FOCUS - RWC Equity Income

Nick Purves and Ian Lance on the launch of the new TM RWC UK Equity Income Fund and why the turning point for value investing is already well underway

WELCOME

RWC’s Nick Purves and Ian Lance have been purveyors of value investing for more than two decades, and are one of the most established and successful portfolio manager partnerships in the industry. Purves and Lance reveal how a long-term approach to value investing has been key to helping them succeed during their careers so far, as they launch the TM RWC UK Equity Income Fund. They also explain in detail the ‘tried and tested’ investment philosophy that drives their fund’s concentrated portfolio of just 25-45 stocks, and helps them generate alpha by specifically focusing on identifying a company’s ‘intrinsic value’.

THE INTERVIEW

A dedicated and tested approach to value investing

Nick Purves and Ian Lance, RWC

Intrinsic value focus

Unlike many value managers, Purves and Lance do not follow a ‘deep value’ strategy, instead focusing on an ‘intrinsic value process’ which aims to preserve capital and growth. They aim to rotate to where they believe there is value in the market, buying and holding out-of-favour companies with improving fundamentals until share prices have recovered, at which point they sell the stock. According to Purves, the intrinsic value process helps smooth returns by avoiding expensive stocks during market peaks, and reducing drawdowns when markets subsequently decline. “Some value funds are ‘mechanistic’ and simply use a Graham & Dodd P/E analysis which uses average earnings to identify value. The problem with that of course is it can lead you to businesses in structural decline. In this day and age, that’s a risk that value investors have to be very aware of because of the disruptive technologies that are around,” he explains. "When we talk about intrinsic value we look to buy companies with decent balance sheets at around two-thirds of what we believe they are worth. We place a heavy emphasis on the strength of a company’s balance sheet because we accept that having bought a company early, share prices and profits may fall. But as long as we buy at a discount to intrinsic value and the balance sheet is intact, we hope that in the fullness of time the stock’s real value will be realised.” The fund managers are unlikely to be swayed by the macro or try to invest based on where markets are in the current economic cycle. Instead, they focus on the cycles of each stock. For example, if investing in a mining stock the managers will look to the commodity cycle for guidance or the credit cycle if investing in a banking stock. Lance says: “Intrinsic value is effectively the value of a business is when you normalise for the economic or business cycle. After all, many businesses can cosmetically look cheap on a P/E basis, but only because earnings are at a cyclical peak. When estimating a company’s intrinsic value we aim to look at the dynamics of the business and the industry itself. We want to find out if there is anything that the business can do to take out costs to improve its profitability and raise earnings from where they are today. Or, if ultimately it is just a business that is likely to succumb to the might of its biggest competitor.”

Veteran fund managers Ian Lance and Nick Purves are hoping to take advantage of current valuation opportunities in the market with the launch of the TM RWC UK Equity Income Fund. The duo, who manage circa £3bn of assets across a number of equity income strategies at RWC, have been purveyors of value investing for most of their careers and previously worked together on the Schroder Income and Income Maximiser Funds from 2000 until 2010. The pair can demonstrate a long track record: a mandate managed by Nick since 2000, and jointly with Ian since 2007, has produced gross outperformance of 3.1% p.a. since inception.(1) The TM RWC UK Equity Income Fund, due to launch 4th October, will search for value by investing in fundamentally ‘sound’ businesses that are out-of-favour and trading below their intrinsic value. This usually occurs when a company or industry experiences a temporary dislocation that investors overreact to. The launch of the fund comes in response to investor demand, with the notion of a turnaround in value’s fortune strong, following years of underperformance. Indeed, Purves and Lance believe the current overvaluation of ‘quality’ growth represents one of the biggest risks in the market. It is well known that investors tend to extrapolate trends such as rising or falling earnings. What investors forget is that, on average, growth rates tend to mean revert.” explains Purves. “Our experience of investing has taught us that nothing goes on forever and eventually trends usually reverse. As patient, disciplined investors we want to benefit from the opportunities that appear along the way. There is already evidence in the marketplace that suggests ‘value’ as an investment style has rarely been cheaper.” The importance of value as a style of investing has been further heightened by the fact many fund managers have shifted styles in recent years, resulting in a significant mismatch between managers’ stated style and a fund’s actual style as defined by its return pattern. Data shows a large majority of funds have - intentionally or not –aligned themselves to a growth style of investing over the past decade; leaving relatively few genuine value funds in the UK universe (see pie chart). “We have a market in which growth has outperformed value but the difference in valuation between the two styles is now at extreme levels,” says Lance. “Despite this, the majority of money in the UK is still being managed to a growth style.”

