Man GLG Undervalued Assets & Man GLG UK Income Fund | March 2019

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  • 26 mins 10 secs
Henry Dixon, Portfolio Manager, gives an update on the Man GLG Undervalued Assets & Man GLG UK Income Funds, and discusses his outlook for the remainder of 2019, the key contributors & detractors, trading activity and Brexit uncertainty.




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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 update with my colleague, Henry Dixon. As you all know, Henry manages the undervalued assets fund and the UK income fund, and he will cover both of those this morning, as well as his outlook for UK equities. Henry will speak for around 25 to 20 minutes, which will then be followed by questions. If you do wish to ask a question please click on the tab at the bottom of your screen, send it in, and I will read those out to Henry at the end. As ever there will be a replay and a transcript available over the next week, and these will be sent to you automatically. So that’s enough from me, I’ll hand straight over to Henry.

HENRY DIXON: Thank you very much Richard and good morning everyone. Perhaps it’s a little retrospective to start with our outlook for 2019 by going back and looking at 2018, but we do want to make the point with regards to 2018 that it did represent something of a record year.

So if we look at page 2, the record was set by a function of the gold line starting bottom left and ending top right, and we show you this earnings line in the context of index points in the context of the All Share index. But starting on Jan 1 we’re expecting 286 index points of earnings from the All Share. We ended the year with over 325, mid-teens growth. But you can see the blue line there, the All Share, very unhappy for vast majority of the year. And the record that was set in 2018 was that earnings growth figure of mid-teens for the negative return of circa 10%. With regards to the history books, the closest we can find to this is if we go back to 1990, which was a year when earnings growth was 10%, and the market also fell by circa 10%.

As a result of that quite notable disconnect between earnings and the market move, what we had in 2018 was quite a notable derating. Here we show you the five worst deratings going back to 1986. The worst derating was registered in 2008. The definition of a derating here is the ending P/E on one year forward earnings relative to the starting P/E on one year forward earnings. The next worst derating was seen in 2002. Here we entered the year reasonably expensive as a hangover from the tech boom of the late ‘90s, 17½ times earnings. It would end the year at nearer 13 times earnings. 2018 was the third worst derating. And as we look at 1990 and 1994 we’d observe slightly cheaper markets, but it was very definitely a case that bond yields in those years definitely actually showed quite a bit of upwards pressure.

So for example in 1990 10-year bond yields in this country had risen from 9% to almost 12%. And in 1994 bond yields rose from 6% to nearer 9%. As we look at these five worst deratings, clearly we have a historic example of what happened next with regards to four of them, and the message from history very definitely with these magnitude of deratings is that the P/E tends to be higher a year later, and if you layer in some earnings growth, which is not always the case clearly, 2009 for example did not register earnings growth, but on average, as we look at these four historic deratings, the total return the year after is 24%.

Moving to page 4, we also show you what I think is quite a statistically significant starting point for valuation for UK equities as we can into this year. As mentioned and looking at page 2, you can see that the P/E on the market had fallen from about 14 times to nearer 11.2 times. And here we just show you on page 4 the 10 instances where valuations had been less than 11.2 times going back to 1986. Nine out of 10 of these are positive, the only one that was a negative was the 2011, which was a year characterised by Arab springs in the first half, London riots in August, and quite a bit of European concern definitely filtered into markets by September. But again the average total return in these years of valuations below 11.2 times earnings, which is where UK equities found themselves at the start of the year, is 15%. So very definitely with statistics in mind it was a very strong starting point as we started the year with regards to valuation.

If we come onto performance now on the fund on page 5 to the end of February, the value fund here, the undervalued assets fund risen by 9.6% relative to the All Share total return of 6.6%, clearly quite a strong start to the year. And in the main I think it’s valuation that has driven this return, and maybe to some extent an absence of negatives that many feared, which we can come onto in more detail. But clearly we do need to put this performance year to date into the context of 2018, which is the fifth line up from the bottom. Clearly that was a disappointing year for the fund falling 11.5% relative to the 9.5% fall for the index.

If we move to page 6, we tell you the key contributors and detractors to performance thus far in 2019. So this is to the end of February. What we show you here is our best performer in the fund has been Grafton. Grafton is a building supplies business, a little bit like Travis Perkins and the like. It started the year on 10.3 times earnings. The recent full year results did deliver the upgrades to forecasts. In no small part the company is enjoying its footprint in Ireland, which is definitely to some extent disconnecting from the UK. But a very well-financed business with very modest debt, cheap valuation, and as I say crucially what we’ve also seen from the company is earnings upgrades. And as ever we find that that earnings upgrades piece is so important for value to be delivered in a share.

