RICHARD PHILLIPS: Morning everyone. My name is Richard Phillips. I’d like to welcome you to the UK equity update with my colleague Henry Dixon. Henry this morning is going to cover both of the funds that he manages: the Undervalued Assets and the UK Income funds. Both funds have had an excellent performance so far this year, and Henry’s going to update you on his current positioning for both strategies, as well as give you his overview of the market. Without further ado, I’ll pass straight over to Henry.
HENRY DIXON: Thank you very much, Richard, and thank you very much for listening. My name is Henry Dixon. I’m now part of a four-man team, and we run the Undervalued Assets and the UK Income Fund. We recently hired a new addition to the team in the form of James Holden, who has started very well.
Moving to a very important thing within the markets and just actually the estimates momentum that we’ve seen this year, I think it’s fair to say 2016 was a year characterised by a welcome return to earnings growth. And while we’ve seen earnings growth this year, it’s been a little bit disappointing with regards to upward momentum. Here we show you index points relative to the All Share, and you can see that broadly speaking it’s oscillated around the neutral starting point relative to the start of the year. We’ll give some more detail in the coming slides on the makeup of that. The only good thing I do want to point out is that at the start of the year and looking out to 2018, analysts were expecting some 10% earnings growth year-on-year in 2018 relative to 2017, and that has now normalised to nearer 6%, and I do think we look at estimates momentum now as being wholly more realistic than they have been for a couple of years.
Moving to the next slide, we give you a sector breakdown with the big moves within the market. There are two things that we want to draw out here. Firstly, there’s been welcome dispersion at a sector level with regards to estimates momentum. You can see the winners there and the losers. And actually it’s the case that if we look at it on a single stock basis, so stock by stock rather than sector weighted, actually there has been more shares giving you upgrades than downgrades. But, as we look to the lower band of this chart, we can see that the big sector, oil and gas producers, has been a very notable downgrade, and oil equipment services has followed, and clearly behind that you can see fixed line telecoms also been very disappointing with BT’s well documented issues earlier in the year to blame for that.
Turn the page to oil price expectations, I think there’s sort of bad and good news here. The first, as we’ve seen clearly from the last slide, is that there’s been some quite material earnings downgrades, but here we’re really bring the two building blocks behind that, and that is twofold. It is analyst expectations, and their expectations of the oil price, and the actual oil price. So here for example we show in the blue line where analysts have been, and broadly speaking analysts now for quite a period of time, almost two years, have been stubbornly high versus the spot and forward market for the oil curve, which is grey. But we started to see a pleasing closing of the jaws here, whereby analysts are getting very much more realistic, and also the oil price has actually started to show some momentum.
From our perspective as stock pickers, we have tried to therefore get more constructive towards the oil sector. We have partaken recently in an IPO of diversified gas and oil for example. On the continent we invested in DNO, which is a Norwegian listed oil company. And then also within oil field services in our most recent fact sheet we alluded to our investment in Hunting. But you should expect more news flow from us with regards to our views and how we’re going to express the oil sector between now and Christmas.
Given that earnings are actually slightly down relative to where we started the year, you know, in all things being equal, you might expect the market to be down, but it is modestly higher. I think a key reason behind that has been the demise we have seen in bond yields over the year. Bond yields in the UK touched as much as 1½% on the 10-year at the end of January, and fell towards 1%. The US also to some extent followed suit, although be it from a higher starting point. And then we might see towards the end of the period here in the bottom right of this chart something of a flurry of activity in the UK 10-year. We put flurry in inverted commas I might add, but clearly there has been a change of narrative and a change of trend in the interest rate outlook, and we wanted to discuss that in more detail.
Moving to the slide clearly it’s vested itself in a slightly stronger sterling. And what we would observe is we start to look at sterling now into 2018, if you think of year-on-year comparisons that we’re going to start comparing with at the start of this year - so at the start of this year sterling nearer 1.20 to the dollar is now comfortably into the mid-1.30s - that is very definitely going to affect quite a number of shares. And what we would observe is there are certain areas of the market that categorically are not growing on a like-for-like basis and have very definitely just benefited from translational gains, and I think some very stern questions will be asked of those shares and those sectors as we go into the end of the year and looking out towards 2018.
