of future performance. The value of investments and the income from them may go down as well as up and you may not get back your original investment. The annual management charge is deducted from the capital of the Fund. This will increase the income from the Fund but may constrain or erode potential for capital growth. We recommend that you read the Prospectus and Key Investor Information Document available from the address below or from our website. The information contained herein including any expression of opinion is for information purposes only and is given on the understanding that it is not a recommendation. Source: JOHCM/Bloomberg/FTSE International. FTSE International Limited (“FTSE”) © FTSE 2017. The Industry Classification Benchmark (“ICB”) and all rights in it are owned by and vest in FTSE and/or its licensors. “FTSE” ® is a trademark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. Neither FTSE or its licensors accept any liability for errors or omissions in the ICV. No further distribution of ICB is permitted without FTSE’s express written consent. Information on how JOHCM handles personal data which it receives can be found in the JOHCM Privacy Statement on our website: www.johcm.com. JOHCM® is a registered trademark of J O Hambro Capital Management Ltd. J O Hambro® is a registered trademark of Barnham Broom Holdings Ltd. Registered in England and Wales under No: 2176004. Registered address: Level 3, 1 St James’s Market, London SW1Y 4AH, United Kingdom.
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