Second best performer for us has been the UK brick manufacturer Forterra. It started the year on 8.3 times earnings. Brick inventories are very low relative to history and imports are very high. We think those two factors definitely provide quite a bit of a cushion to demand in the event that there was any weakness. And as mentioned we think the starting valuation of circa eight times earnings was very attractive. And then finally our third best performer here, Hunting, big disappointment for us in 2018. It delivered unbelievably well with regards to its earnings. Delivered very good earnings upgrades, but really failed to register any meaningful performance last year. That disconnect meant that the shares started the year on circa 10 times earnings. Net cash was approximately 10% of market cap, so again you could walk down that valuation even more to circa nine times, and that’s actually delivered us some very good performance as well, and just to be clear where you see Vodafone and HSBC that’s a function of underweights contributing to relative performance.

If we quickly touch on some detractors, I guess our big disappointment has been Chemring, which continues to suffer in the wake of a fire that they registered in one of their facilities last year, but otherwise I think some of the detractors have been much lower than we look at the figures on the left-hand side. And this has driven the outperformance of the strategy thus far in 2019. If we now move to the income fund, again just on the top line, the income fund is modestly ahead of the index 8.5% relative to the index at 6.6%. It has clearly lagged the value fund thus far this year. But I think if we maybe look at the slightly differing performance of the fund, probably it’s best exhibited in 2018 when the fund actually outperformed the index relative to the 2% lag from the value fund. And it outperformed by slightly over 2% in 2018. But clearly I think if you see what I mean, with regards to that performance and bettering the index in 2018, perhaps it has led to a slight lag relative to the value fund in 2019.

Crucially, with regards to the dividend, and move to page 8, we show you the historic dividend track record of the fund to the year ending February. That is the year end of the fund. When we did take over the fund it did find itself outside of the income fund index. And very definitely we wanted to get it back into the income fund with a yield greater than that of the market. Another decision we did take approximately two years ago now is we did feel we should move the dividend distribution of the fund to monthly. And the confidence that we had in moving the dividend distribution to a monthly distribution was a couple of things.

Firstly, the February year end of the fund is very well timed. Because what happens, because it’s a unit trust we cannot reserve our dividends outside of the year, we do have to pay out all our income in-year. But we very definitely can smooth payments to you during the year, and I’ll come on to provide you more detail on that. But, as we enter that March, April, May period, which is the start of the year for the fund with regards to dividend collection, we very definitely enter a bit of a rich seam of dividend collections on the right-hand side of page 8. And it’s definitely in the first half of the year we almost get two thirds of the yield from the market.

On page 9, we actually give you some more detail on the dividend distribution from the fund, and here we show you what we delivered you to the yearend February 2019. You can see it’s our intention to give you 11 flat payments from March through to January. These payments are payable on the first business day of the next month. And then there is a bigger dividend that we provide you on the last month of the year, which is payable first day of March. In aggregate the fund delivered you 6.62p of earnings. The price for the fund, the distribution class that is, was almost 126p, which provides you with a trailing yield of 5.3%. And it’s very definitely our intention to grow the monthly distributions to you this year by 10%.

Moving to page 10, we will show you the split of the fund across the processes, and we’ll also give you some valuation data points at each every one of these strands. The process of the income fund is threefold. Firstly, we use the existing process of the undervalued assets fund, but we set a yield criteria at least that of the wider market; this portion of the process accounts for slightly over 60% of the NAV of the income fund. The second element of the income fund is the area of the fund that we target for dividend growth. Here we try to isolate superior free cashflow trends and superior balance sheet trends, and that forms almost a third of the fund. And then finally we do have a portion of the fund that we put over to bond investments, and our checklist to be invested in bonds is threefold.

Firstly, there must be a listed equity that we can analyse. We must come up with a view that that equity has equity value. And then we must be able to access that equity value by going up the capital structure into the bonds of that company, but crucially we will not forego our requirement for capital upside. That means we need our bond investments to be in the low 90s as a minimum in order to provide us with capital upside akin to equity, but also very attractive running yield.

