Man GLG Japan CoreAlpha Fund - Q2 2018

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  • 17 mins 07 secs
Stephen Harker, Head of the Man GLG Japan CoreAlpha team, provides an update for the second quarter of 2018.


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WARREN SHIELS: Hello and a warm welcome to Man GLG Japan CoreAlpha conference call with Steve Harker, Portfolio Manager, and myself Warren Shiels, Director within our UK retail business. We’ll follow our usual format for these quarterly calls. On this call, Steve will provide an update on the performance of the Large Cap Value style versus the fund, cover the current positioning on the portfolio and discuss the top 10 stocks, which we hope you’ll find useful. I will now hand over to Steve.

STEVE HARKER: Good morning everybody. If you could turn to page 3 to start, we’ve had a sort of two-and-a-half year period when volatility of, intra market volatility of Value versus Growth, small versus large has been on the high side, and top cap and mid cap Value have been, it’s been a rollercoaster since the end of ’15. But I think before I start I’d just like to say how extremely pleased we are with the way that we’ve executed our strategy over the recent past. I’m really pleased with the way that the team is operating and the way that the process is being run. As you know top cap and mid cap Value represent about 40% of the total market opportunity, and we’re making statements within that 40% so obviously volatility against topics is going to be high, particularly given the fact that the two sides of the market coin of Value versus Growth are at such wide extremes of valuation. Over the quarter, there’s been no change to this position. There’s been a slight increase in top cap Value. But we continue as always to be invested in these two blocks of the total exposure. Turnover has continued to be low, continuing something that’s been going on for the last 18 months.

Turning now to page 4, we’ve not really a lot to say here. We produce this slide every time. This is Q2 returns on the right-hand side, and Value and Growth in total were bang in line with each other in the quarter. And just to the left of that there was a minor, top caps underperformed by a small amount relative to mid and small but there was really nothing doing.

On to page 5, this shows, since 1985, each year running from January to December, from left to right, and the last three years ’16, ’17 and ’18 are highlighted in yellow, blue and red. And red is obviously year to date. 2018 is as of today a Growth year, a very small outperformance by Growth stocks in the first quarter with no deterioration in the second quarter. 2018 is so far better than 2016 which turned out to be a good year for Value and 2017 where there was no further deterioration in the second half. So we don’t know where we’re going next but it’s been a disappointing start to the year for Value but nothing very significant.

Moving on now to page 6, we’ve got the, normally we don’t have the performance figures ready for this conference call, but we do have them, and you can see that, due to, it was actually the fifth worst performance against Large Cap Value for the strategy since 50 quarters ago, in 2006. A number of things to say, I think what is interesting is that the weaknesses in stocks within the portfolio were spread widely across; it wasn’t any particular sector. It was REKO, it was Impex, it was Nomura. We have some good stock selection in the banks and for the banks we’re not significantly negative. And I think the other thing I’d like to say is that if you look at the last four occasions in which we’ve had a return of 2% adrift or worse, the next 18 months in all four cases has been very positive. We wouldn’t do anything differently from what we’ve done. And I think all that’s happened is that low price to book stocks within Large Cap Value, i.e. the cheaper end of the Large Cap Value index, has underperformed relative to the more expensive one.

Now, moving on to page 7, 50% of the CoreAlpha portfolio is in the top 10 holdings. On the left-hand side, we have where we are at June 2018, the end of the month, and on the right-hand side where we were at the end of 2017. I’m going to talk about in a couple of slides time about the de-risking and re-risking of the portfolio that’s taken place over the last two-and-a-half years. And since February/March we have been re-risking, we’ve been adding to risk relative to Large Cap Value. After a period of about 18 months where we’d been systematically reducing risk and tracking error. And as part of that re-risking you can see if you examine in detail the top 10, six months ago with now, there have been a couple of things that I can comment on.

