Having enjoyed a strong run in the first five months of 2017, equity markets came under pressure in June. This was partly the result of conflicting messages emanating from the major central banks.
Following the Federal Reserve’s second rate rise this year and more hawkish tones from other central banks, the market is now worrying about a more widespread tightening of monetary policy. There appears to be some confusion among central bankers about the causes of current levels of inflation and how long they may be expected to last. In our view, there is no evidence of sustained inflation at present. Indeed, we are still more concerned about the prospect of deflation once the current bout of temporary, commodity-price related (and, in the case of the UK, currency-related) inflation washes through the system. The ultra-low interest rates that have been in place for so long now have failed to take inflation sustainably back to the 2% rate targeted by policymakers. This suggests that, if anything, even lower rates may be needed to deliver monetary policymakers’ objectives. Nevertheless, the mixed messages emanating from the central banks have prompted more volatile conditions for equity markets.
Against this backdrop, the fund delivered a negative return during the period but outperformed its benchmark.
Capita made the largest contribution to return. The company experienced some operational challenges in the second half of last year but there is growing evidence that it has turned a corner. However, towards the end of the quarter, it announced a positive trading update, which underscored the work that its management has been doing to get the company back on track. Also, towards the end of the month, Capita completed the sale of its asset services division for a much better price than the market had expected. This reduces both the pressure on its balance sheet and the fears that a rights issue will be needed. It will take time for the company to complete its turnaround, but we are encouraged that its management is making good progress. In the meantime, with an estimated yield of almost 5% for 2017, its valuation is still very attractive.
Also, biotech stocks Gilead and AbbVie (whose shares reached all-time highs) performed well too, benefiting from a broader rally in the US pharmaceutical and biotechnology sectors. This is of course a part of the market that has been subject to some sharp swings in sentiment over the last couple of years and, although it is difficult to fathom exactly what has driven the recent pick-up in share prices, it has been helpful to short-term performance. The market has exhibited a fickle tendency towards the sector as a whole, so it is worth reminding investors that our interest is focused on the specific and compelling attractions of individual companies. Their return to form in recent weeks is pleasing but insignificant in the context of the long-term potential that they hold.
Meanwhile, the largest detractor from performance was Provident Financial. During the month, the company issued a profit warning related to its consumer credit division. This was due to the reorganisation of its doorstep-lending business, which has involved bringing its self-employed agents in-house. The process is largely complete and should prove highly beneficial for the business in the medium and long-term as it will enable Provident Financial to better manage customer relationships, improve debt collection and drive higher profits in the future. However, the disruption to trading caused by the departure of agents which were not taken on as full-time employees has been greater than management had previously anticipated.
Although this is clearly not helpful, more often than not, the market over-reacts in response to bad news, even if the causes are only transitory. We believe this to be the case here – it doesn’t disrupt the long-term investment case, in our view. Although Provident Financial’s consumer credit division is normally stable and highly cash generative, the real business growth drivers exist elsewhere in the group – Vanquis Bank, Moneybarn and Satsuma all continue to perform very well. Therefore, we believe that Provident’s dividend is unlikely to be affected by this temporary event and the long-term attractions of the group remain very much in place.
Another poor performer was Utilitywise. The company announced that one of its major energy suppliers has experienced significant levels of energy under-consumption by its end clients. This means that Utilitywise has to pay back some of the upfront commission it has already received on those contracts. This led to an immediate share price fall of more than 30% which looks harsh but should be seen in the context of a business that has had operational issues in the past. We have had a recent call with management and are reassured by the actions they have already taken to mitigate this sort of thing happening again. We continue to monitor the situation closely.
Next was also weak, along with the broader UK retail sector. This has been the result of lingering concerns about the outlook for the UK consumer economy. As regular readers will know, we believe the market has become far too pessimistic about the prospects of the domestic economy and although this has weighed on the share prices of businesses like Next, a compelling and contrarian opportunity has, in our view, opened up. As far as Next is concerned, this view was reinforced during the month following a meeting with Lord Wolfson, the company’s CEO, which reassured us that the company remains a well-managed retailer, determined and well-situated to deliver long-term shareholder value.
In terms of portfolio activity, we introduced a new position in Redrow. The company is a well-managed, UK-based housebuilder with attractive growth prospects. Its management has been investing in the company’s future growth and therefore, Redrow’s cash returns to shareholders have been modest when compared to other housebuilders. However, as this investment starts to bear fruit, we believe there is material upside in the years ahead. Moreover, as with the other construction-related holdings within the portfolio, our position in Redrow also reflects our more positive view of the UK economy.
Additionally, we took advantage of share price weakness and added to Provident Financial and Next. Other increased positions include Hostelworld, Vodafone, Lloyds, Bovis Homes, Countryside Properties and Stobart among others.
To fund the above purchases, we completely sold the fund’s position in British American Tobacco which has been present in the portfolio since its inception and has been a part of Neil’s mandates practically throughout his career. Neil owned stakes in tobacco companies before the dot.com bubble of the late nineties, but it was that episode of market history that marked a significant increase in tobacco exposure which has prevailed until recently. During the bubble, old economy stocks like British American Tobacco became completely unloved by the market – at the peak of the dot.com bubble in March 2000, you could have bought shares in British American Tobacco for just £2.25 per share. We have recently disposed of the holding at over £50 per share.
Over the last twenty years, tobacco has been the best performing sector in the UK stock market as a combination of dividend income, dividend growth and, over time, a re-rating to more appropriate valuation territory, resulted in material capital appreciation for investors and an even more substantial total return. We still retain some exposure to tobacco through Imperial Brands, which remains undervalued in our view, but the valuation opportunity elsewhere in the sector has largely played out. We have evolved the portfolio towards other areas of the stockmarket which we believe can deliver more attractive long-term returns to shareholders.
Overall, the portfolio reflects our caution on the global economic outlook and our growing confidence in the prospects for the UK economy. The result is a mix of attractively-valued, high-quality dependable growth companies and a selection of compellingly undervalued domestic cyclical stocks. All of these positions can contribute meaningfully to performance and we remain very confident in the fund’s ability to deliver attractively positive long-term returns.