November saw a modest decline in the UK stock market amid slightly higher levels of volatility than we have seen of late. A strong pound, which greeted the steady progress that Theresa May appeared to be making towards an agreement with the EU on Brexit, saw some weakness in the share prices of global-facing businesses. But this failed to meaningfully change the momentum grip on markets that has been in place for much of the last two years now. The valuation stretch in markets is now close to breaking point, in our view, as we explained in our recent article.
The fund also declined in value during the month, with domestically-focused businesses, such as Barratt Developments, Next, Crest Nicholson and Lloyds, remaining heavily out of favour with investors, despite the progress being made by Davis, Barnier et al in the ongoing Brexit talks. From a fundamental perspective, these businesses and many others like them, have continued to trade well this year despite the market’s preoccupation with Brexit sentiment. We expect this to continue and have positioned the portfolios to exploit this meaningful gap between perception and reality.
Similarly, Babcock International also detracted from returns, as its shares declined after its interim results which were broadly in line with expectations. The bears have seized upon some cautious statements regarding the effects of the spending environment on future growth, but we would argue that the stock’s valuation is already discounting a much worse outcome. Furthermore, much of the work that Babcock undertakes is maintenance-related, non-discretionary in nature and governed by long term contracts. This should insulate it to a degree from any further worsening in the spending environment, despite modestly cautious forward statements from management. Indeed, Babcock provides a clear illustration of the valuation stretch in markets currently; the company is due to be evicted from the FTSE 100, despite the fact that it has estimated annual revenues of £5.4 billion and operating profit of £584 million. It is to be replaced with Just Eat, which has forecast annual revenues of £520 million and operating profit of £132 million – so Just Eat’s estimated revenues are lower than Babcock’s forecast profits.
Turning to the positive contributors, shares in Imperial Brands enjoyed a brief bounce after it announced robust annual results. As we noted last month, its shares have been out of favour for some time, as the bubble in markets has inflated, but we expect it to continue to deliver strong and dependable growth in cash flow, earnings and dividend. It has been, however, quite out of tune with the current mood music in the market. The small bounce in its share price of late is, in our view, a precursor to a more meaningfully positive contribution to performance on a longer-term view, as market behaviour corrects, and fundamentals reassert themselves.
Vodafone also performed well following a robust set of interim results which were well ahead of expectations. The company also raised guidance for full year growth and free cash flow generation. Meanwhile, British Land also beat expectations with its interim results, and its share price defied the widespread gloom about the domestic economic outlook to post strong gains in the second half of the month. The shares continue to trade at a steep discount to the company’s net asset value, despite the fact that several recent property disposals have taken place at a premium to their carrying value. When this anomaly closes, we should see a significantly higher share price for British Land. In the meantime, the shares are delivering a 4.5% yield with sustainable long-term growth prospects.
Turning to the fund’s income generating capacity, the fund went ex-dividend on 1 November for its second quarterly distribution, with an estimated 1.3p per share due to be paid to income share class holder at the end of this month. The fund is on track to deliver at least 5p of income in its first full calendar year, which has been part of the objective of this fund since its launch in April. Indeed, such is our confidence in comfortably meeting this target, we have been able to free up a small part of the portfolio to opportunistically capture some long-term capital growth potential for the fund, in stocks which are misunderstood by the market and which are therefore profoundly undervalued. As such, we introduced three new positions to the portfolio during the month, in the form of Allied Minds, Prothena and Purplebricks. We believe the portfolio will benefit meaningfully from their presence going forward, as they deliver the growth that we believe they are capable of.
Elsewhere, we added slightly to several UK-focused businesses whose share prices have been unjustifiably under pressure for much of this year. These include ITV, Crest Nicholson, Babcock International and Next. These additions were financed through the disposal of positions such as Homeserve, Leg Immobilien and Londonmetric Property, which have performed well since the fund was launched.
In terms of outlook, we believe we are close now to an inflexion point in markets, which will see the valuation stretch in markets start to reverse.
As the era of easy money draws to a close, with the Federal Reserve intent on steadily shrinking the size of its substantial balance sheet, the implications for global liquidity and the US dollar pose a hazard for financial markets that have been paying too little attention to risk.
Meanwhile, the winds of change in China also threaten the consensus view that the outlook for global growth is benign and almost trouble free. There is growing evidence to suggest that, with Xi Xinping having consolidated his power base at the communist party congress a few weeks ago, the priorities of the Chinese authorities going forward will be very different to the ‘growth at all costs’ mantra of the last decade.
For example, there was a conspicuous absence of an economic growth target in Xi Xinping’s opening congress address and the remarks made by China’s central bank governor about an approaching ‘Minsky moment’ for a Chinese banking system that has been creating credit at an alarming and increasingly ineffective rate for years are also important. Meanwhile, a number of billion-dollar infrastructure projects have been cancelled and initiatives to tighten Chinese financial regulation have been introduced. All of this points to the inevitability of slower growth from the Chinese economy as it faces up to its massive bad debt problem and exports deflation to the rest of the world via its currency.
This may sound like a very bleak assessment of the global growth outlook but it should only be disturbing for those who are not prepared for it. The stock market consensus does not appear to be prepared for this outcome but we are. We continue to believe that the fund is appropriately positioned for the prevailing economic and market environment. In turn, we are very confident that the fund will deliver attractive, positive long-term returns to its patient investors.