The interest rate narrative has changed. Invariably the feeling is that that is bad news to some extent in aggregate, but we just wanted to temper people’s pessimism towards the interest rate cycle and the possible effects there might be. And in order to do that we just share with you two bits of data. Firstly, we would share with you the breakdown of if you like the aggregated balance sheet of the UK economy. Here on the left-hand side of this chart on page 8 we show you core M4 deposits, in the blue bars on the left-hand side, and core M4 lending. These are the widest measures of both lending and deposits, but you can now see a situation whereby the UK economy actually has more deposits than lending.
And then also to express that deposit base as a percentage of GDP just on the right-hand chart here, it is now the case that over 100% of GDP of this country is sitting at cash in the bank. And clearly if we
compare that with the mid-80s when interest rates were 15% or as near as, it is rather depressing asset allocation decision in many ways given that interest rates today are 25 basis points, albeit rising. Now, what we want to say here that as I say in aggregate we feel that interest rate rises are very manageable for the UK economy, but clearly as active stock pickers it’s our job in order to sort the winners from the losers, and there will be both absolutely you can be assured of that.
The other area as well that I think the interest rate or the change of narrative around interest rates I think will be welcome, will be those companies that have suffered from pension deficits. Here, we just give you some data points on the size of pension deficits, and we just give you a few data points with regards to the amount of money that these companies are paying into their pension deficits on an annual basis. But it does look to us to be a significant economic drain. Almost 3% of GDP we would estimate is spent on topping up actuarial deficits, and clearly at a company level if BT for example wasn’t paying £900m to plug its pension deficit, it could be used to pay down debt, push on a dividend or improve its CAPEX spend. So as I say I think again we just want to observe that the change in interest rate narrative will very definitely bring about winners and losers.
As we move to our fund, we’ll very quickly just recap on the process, but simplistically from our perspective they’re just two types of shares that we look to put within the Man GLG Undervalued Assets Fund. The first would be those shares trading below replacement cost that are cash generative. And the second type of share if where we think the profit stream is undervalued. And here we would look to ally good value with earnings growth and estimates momentum. The first instance was share traded below replacement cost tends to be the best rewarded as you look back through historical data, and the most reliable type of share you’ll find within the market is those that are good value with earnings growth and momentum. And we hope that by combining the best rewarded with the most reliable that through a market cycle we can put a reasonable distance between us and the index.
Moving to the next slide, we just show you our valuation output on the FTSE 100 at the end of August. As I mentioned simplistic there, two pieces of analysis we do on every share we analyse. We work out how much money you would need to replace it. That is the Y-axis: price to replacement cost. And the profit analysis is the X-axis. So simplistically those shares on the left-hand side of the page are not as profitable as those on the right-hand side relative to their cost of being in business. And it’s a reasonably good correlation that the money you tend to make the higher up the page you trade.
We split this chart into three areas. Below the dark blue line is businesses that would be tough to be replicated, and as I say we very definitely look to expose ourselves to those businesses that we think are soundly financed and cash generative. The middle right triangle if you like is the area of the market that is cheap based on earnings. But here it’s absolutely crucial to combine good value with estimates momentum. So for example if you look across the X-axis and get to about 2.2 on the X-axis you’ll come to Provident Financial. Had I been here about two months ago, Provident Financial would have been a
good two units to the right if you like. And then also another share that I think observably while it’s been cheap but has been disappointing would be ITV, which has been a persistent source of downgrades. And we would to some extent contrast these with shares looking again into this zone of being good for the fund in the form of Direct Line, for example, and some of the house builders as well as Prudential, which have shown good value and also estimates momentum.
By visual comparison, as we move to the next slide, we show you our fund. We’re very happy to discuss any share that you see here. Every single dot relates to a constituent within the fund, but hopefully visually you can see very much better value based on more asset value, and also nearer that bottom right-hand corner, so that’s to say more asset value and more earnings. And it is absolutely our view that the fund is better value than the wider market trading nearer 12 times versus the wider market on 15 times earnings.
Moving to the next slide, we give you some feel for the contribution to performance this year, and just with regards to basis point contribution we give you our top 10 performers year-to-date to the end of August, and we share with you some data points. So if we start with Conviviality, for example, almost 1% has been added to performance from owning this share. The shares are up almost 90%. Interestingly actually the shares have not given any estimates momentum this year, but we were very definitely of the view that the share price performance was sort of overdue relative to the fantastic progress that the company did from a strategic perspective with regards to an acquisition last year, and also from a valuation perspective we felt the starting valuation was incredibly undemanding.