In order to give you a feel for the valuation of the fund, we split out these processes on some key valuation data points. Our existing process ends February at about 10.6 times earnings, which is a pleasing discount to the wider market, which is in the realms of nearer 12. The yield on average is for 5½ I would say. If we move to real estate, what you’ll notice is our price to book is not hugely discounted. That’s to say we have not gone big discount hunting in some of the names that might be exposed to retail property for example. We’ve been very much happier to pay a tighter discount for our real estate names where we’re convinced that rents are rising, and we’re also convinced that the square foot value of each and every one of their square feet is very low indeed.

Looking at the dividend growth portion of the fund, again it’s about 10½ times earnings with a slightly lower yield of about 5%. But crucially it does have very strong balance sheet characteristics in the form of net cash, which is approximately 11% of market cap on average, and a free cashflow yield approaching 6%, which is very definitely above that of the wider market. And then finally with our bonds, at the end of February our average bond price, and there are currently seven bonds in the fund, it’s about 90p on average relative to part. That’s 90p in the pound. And as we just look at our coupons relative to that average price of 90p, the running yield from our bonds is 6.3%. So plenty of opportunity I think this year to deliver a yield in the high five ranges relative to the 5.3% that we delivered historically.

If we give you a feel for some trading activity in the income fund year to date, new purchases for us this year have been 888 Group the online gamer. It’s about 13 times earnings, cash equates to almost 20% of the market cap and the yield is slightly over 6%. We have also bought into an Irish bank in the form of AIB Group. It’s about 0.75 times of book value, which is attractive relative to some of the UK names we have, but crucially the capital ratio is one of the strongest capital ratios in Europe. And we very much look forward to that in the next year being returned to us in the form of both dividends and buybacks.

We have also added a bond to the fund this year: Phoenix Group bonds. We were happy to buy into that insurance company’s bonds in the high 80s with a coupon of almost 5½%. And then finally we’ve added Direct Line to the fund in January and February. The valuation’s slightly over 10 times, with a yield approaching that of 8%. Further to that our additions year to date have been both the tobacco names on approximately eight times earnings, with yields in the range of 8% as well. We have also been buying into Cairn Homes, the Irish house builder. Clearly that is a couple of Irish names on the buy side for us, but we did observe that the Irish stock market was one of the worst performing stock markets in 2018, and we therefore felt that it was clearly quite a fertile hunting ground for us with potential buy ideas.

Within the dividend growth element of the fund, we keep adding to Associated British Foods. It’s about 16 times earnings with a very strong balance sheet in the form of net cash, and we’re actually quite excited for the outlook for sugar profits within that business. Also been adding to Thomas Cook bonds in the 70p/80p realms, we have written to investors in December fact sheets to allude to this. And then also with regards to easyJet, we’re very keen to add to easyJet, where we believe easyJet today really trading below the value of its fleet.

With reductions in mind, John Laing, the infrastructure company, we’ve reduced quite heavily; since the start of 2018 it has risen by approximately 40%. Also having held our nerves in house builders last year, and definitely bought into the weakness that we observed particularly in Q4 last year, we’ve had quite a good run this year and many house builders in the region of 25 to 30% and we feel it’s prudent maybe to reduce our holdings there.

Also, with regards to the Fed put that potentially we’ve seen in America, some of our bond holdings have actually registered quite good performance. So we registered 10% couple upside in some of our bond holdings, and we feel it’s appropriate that we therefore reduced out holding in our Prudential bond. And then Ashmore, the emerging market fund manager, again perhaps with comments out of PAL. Emerging markets seems a bit more in vogue, but we’re keen to reduce our position in Ashmore as it approached all-time highs. And the outright sales that we’ve registered this year would be the housebuilder Persimmon, again after a strong run year to date. And then also perhaps fortunately we took the opportunity to reduce our holding in Centamin in January and sell it outright, and the subsequent update from the company has been disappointing with regards to production. So that looks fortunate at this stage.

If we quickly come onto three or four slides on outlook, and perhaps start domestically, it is clearly very observable that the UK is an uncomfortable and notable underweight in investors’ portfolios. And if we just very simply talk about the three planks of the UK economy, and we’ll start with the consumer on page 12. The jobs market continues to confound a lot of the sceptics. The recent jobs data that we saw just last week was very impressive indeed, with the amount of hires well ahead of expectation, and also wage growth in the private sector definitely approaching 4% now. But the job vacancies number we show you there on the bottom left-hand side, 850,000 job vacancies, and that was relative to an unemployed number of about 1.2 million.

