Man GLG Undervalued Asset Fund & Man GLG UK Income Fund

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  • 19 mins 59 secs
Henry Dixon, Portfolio Manager, gives an update for the Man GLG Undervalued Assets Fund.

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RICHARD PHILLIPS: Good morning everyone. My name is Richard Phillips and I’d like to welcome you to today’s UK equity conference call with my colleague Henry Dixon. Henry is going to cover his outlook for UK equities, which includes both the undervalued assets and the income fund, and at the end he’ll spend a little more time on the income fund and how it’s managed slightly differently. So enough from me we’ll go straight to page 3 and I’ll hand over to Henry.

HENRY DIXON: Thank you very much Richard. We’ll just start with how we felt actually a year ago and then give you, work through the slides and we give you how our outlook for 2018 is. A year ago we felt that as we sat down at the start of last year that historical analysis of currency devaluations which have clearly happened in the wake of Brexit encourages us to challenge the pervasive bearishness that engulfed the UK. As stock pickers I think really pleasingly this is also went hand-in-hand with some very depressed expectations. And I think the latter point is very crucial because I think value at any given moment in time is to some extent a quantifiable statistic.

But when it’s married up with very low expectations that can be beaten, that typically is when some of the best outcomes are achieved within the stock market. With regards to overseas earnings, we noted the fundamental value of sterling, and we’ll come on and give an update there. We therefore felt it was very important to concentrate on operational excellence rather than just translational gains. And then finally I think as ever our hope was for a slightly more elevated bond yield environment because this typically brings a sharper focus to valuation and balance sheet which suits the funds given its better value metrics and also very definitely better balance sheet characteristics.

Just with regards to the UK’s economic performance, I think it was not as bad as feared but it was clearly a laggard as measured against the G7. I think as we looked domestically they’re also some notable, quite big disappointments at the stock level. But within our fund actually we did manage to shield ourselves from some of the most notable disappointments at the domestic level. And as we turn now to the next slide we can give you some of our big contributors to the fund. We start here with the income fund and we just give you our top 10 contributors in basis points. We also give you two further items of information, namely EPS momentum throughout the year and also the starting valuation a year ago.

I think as we look at the sort of the average line at the bottom here I think very simply we’d observe this was a collection of very cheap shares, less than 10 times earnings. They managed to give you a 15% earnings upgrade which contrasted with the market that gave you only a very modest earnings upgrade. And then we’d sort of pull out some domestic contributors here. Conviviality being our best. We actually wrote to investors in September informing them of this decision to sell the position in Conviviality, Morgan Sindall, Watkin Jones, some house builders as well, and also a brick company in the form of Ibstock. But as I say very definitely we had that pleasing combination of low valuation and good earnings momentum.

Moving to the value fund contributors, there are a few differences. I might highlight Wizz Air and KAZ Minerals as being two contributors to the value fund that weren’t present in the income fund. These were both positions that made their way from the undervalued assets portion of the value fund which did not have a yield of at least that of the wider market which therefore precluded them from the income fund. But once again it’s very similar characteristics with the value fund here, the starting P/E of our top 10 contributors less than nine times actually, slightly cheaper, slightly better estimates for momentum, and again as I say with regards to the domestic shares that featured prominently, we’d highlight again Conviviality, the house builders and [unclear 0:03:32] both brick companies in the form of Ibstock and Forterra.

With regards to overseas earnings, you can see that commodities played a reasonable part in the fund. And here we show you purchasing power parity analysis of both sterling against the euro on the left-hand side and sterling against the dollar on the right. With regards to the fundamental value that has been exhibited by sterling, this is a very wide basket of goods which tries to ascertain simplistically the value as measured by well over a thousand items and very simplistically where you should go shopping bid, in UK or Europe on the left-hand side or here in the US on the right-hand side. And we can see that the sterling towards the end of last year really got to about as cheap as we’ve seen against the euro. Not quite the cheapest we’ve ever seen against the dollar. That would have been in the mid-80s but again really representing the right side of fair value against the dollar.

Over the course of 2017, sterling did actually manage to find some form against the dollar and strengthened by about 10%, but clearly it’s still been quite subdued against the euro. But from that perspective of the weak dollar, that very definitely helped us with regards to resources which were a key notable feature as well within the funds, and we’d highlighted to our investors at the end of the second quarter a reasonable move within to the mining sector and at the end of the third quarter we also moved very heavily into the oil sector.