However, just on average, if we maybe look to the averages towards the bottom of the page, in a market that really hasn’t been able to provide much estimates momentum, very definitely we have been able to harness very good estimates momentum. So the average estimates momentum of our top 10 contributors this year would be a 21% upgrade year-to-date, which I think is statistically very significant; the starting valuation very undemanding of this, the blended number of these shares at nine times; and while there clearly has been a rerating, you know, still this portion of shares only trades on 12 times. But that’s not to say that we haven’t been releasing profits from this area, and I would highlight Conviviality now at 17 times earnings has just started very definitely to get towards the upper range of where we would want to hold those shares. And then also if we look into the middle of the pack and Hastings, very definitely we’ve started to release some profits from our car insurers as well.
On the next slide, we give you our top 10 at the end of August, and obviously our biggest overweights from an active perspective against the index, and our biggest underweights. As mentioned further to the slide, where you saw our portfolio on our two metrics of replacement cost and profitability, very happy to take any questions around any of the shares, and then as we move to the next slide we also give you the breakdown of the portfolio on a sector basis, be it overweights and underweights.
Now, as we move to the next slide, we wanted to bring out some sort of discussion around our sector bets
and also our stock positioning as well. And as we move to the next slide we just share with you some data points for the real estate sector. As you can see, the real estate is our biggest active overweight as a sector level. And here we share with you some statistics about the amount of rent one might be likely to pay, the capitalisation rate that is used in order to derive the NAVs, and therefore the valuation per square foot.
So, for example, as we look at West End offices, we can see the rent on average is about £120 a square foot. Because the West End is deemed to be a very attractive area, the capitalisation rate that that £120 is divided by is very low, giving you a very high capital value. And as we track this data down through the rest of the sector or some very notable portions of the sector, be it City Office, Canary Wharf, Dublin office, supermarkets, that would be out of town supermarkets, retail parks again out of town, logistics and light industrial.
Here we just highlight three areas that we really like within the real estate market. The first would be the Dublin office market. Here we just think that the rental outlook looks very positive versus the comparables of City Office and Canary Wharf. And we’d also look at the capitalisation rate of 5% being unusually high. It doesn’t look excessively high versus the city, but what it very definitely looks very high relative is to other European markets. So for example the Paris office market is nearer 3%. And simplistically I think there are three ways you can lose money in a property share, and that is rents go down, the capitalisation rate is too low and needs to rise, or you have too much leverage. In the Dublin office market, there is a huge confident probability from us that rents will rise. We do think the cap rates look high. And then also with regards to leverage it’s fair to say a huge number of industry participants are still very cautious given the size of the downturn seen in Dublin, and loan to value ratios are actually very low in a sector context.
Towards the bottom of the page, we also highlight two other sectors that we really like. Logistics I think it’s fair to say there is some secular change underway with regards to how we go about our buying patterns from a retail perspective. And we absolutely feel the outlook for rental growth in the logistics sector is all but assured. The capitalisation looks very high, and to think of these logistic hubs are being valued at less than £100 on a square foot basis looks very low to us relative to replacement cost. I’m not saying we need a plan B in this basis, but if there was a plan B you could very definitely get to an alternative use value argument at least in line with current values. And finally light industrial is probably the cheapest square feet going, comfortably below replacement cost. Rents are incredibly low, and I think it’s that low starting point that gives the outlook for rental growth as being very positive. The capitalisation rate looks excessively high, and as I say valued on average in an around £50-60 a square foot, that looks unbelievably undemanding relative to replacement cost. And the clear light industrial play that we have in the portfolio is Hansteen.
Other areas you’ll notice that Rio Tinto is one of our largest positions. Just in contrast to the oil sector, we’ve had a case where analysts have been pleasingly realistic about the iron ore price. And so as we look at this year you can see analyst assumptions for the vast majority of this year have been actually below
that of the forward curve - there the grey line - and so there was a fabulous opportunity whereby we could buy into the mining sector about two to three months ago, which we wrote to our investors about, whereby we were exposing ourselves to a number of single figure P/Es in the forms of Kazakhmys, Rio Tinto and South32.
With regards to price momentum, it’s fair to say Kazakhmys has been quite eye catching, and you can say that featured in one of our top 10 contributors. But we have therefore looked to harvest profits from Kazakhmys, but we have actually retained our holdings in Rio Tinto and South32, where we see unbelievably strong balance sheets. And I think from the perspective of strong balance sheets we therefore wanted to come onto the next slide to see what sort of valuation opportunity is on offer when we look at businesses on a more holistic basis with regards to their enterprise value.