The earnings growth as well is also starting to pick up. There have been moments when the private sector definitely registered some quite good earnings growth. So it was clearly hard going after the financial crisis, but private sector wage growth definitely came to life in 2014 and 2015. Very definitely then the referendum, I think Brexit uncertainty has hampered the private sector to some extent bottom right. But we’ve started to see convincing wage growth trends in recent months, and also a slight change in rhetoric from government regarding public sector pay as well. And then I think top right is the most crucial slide of all. Here what we try to capture is the year-on-year change in discretionary spending capability at the consumer level. We can definitely see quite a big spike there in 2009, which was all a function of the interest rate cut. And fortunately for us it was almost 75% of mortgages that day were on a standard variable rate. Therefore the transmission into economy was pretty rapid.

What we then unfolded in 2010, 2011, 2012 and 2013 was very difficult going for the consumer. Wage growth was elusive, there were some inflationary pressures. But things really started to align nicely in 2014 and 2015 with some wage growth more notably in the private sector, and definitely some deflation on our bills, so most notably the petrol price for example. But those sort of consumer trends we started to see a glimpse of last year in 2018, consumer trends were positive with discretionary income picking up, because of inflation falling and some wage growth. But the picture is set to improve as we think this year yet further, and it clearly is food for thought that in 2014 and 2015 with that type of consumer picture the UK was one of the fastest growing G7 economies.

The other key player, the second most important player in the UK economy will be the government. Here just on page 13 we wanted to make the point that the government to some extent with its finances is getting back to a position that we have not seen since 2002. And I think the key line for us here is that dark blue line, which shows you the current deficit. So the message from this chart is that for the first time since 2002 tax revenues in the economy more than covered day-to-day spending by the government, which I think does explain to some extent the end of austerity from a very fiscally justified starting point, rather than just a political narrative. As I say I do think this does point in a way to the view that the government is paying its way in the world, and therefore its stance with regard to public sector wages and perhaps more investment in the economy is appropriate. But if we go back and look at the recent announcements from the government, it’s very definitely the case that we think the government will now be making a net contribution to the economy this year. Whereas really for every year since the crisis it has clearly been a key part of the economy, but it year on year hasn’t made a net contribution.

And then finally on page 14, the last key player in the economy, which is much harder to analyse, will be business, and here we show you a disappointing trend of late in business investment. So you can see business investment rolling quite heavily towards the end of 2018. As I say it’s approximately five million businesses in this country. So to speculate about why they are not spending more is as I say mere speculation. But I think we clearly can observe perhaps some Brexit uncertainty. But who knows if the clouds will ever lift on Brexit. It’s fair to say it does remain elusive as we sit here today. But I think the food for thought that I wanted to leave with you today, should there be some more certainty on Brexit, should business investment return, I think it’s with a high deal of probability we think the government will contribute to the economy in the year ahead, and also the consumer position looks very promising. And all we would make the point is that the last time that we had all three of these key players pointing in the right direction, pulling in the right direction for the economy, was pre-crisis when we were growing at nearer 5%.

So by way of conclusion I would say there’s been a good start for markets in 2019, driven by valuation in the main, I think we have seen the removal of a threat of outside rate rises in America, which is clearly helpful for asset classes. There does seem to be some progress has been made on the trade dispute that very definitely occupied our minds in the third and fourth quarter of last year. It is fair to say however that Brexit’s progress remains elusive, but I think there are some good reasons for optimism regarding the domestic economy. The funds are modestly ahead of the index, and the final point we wanted to make is that the Man GLG UK Income Fund will target 10% dividend growth this year from a starting point of 5.3%.

Thank you very much for listening. Now I’m very happy to take some questions, and I look forward to speaking to you all in the coming months.

RICHARD PHILLIPS: Thank you Henry. Just a reminder, if you do wish to ask a question please click on the tab and submit it, and I’ll read it out here. Thank you to those who have already sent it in, so let’s start with the first one Henry. In December 2018 the UK equity market looked cheap, but given the reasonable rebounds so far this year, is it still looking such good value, or has it moved closer to fair value price relative to history?

HENRY DIXON: Yes, very good question. So we started the year on 11.2 times earnings. We’ve risen by about 6%. And earnings have been modestly downgraded this year. You’re looking at about a 1 to 2% downgrade in earnings. So if you work that through, the valuation on the All Share would therefore transition to nearer 12 times, which is a combination of the 6% price rise and the slight downgrade in earnings. Just to say that the vast proportion of the downgrade, literally 90% of the downgrade has been downgrade to the oil sector. But we’ve actually seen a much more buoyant oil price now, so it’s very much more poised with regards to earnings growth now in the year ahead. That’s to say I think many people who cut their earnings quite savagely for Royal Dutch and BP potentially need to reappraise those inputs. Sitting here on 12 times earnings we’d still observe the market is below a 30 year average of 12.8 times. So I still think that you could say UK equities represent absolutely value.