One is that within the financial sector we’ve been increasing MUFG Mitsubishi, and Nomura relative to SMTAs and SMFG. That is essentially increasing our exposure to yen weakness and to market risk. We have been increasing Nippon Steel. We have not been increasing our exposure to steel. We’ve been increasing Nippon Steel in relation, at the same time as reducing our exposure to JFE, the number two steel operator, so our steel weighting is unchanged but within it we’ve been buying more Nippon Steel than selling JFE. And then thirdly I think and probably most significantly is we’ve been increasing, particularly in the first quarter and carried on into the second, we’ve been increasing our exposure to real estate, which is a sector we hated 10 years ago and now it’s one of our biggest overweights. And that’s really, those changes are probably the significant things that we’ve been doing within the portfolio.

Because if you turn to page 8, you can see that in terms of name changes within the portfolio, this is over the last 18 months, it’s the whole of 2017 and the first half of 2018, you can see the numbers of stocks changing, they’re coming into the portfolio or going out of the portfolio, complete disposals and new holdings, we’re running it about half of the acquisition deleting rate that we were running at in, five years up to 2016. And we normally would expect to add one and take one away in each month, so 12 in and 12 out a year. Last year we only bought three new names, this year we’ve only bought three new names, and one of them was so small that we decided to sell it as being inconsequential after it rallied in February, March and April. So turnover of new names, getting rid of old names has been really extremely low because essentially the Large Cap Value stocks that we want to buy, the really cheap stuff, almost self-selects, and there’s been, there is such a wide gap between those stocks and the rest of the market, there’s been very little opportunity for us to make adjustments.

Now, turning to page 9, I think this is quite complicated but really quite interesting way of looking at what we do. The CoreAlpha approach and my approach to investment going back to 1987, it’s always been to do two things. One is to, when you’re in a hole, keep digging. So if you’re in a period of underperformance, keep adding to risk and trying to get in to really cheap stocks on the assumption they’ll bounce. And as poor performance of the fund and the style as well over a period of time reduce risk and become much less risky after a period of strength, this chart shows our behaviour over the last two-and-a-half years. If you can look at the blue line first, this shows the performance of the Large Cap Value index divided by that of the whole market. Starting in December ‘15, so two-and-a-half years from December ’15. The first half of 2016 was extremely difficult because of for large Value because interest rates were falling, went negative, and there was serious concern that something was amiss, complicated by the reactions of the Japanese market and the yen to the Brexit result, and then from the 7th of July ’16, a really powerful recovery with Value eventually winning for the year.

The red line shows the fund’s tracking error against Large Cap Value index. And as you can see going through the first half of 2016, peaking in July, the tracking error of the fund was increasing. So as our style was losing we were increasing risk into that trough. As soon as the reversal started or just after that, we started to reduce risk. Our style peaked on the 9th of December and tracking error was coming down way before that and then continued to fall, bottoming out first of all in March ’17 and then in early ’18. Essentially we’ve had 18 months from sort of Q3 ’16 to January of ’18, 18 months of de-risking.

So risking up the portfolio in the first half of ’16, then de-risking from August/September through to January/February of ’18. And what’s interesting is that we were buying defences, we were selling cyclical manufacturing, we weren’t really doing a great deal within the financial sector, so it was essentially a shift from cyclical manufacturing into defensives, and that process reversed from January because the defensives start to win. And the first half of 2018 has been essentially a period when defensive stocks which in general look very expensive and we can’t buy them have been winning. And I’ll talk about some of the things that we’ve been doing.

So that’s page 9, if you can move now on to page 10. This is one of the moves that we made as a consequence of the dramatic outperformance that we had in late ’16. We went into the turning point in the middle of ’16 with a very big position in very high exposure to interest rate sensitivity. One of the examples of stocks that have high interest rates sensitivity, the life insurers performed amazingly well for about eight to nine months after the turning point. And as you can see we took the holding down from over 4% to below 1% in the following nine months. And actually we’ve only just taken out the last holding of Sony Financial Holdings in the last few weeks.