So here on the next slide we show you Rio Tinto’s EV/EBIT - EV in this situation just the market cap plus its debt - but you can see that Rio Tinto really is almost as lowly valued at any stage since 2011 if we take account of its unbelievably good progress that it has taken with regards to its balance sheet. It’s not quite as cheap as it was in 2001, but I think we must never forget that in 2011 the wider UK market was on nine times earnings, and now it’s on nearer 15. So we do think that that looks to be a fantastic valuation opportunity, and it’s absolutely a balance sheet that we’re happy to own for the longer term.
And then finally on mining, here we just show you some reasonably long-dated data with regards to capital discipline within the sector. And while I always think the demand side of the supply demand equation is just an educated guess, we definitely look at the supply side of industries with a lot of confidence. And as I say it’s almost to some extent you can actually come up with some very hard and fast reliable data about the supply side. But what we show you here is that the supply side is probably as depressed as it has been at any stage in the last 30 years, with regards to the amount that companies are spending on capex relative to the depreciation.
If we look at two other moments if you like of relatively sparse investment in the sector, it was the mid ‘80s, and that very definitely sowed the seeds of a mining rally. As we look into the late ‘90s again, investment looked quite low relative to depreciation, and that sowed the seeds for a fabulous rally. But now we probably see as draconian a supply response that we’ve ever seen from the sector, and that very definitely I think does explain to some extent the more buoyant metal price environment we have been in.
Finally on banks, which has definitely been a slightly disappointing area within the market this year, but we continue to increase our exposure to banks, and we just wanted to share some analysis that we put in our half yearly document, which we sent to you. But on the left-hand side of this page, we just show you a simulated loss at a business called Aldermore, a recently IPO challenger bank. But what we just want to show you is the strides we think the banking sector has taken since the financial crisis with regards to improving its margins and improving its capital base.
So here on the data we start, we break out Aldermore’s balance sheet across the four sectors that it lends into, and we give you its balance sheet ratings. So there it’s almost £1.5bn worth is lent within asset finance. Our loss ratio assumption is we’ve gone and we’ve looked at data points from the global financial crisis to see what type of losses were taken in the years of 08 and 09. And as I say I don’t think we’ve held back here. We’ve gone to some pretty eye catchingly high numbers and some very eye catchingly poor shares during that period. So we’ve shown you the loss ratios taken by companies for example within those various business lines. But what we can find is actually the business is still profitable in an environment of a rerun of this scenario.
And so from our perspective we think the capital position is very much improved. We think margins have improved materially. As I say, we do think the banking sector is very definitely in a situation to weather a recession. And this might sound a very perverse comment indeed, but potential it’s our view that potentially we need to see a recession in order to rerate the banking sector, because I think it’s not until we see profits from the sector in a difficult economic period will we grow more confident in their outlook. And then to give you some historical comparison if you like of the bad old days, I guess we haven’t pulled any punches here but we’ve just gone to Northern Rock. But we would observe an unbelievable disconnect between their loan book and their deposit base. That is very definitely not a feature now. You’ve broadly speaking got the banking system fully deposit financed. Wafer thin equity, wafer thin capital and very thin margins with regards to their profit.
Moving to the next slide, we show you some performance data. Performance this year has been better, but it very definitely needed to be better to correct for last year’s lag versus the index, but we are pleased that actually our progress this year has been better than our lag last year. And clearly longer term the performance of the fund looks good.
As we move now to the Income Fund, there are three types of shares that we look to put within the Man GLG UK Income Fund. The first type of share is our existing process that you see within the value fund. And where the dividend yield is at least that of the wider market we are happy to invest within this portion of the fund as well. Further to that, there are two other types of shares that we look to put within the fund. Firstly would be strong balance sheets, and we’ll come on to a slide to show what we’re trying to harness here, but simplistically it’s superior free cashflow yield, and a superior balance sheet as defined by net cash. And finally there will also be opportunities for us to invest in bonds. Here our hurdle to invest is that we must have capital upside as well as attractive running yields, so that’s to say we like at outset to have shares trading below par, and as I say complemented that and the capital upside clearly bonds provide us with an opportunity to have an attractive running yield.