Coming onto these two sectors now, we just really wanted to sort of highlight why we made the investment decisions we did at the end of the second quarter in mining, at the end of the third quarter in oil, and as we sit here today how we feel about those sectors going into 2018. Just as we look at the left-hand side and we use copper as an example of the trends we saw throughout the year. We saw a bit of weakness in the copper prices. Some sort of concerns started to vest themselves about the Chinese economy. That also went hand-in-hand with weak share prices. But what we started to see was very definitely some reasonable copper price strength into the end of the second quarter and into the third quarter, and this also married itself up with quite a conservative set of analyst assumptions. So you can see that analysts were significantly below that spot market in copper, and this was also seen further round to the forward curve and also across a number of industrial metals.

So we had the opportunity there to visit the mining sector on a single figure P/E with balance sheets in many situations scaling toward net cash, and actually as we sit down at the start of this year, we still think there’s a very meaningful amount of analyst backwardation that exists in the mining sector. That’s to say that analysts do look cautious relative to the spot in the forward curve. And also it’s fair to say as judged by capex, depreciation trends that we observe in the mining sector, companies are also being cautious with regards to their capital allocation decisions. And it’s fair to say that these capex/depreciation trends are probably the most conservative that we have seen. And as we go back and look through history at moments in time when the mining sector’s been investing this little, it typically does translate itself into buoyant metal prices and also very good share prices.

With regards to the old market on the right-hand side of this chart, we saw a situation which really was the first moment since the first half of 2014 where analysts finally got themselves below the spot in the forward curve in oil. As I say it’s been slightly over three years since we’ve had that phenomena, and that was a good catalyst actually for share prices to push on in the realms of about 20% in to yearend from August onwards. In aggregate over the year, the oil sector was of notable disappointment with regards to earnings. But as I say it will improve materially from the low point seen at the end of July when downgrades in year as much as 25%. And actually the sector ended the year with some very notable estimate progression and again, not to quite the degree within the mining sector, and we’d also observe that balance sheets aren’t quite as strong in the oil sector but we definitely have a situation where analysts look cautious relative to the spot in the forward curve.

Moving in aggregate to the all-important inputs of earnings and debt, 2017 was a year which a lot was expected of it with regards to earnings. As we sat down on January 1st of 2017, we were looking for slightly over 20% earnings growth, which to our mind felt like something of a stretch. I think in no small part we’d say that that’s because we very definitely disagreed with oil inputs as they were at the start of the year. And also if sterling was to find some strength against the dollar then that would also be a headwind. But the 20% earnings growth which we were hoping for was achieved which is a good thing.

Far more concerning, in my opinion, is at this point in time it feels though net debt is really only going to have fallen modestly year-on-year. This is hugely disappointing in our view. Three very valuable building blocks to get net down should be earnings growth, which we saw, the strengthening of sterling against the dollar, which will have positive translational effects for all debt denominated in dollars, and finally we shouldn’t forget that we had two sectors very definitely in debt, apology mode, in the form of mining and oil. However, beneath the surface is what you want to go in to the trends that we’re seeing within net debt within the market. Because as I say it is our one disappointment in a year of great earnings growth that net debt did not fall in the UK market from what we can observe is really quite a high level.

With regards to earnings in 2017, we show you three lines here just to give you the evolution that we saw in earnings in 2017. Here that blue line, bottom left-hand corner, you can just see where the 2016 number ended at approximately 222 index points when the All Share, so put that into the context for the All Share slightly over 4000. You can see the 2017 number quite a bit higher than where we finished 2016, talking to that 20-22% earnings growth we were hoping for, but you can see that the picture was incredibly calm throughout the year which definitely contrasted to the gyrations that we saw in 2016.

As we look out to 2018, the observation we’d like to make is that that red line relative to 2017 has actually compressed quite nicely. And so as we sit here now, we really are only expecting sort of mid to high single digit earnings for the UK market. This is a very undemanding number relative to history. Typically, it’s the case that about 12-14% earnings growth is expected in any given year. And so to have it in the range of 6-7% is actually very undemanding and it’s probably as realistic starting point that we can find for earnings growth in any given recent year. And as I say I do think so much of what we do does relate to expectations, and it’s these low expectations that hopefully gives us a reasonably easy hurdle to beat.