In its place and in the place of other things like chemicals and machinery, we were buying one of the most defensive sectors, the regulated power utilities and you can see the blue line going up. We shifted from about 1% to 7% in the wake of our strong performance. So we were defending into strength as opposed to attacking into weakness. Our holding in electric power and gas has been stable over the last year or so. And the electric power and gas sector in the first half of the year has been I think either the top or the second best performer in the market. So that switch paid off in the first half of the year. So I mean I think, hopefully you can see in the first half of ’16 we were raising risk; from September onwards, we were reducing risk; and since January/February this year we have been raising risk again.

Now, turning to page 11, we normally show price to book ratio relative to the market and our price to book ratio relative to the market. And I thought for a change we’d look at another indicator. There is still on the price to book ratio, we’re still enormously cheap. Large Cap Value is enormously cheap relative to the rest of the market. And our portfolio is very cheap relative to the Large Cap Value segment. So we’ve still got the same tilt, we’ve got about a 45% discount to market price to book, and we think that, you know, when we have situations like this, typically they’re the optimal time to be investing in this process. But that’s historic and the future is the future.

But if you look at the dividend yield of the core 30, the top 30 stocks in Japan. In 1999 when small caps were very cheap and large caps very expensive, the core 30 was yielding 0.37%. So the average stock at dividend yield was 0.37%. The dividend yield of core 30 as of today is 2 point, nearly 2.6%, an extraordinary derating of core 30. And we just think that this is frankly nonsense and will be reversed. Core 30 dividend yield relative to the dividend yield of small caps is now at a 60% premium. It’s never been as a 60% premium in the whole 45 years of the history of the Japanese stock market and we think that and, you know, the small cap, large cap effect and the Value Growth effect are at such extremes that on any decent time period you have to be in Large Cap Value. But we would say that wouldn’t we?

So at that point I’d like to hand it over to Warren and field any questions that you might have.

WARREN SHIELS: Thanks for the update Steve. Steve, the first question we have is trade wars are making headlines. What impact could these have on the fund?

STEVE HARKER: Trade wars, this is all really complicated and I suspect that what’s happening is that we’re seeing a lot of noise and a lot of negotiating going on. The manufacturing sectors, machinery, chemicals, whole range of manufacturing industries in Japan have had a really difficult time over the last four months. You know, we’re basically underweight in manufacturing. We’ve got some steel, we’ve got some autos but we haven’t got lots of other things. And, you know, we stripped out a lot of manufacturing stocks in ’16, ’17 and early ’18. We’ve reduced our exposure dramatically to the economic cycle. My feeling is that, you know, this is much less to do with Trump and trade; it’s much more important to look at US interest rates. Two-year treasuries are at 3% and the 10-year yield is at just below 3% so the yield curve is flat over that two-year, 10-year spread. You must not underestimate the potential that that has for affecting both asset prices and economic realities. And I think the weakness of cyclicals over the last four months is probably more to do with that rather than any noise on the trade front.

WARREN SHIELS: OK that’s great, another question. This morning a well-known Growth manager has declared Value is so 20th century. How would you respond to the statement?

STEVE HARKER: What’s really interesting is that in the 21st century so far, Value has outperformed Growth by 150% in Japan and in the last three years in the 20th century Value was shockingly weak, ‘97 to ‘99, so I’m not quite sure which part of the 20th and 21st century he’s talking about. But I think we’ve been through these periods before when Value loses and the more that Growth wins the more Growth managers bang the drum for Growth and I would just, you know, we’re staying calm and I would encourage everyone else to stay calm. I think the opportunities for investment in Value have probably only been better than this in July of 2016. I think Value stocks are extraordinarily good Value. And I obviously can’t say anything about the future but my instincts are we’re going to be fine.

WARREN SHIELS: OK that’s great Steve. We’ve only had two questions this morning so that concludes the Q&A session for the update. Finally on behalf of myself Steve and the Man GLG Japan CoreAlpha team would like to thank you for your continued support and for listening to this quarterly update, thank you.