On the next page, we show you the split of the portfolio by the strategies, but it’s almost two thirds of the fund if you like is the existing value process where there’s a yield of at least that of the wider market, 25% of the fund is exposed to strong balance sheets, and we’ll give you some breakdown there, and then it’s 10% of the fund is exposed to bonds.
Just to show you a slide that we think hopefully shows you exactly what we’re trying to harness within our dividend growth portion of the portfolio, here we show you the FTSE 100 and our dividend growth portion of our portfolio on two simple but I think very important metrics. The X-axis on the left-hand side would be the portion of net debt you have relative to your Market Cap. And as you move to the right it’s the amount of net cash that you’d have on a net cash basis relative to your Market Cap. The Y-axis here shows your free cashflow yield, and the overall market average would be about 3-4% free cashflow yield with almost 30% of your market cap in net debt.
From our perspective and within our dividend growth portion, we just keep trying to pepper the top right-hand corner of this hand. We’re looking for superior free cashflow. What we’re looking for if you like is excess free cashflow. So that’s to say free cashflow in in the range of five, six, seven to eight, dividend yields, maybe, nearer two to two-and-a-half level, but if it’s complemented by net cash what you tend to find is that you will actually receive something of a dividend surprise and a very good outlook for dividend growth. So within the middle of this pack you might see a dot here relating to CCC. That would be Computer Centre, which very definitely I think talks to our notion of buying into cheap shares, strong balance sheets, good free cashflow, and about two to three weeks ago Computer Centre came out with some good results, and also news that they were actually going to repatriate more dividends than people expected at the start of the year.
Finally, with regards to the bond portfolio, we just give an example of a bond that we’ve had in the fund this year. Here, we show you a Norwegian oil company called DNO. The coupon on this bond was almost 9% and as I say we had the ability to buy this bond below 90 at the start of the year. The entry point I think was provided by oil gyrations and geopolitical concerns. But from our perspective what we had under very modest oil price expectations, we had a company that was forecast to end the year net cash. Also its onshore operations mean that its lifting costs, its cost of getting barrels out of the ground, would be very low indeed in a sector context. And we’re pleased to say that we’ve combined an attractive running yield that was almost 10% at the outset of the investment with some good capital upside as well. And those are absolutely the type of opportunities that we’re looking to put within the bond portion of the portfolio.
Finally, moving on to the dividend stream within the Income fund, the Income fund used to distribute semi-annually. So let’s say on March 1st we’d pay a dividend, and also September 1st. We are now looking for monthly distributions from October 2017 onwards. Now, what you can see with regards to our dividend payments, they have grown well over the years. We only grow our dividend by 5% into the year of 2017, and that’s because we wanted to some extent reserve some dividend payment as we move to our monthly distributions that will take effect from the 1st of October. The year end on the fund is February,
so that is the moment when we have to pay out all income in year, but we want to come out with 11 smooth dividend payments, and then as I say we’ll pay out all income by February. But as we look at the trailing dividend on the fund it’s almost 5.8p of dividend. The unit price on the Income Fund today is now about 125p on the distribution unit. So the trailing yield on the fund is about 4.8%. As I say, it’s very definitely our intention to continue to grow that. And finally, with regards to performance, again a similar story to the Value Fund, performance this year has been better. It very definitely needed to be better in order to correct for last year’s disappointment. And clearly on a longer term basis it looks competitive relative to the sector.
I will leave it there, but very happy to take any questions, and also please as always do feel free to email either me or Richard at a later date.
RICHARD PHILLIPS: Thank you very much, Henry. We’ve got one here already, Henry. Related to our Man GLG Undervalued Assets Fund, you’ve had a strong year, but how much value do you see in the portfolio today against December last year?
HENRY DIXON: Absolutely, so just to give you hard and fast today, we sat down at the start of this year with the Value Fund trading at about 11.3 times earnings. Today, the Value Fund is only slightly over 12 times earnings, so you could argue if you like it has rerated by almost 10%. So we wouldn’t want to get away that it’s not quite as cheap. We’d still however point at 12 times as being below long run averages for the market as a whole if you look at a 30-year average. And it’s clearly about a 20-30% discount relative to the wider market. And then also as I say if you dig beneath the surface it’s observable that the balance sheet of the portfolio as measured by net debt or net cash is materially stronger than that of the wider market.
RICHARD PHILLIPS: Thank you, Henry. That looks like all the questions we’ve had in for today, thank you very much for listening in, and we look forward to speaking to you again in the future. Thank you.
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