Typically beneath the surface there was a hell of a lot going on with regards to earnings in the year. We highlight the big disappointments on the left-hand side and the beats relative to consensus at the start of the year. Maybe if we just come on to some of the disappointments here. Healthcare equipment was actually the most disappointing sector. That was slight operational disappointment that Smith & Nephew combined with the translational disbenefits of a weaker dollar. Oil and gas, we came on to in quite a bit of detail above, but as I say it’s materially improved from where it was at the worst in July. And maybe if we look at some of the winners: IT Software’s a notable one. That is very definitely deal-led by Micro Focus. Industrial metals and mining’s featured again. House builders I think very definitely climbed the wall of worry. And mobile telecoms, to some extent, is at the other end of the spectrum with regards to currency translation because the euro did remain very strong, and that talked to a slight earning’s beat at Vodafone.

Elsewhere with M&A activity in mind, tobacco was another notable contributor with regards to earnings at the start of the year relative to the end of the year. But we would note that this came at quite a heavy cost to the balance sheet. And we’ll come on to balance sheets now in more detail.

As mentioned earlier, we were disappointed that net debt couldn’t fall in a more meaningful manner in the market in 2017. There were two sectors as we noted who were really apologising for capital excesses of the past: namely the mining sector and the oil and gas producers. As we look at the top half of this chart, we can see the three sectors that really increased their net debt in quite a meaningful manner. We’d highlight tobacco here, which was deal-led, both companies involved; household goods is Reckitt Benckiser, who clearly carried out quite expensive M&A in the US; and then also personal goods with regards to Unilever in no small part being in bid defence given its approach they received earlier in the year. But these defensive sectors are more than offsetting the debt paydown that we’re seeing in other sectors in the market. And as I say I do therefore think that we just need to give some thought to the defensive sectors if valuations are ever higher and balance sheets are being put under more duress, I think to some extent we maybe need to question the validity of their defensive nature.

With regards to interest rates, I think it would probably be remiss not to comment on the first interest rate rise in 10 years in the UK. And here in just a very numerical manner, we just highlight six data points with regards to, data points as they sit with the latest rate rising Q3 of 2017 and when the rates were last raised in Q3 of 2007 to a level of 5.75%. I think the point we wanted to make here to some extent is that the economy in many ways just judged by these simple metrics feels very much stronger today than it did in Q3 of 2007. And so as I say with regards to the rate narrative, it seems to be that to some extent half a percent seems to be unmanageably high. And we very definitely just want to sort of leave with you that that to some extent is something that we think could probably start to be challenged as we go through this year, and also it's clearly starting to unfold the different narrative in the bond market.

Our final point on 2017 is that it was a year of synchronised global earnings growth. As we go away and look at these periods of times when earnings have grown in a synchronised manner globally to break an earnings downtrend, we come up with three periods of time. The first would be 1993 and ’94. We’d then get to 2003, 2004, and then finally we get to 2009, 2010. And if we go away and try and come up with a common denominator of those periods of time, we would come up with four consistent messages from history regarding synchronised global earnings. The first is to say that the earnings story has longevity beyond a year; the second is to say that oil prices rise; the third is to say industrial metal prices rises; and finally bond yields rise as well in all those instances. With regards to the narrative that was playing out in the market towards the backend of last year, it very definitely did unfold with the earnings story continue to pace with regards to earnings growth and also upgrades. Oil prices and metal prices were clearly strong, but the bond yield environment remained very subdued.

January I think has seen a noticeable change in trend in the bond market, with regards to the US 10-year you’ve seen the yield rise from 2.4 to 2.7% which has encouraged some to make comments around the longevity of that bull market. But it is quite clear now that bond yields do seem to be placing some pressure on the equity market in aggregate. And while of course bond yields when they rise will our searching questions of both valuation and balance sheets, we do think they’re very definitely some areas of the market which actually really definitely enjoy a rising bond yield environment. And here we highlight life insurance and also the non-life insurance sector as well. But it very definitely I think talks to cheap financials potentially at the expense of expensive defensives where balance sheets might be placed under ever greater pressure.