RICHARD PHILLIPS: OK. This is a question on the bond exposure within the income fund. What’s the duration of the bond exposure that you have?

HENRY DIXON: So there are a couple of perpetuals within the fund. So I do have a perpetual in Prudential, but that is actually the bond I reduced. I also have a perpetual bond in the form of HSBC, but again actually that’s had a very strong start to the year. And that’s something I’m reducing as well. Otherwise my bond durations are 2021 is when the Thomas, sorry, 2022 is when the Thomas Cook bonds will be called. 2021 is when the International Personal Finance bonds are called, and then other than that my longest duration is 2027. So if you piece that all together I’d suggest our duration, obviously very difficult for me to say what the duration of the perpetuals is, but they all have a call date in 2027. But I’d say the duration there on average, I’d feel comfortable quoting approximately seven years.

RICHARD PHILLIPS: Thank you. Right, the US yield curve has been in the news over the last week, so do you have any views on the US yield curve inversion, and a potential US recession?

HENRY DIXON: Good question, key question. It’s been, I can’t recall a time when I’ve had so many emails fill my inbox over the weekend and today regarding the inversion, I think the key thing on the yield curve to look at would be the two-year and 10-year. And at this point in time it’s clearly not that that has inverted. As we sit here today that is still not inverted to the tune of about 14 basis points so we acknowledge it’s close. But it hasn’t actually that key measure of two and 10 is not inverted. With regards to outlook for US recession, I mean it’s, I’m not going to sit here in the UK as definitely a bottom-up investor and try and come out with some sort of forecast for a recession. As I go through all the recessions in history, I would observe three common threads to the big recessions we’ve incurred in history.

One would be runaway credit growth, chronic overvaluation probably exacerbated by fraud. So that would explain 1873, 1907, the Great Depression, probably also closer to home in 2000 you’d say runaway credit growth, overvaluation, and your fraud would come in the form of WorldCom and Enron. And then with regards to the global financial crisis again clearly it was a case of runaway credit growth and quite a bit of overvaluation in the bond market. Personally I think the regulator is unbelievably alive to that as a cause of recessions.

Then you come onto two other recessions. Inflation would definitely be a key component in some of the big recessions we’ve seen over the last 200 years. As to where inflation will come from, that is clearly anyone’s guess. Maybe as a worker I would like to think that it might be labour that has some pricing power in the years ahead, but I’m definitely in financial services. That feels like a slightly curious comment to make. And then the third reason of historical recessions we’d have is fiscal austerity, which I don’t think we can completely ignore as a possible risk, because we do have clearly deteriorating government balance sheets. So if you were to ask me for my pick of the next recession I think it could be inflation led with labour having some pricing power, or potentially fiscal austerity. But that is a very of a historian and categorically not the view of a macroeconomic forecaster.

RICHARD PHILLIPS: Right, the next question is on size or indices, what are the prospects for the FTSE 100 versus the FTSE 250 and small cap?

HENRY DIXON: Sterling will dictate that a lot. And if we could envisage a scenario whereby sterling is stronger, then it will clearly work mostly against FTSE 100. And it will clearly be very much to the enjoyment of the FTSE 250 and small cap. With regards to how punishing sterling could be to the FTSE 100, I’d again just give you some numbers. So here we’ve got the FTSE 100 on let’s call it circa 12 times earnings. If sterling was to appreciate by let’s say 10%, then just translationally the FTSE 100 will lose approximately 7% of its earnings. So that’s to say even if the FTSE 100 just stays flat, the P/E on the FTSE will rise from 12 to 13 times. That is in line with long run averages of valuation, but clearly the 30-year period that I will talk to with regard to long run valuation was characterised by materially higher bond yields. And I would still see room for the FTSE 100 to rerate upwards from 13 times, because there’s still a reasonable amount of headroom to the FTSE World Index, which is nearer 15 times earnings. So there would still be room to make reasonable money, but in the event that sterling was stronger it would clearly favour the 250 and small cap.

RICHARD PHILLIPS: Wonderful, well that looks like all the questions for today Henry. So thank you everyone for submitting those questions and for dialling in. As I said earlier there will be a replay and a transcript sent to you automatically over the next week. But for now thank you very much.