Moving quickly to the income fund and just I think talked about this in some detail, it is very definitely an extension of the value process we use in the undervalued assets fund. On the left-hand side of this chart you can see that it’s slightly over 70% of the income fund is the undervalued assets process where the yield is at least that at the wider market. Further to that there are two strands to the process which you could argue are new. The first would be strong dividend growth where we try and isolate excess free cashflow yield. And we’ll come on to a matrix to say how the market looks to our eye with regards to how we’re trying to harness better balance sheets and superior free cashflow. And then finally also sparingly we will invest in bonds. But we’re very definitely adamant that we want both capital upside as well as attractive running yields. So that is to say we’ll only invest in bonds where we see the opportunity below par.

Moving to dividend growth stocks, we show you the FTSE 100 and the constituents of the fund from this dividend growth portion of the portfolio on two basic but I think very relevant measures. The x-axis here is net debt or net cash on the right-hand side as a percentage of market cap and the y-axis is the free cashflow yield. Overall the UK market on average is almost sort of 25-30% of market cap in net debt and it’s about a 3-4% free cashflow yield. And just within the fund here, we pepper the top right hand corner of this chart. What we’re looking for is excess free cashflow coming from the basis of a superior balance sheet starting point. And we hope that this can very definitely translate itself into a dividend surprise. This will clearly assist dividend growth within the income fund but also we hope very definitely provide capital upside to the shares that we own.

Within the bond portion of the portfolio, as mentioned we’re looking for capital upside as well as attractive running yield. We do have the opportunity to look slightly further afield in both funds and here we give an example of a Norwegian oil company. This was an oil company that in the second quarter of last year was transitioning to net cash; yet we had the opportunity at the start of last year to pay 90p in the £1 for those bonds. The coupon was 8.75. And it’s very definitely these types of opportunities that we’re looking to put within the fund, potentially it comes from a starting point of a little bit of a fallout within the market and clearly there is an overhang in the oil market with regards to events in 2016, but where we can see equity value in the issuer that we can analyse on the market and we can access that equity value from a discount to par in the bond structure, then we’re very happy to do so.

Bringing it all together with regards to the dividend history of the fund, we’re pleased that the dividend growth has been strong relative to the sector. And indeed it was in 2016 that the fund actually got readmitted into the sector. But the big move that we took in September of 2017 was to move from semi-annual distributions on the fund to monthly, and it is our intention to give 11 flat payments throughout the year with all income paid out at the end of the year. Our confidence in moving from semi-annual to monthly I think was derived by two points. The first is to say that the yearend for the fund is February and all income has to be paid out on the first business day of March. But as we look out to March, April, May and June, this is a very rich moment of the year to accumulate dividends. And it was this shape of the dividend structure from the UK market that encouraged us to move to monthly payments.

Finally with some statistics on the income fund we show you some performance statistics on page 20 but I think very much more importantly we give you some value characteristics of the fund on page 21. We give you the split of the fund by weight and where the dividend contribution comes from across the three strategies, and we then give you some valuation data points for the undervalued returns portion of the existing process, the undervalued assets. We also strip out our real estate as well. Finally, we give you our dividend growth statistics, again on P/E and yields, but we also show you our free cashflow yield characteristics as well as the amount of net cash as a percentage of market cap on average. And finally we give you the prevailing price of our bonds and their running yields. But as we sit here today the trailing yield on the income fund is about 4.4%. And we will update investors in March, our intention of the growth in the monthly dividend as we look out for the rest of the year.

Many thanks indeed for listening and we’re very happy to take any questions.

RICHARD PHILLIPS: Thank you. I’ll just go with what we have already Henry and the first one is are earnings expectations really that conservative when you factor in the rebound in the pound and the negative impact that will have on earnings?

HENRY DIXON: It’s clearly a very good point. As we sit here today, we have not seen earnings come under pressure. In my opinion there is about, as I look at it about 15% of the market that has not had those modest dollar downgrades reflected in their assumptions. But as I look at it on a market cap aggregated basis, there’s still nothing to call into question UK growth expectations being hit, and that’s to say given the analysts backwardation that does exist in mining and oil, and is actually starting to be written back, we still actually sit here today, early February, with slightly more earnings than we started the year despite the rise in the sterling.

RICHARD PHILLIPS: Thank you Henry. That looks like all the questions we have for today, so thank you very much for dialling in and we look forward to speaking to you later on in the year, thank you very much.