Stock opportunity

He refers to FTSE 250 listed Capita and one-time growth ‘darling’ as an example of a stock that fits the fund’s search for stocks at a discount to intrinsic value. Once widely regarded as one of the UK’s best growth industries, the outsourcing industry (in which this stock sits) had delivered high returns on capital and earnings growth for several years. However, the market did what it “always tends to do, and assumed that these good times would last forever”, says Purves. “Management teams often get used to delivering high rates of growth to the market and are tempted into making acquisitions to supplement falling internal growth rates. In most cases this only increases risk and complexity within a business. It can sometimes lead to a loss of control and an increase in balance sheet debt,” he explains. “This is what happened in the case of Capita. It wasn’t that long ago when it (alongside other UK outsourcers) was valued at over 20x earnings.” Yet Capita’s growth ultimately proved to be unsustainable. Following a period of share price decline and increased competition, its share price fell by 50% in one day following a profit warning. Despite the challenges facing the company, Lance believes the business represents a core value opportunity for investors today. “Once the ship has been steadied, it is a company that can generate a level of profit which will justify a share price that is significantly higher than where we are today,” he says.

Source: RWC / Bloomberg. Stated style reflects the individual fund’s documentation, actual style is classified through returns based style analysis

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. The names shown above are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or advice.

Fund Snapshot: TM RWC UK Equity Income Fund

The managers of the TM RWC UK Equity Income* Fund aim to continually rotate the portfolio to where value is in the market. This allows stocks to typically fall into three distinct categories (see right). Meanwhile, the managers also monitor and look to avoid three different types of risk, including: • Valuation - extrapolating favourable trends and paying more than the intrinsic value of the business • Earnings - the risk that the earnings of the company decline for cyclical or secular reasons • Financial - debts overwhelm equity holders whose interests are subsequently diluted down

Rotating to where the value is in the market

Model Portfolio: Top 10 holdings

Model Portfolio: Sector breakdown

Source: RWC, Proposed Portfolio. Proposed portfolio holdings are subject to change at any time without notice.

TM RWC UK Equity Income Fund – Model Portfolios

MACRO OUTLOOK

Unwarranted speculation

For Lance and Purves, the tug of war between value and growth that is being observed in the market today is something they have both experienced several times before in their 25-year plus careers, and explored on a wider scale when delving further back into history. In the 1960s a new age of disruption saw investors ditch value investing for high-growth stocks such as Xerox, Polaroid and Eastman Kodak – institutional darlings that were part of the ‘Nifty fifty’ range. Similarly, in the 1990s, value fell behind as investors sought growth in TMT stocks including Dell, Microsoft, Cisco and Intel. Dubbed the ‘four horsemen’, these stocks accounted for 55% of NASDAQ’s 1999 gains. This stock performance is eerily similar to core market disruptors such as FANGMAN – Facebook, Apple, Netflix, Google, Microsoft, Amazon and Nvidia – which in 2017 represented almost a quarter of the Russell 1000’s overall gains. Yet, in the past, many of these popular trades saw their valuations spurred higher by unwarranted speculation. Stories of their growth became so compelling that the notion of value became much less important. Investors ended up paying record multiples for growth stocks that failed to line up to their high expectations. “One of the ‘hot’ stocks of the dot com boom was Sun Microsystems which investors, just like today’s growth stocks, were so desperate to own that they bid the stock up from $10 to over $60 in 1999. They then watched with horror as it crashed back down to $5 the following year,” recalls Purves. “At the peak, investors were valuing the stock on ten times revenues (similar to Facebook and Netflix today). Today, given their lofty valuations, it would appear the FANGMAN stocks are going to dominate the world and therefore any valuation can be justified. However, people thought the same about the Nifty Fifty stocks.”

Regime changes

Lance and his co-manager of the TM RWC UK Equity Income Fund, Nick Purves, believe the trend towards quality growth over the past decade has been driven by the fact many investors sought growth in a world of secular stagnation, and monetary policy initiatives such as falling interest rates have allowed growth stocks to thrive. However, Purves notes there are now signs that the regime that has existed since the financial crisis is changing, particularly with the onset of quantitative tightening and the normalising of interest rates in the US and UK. Markets are reacting to these changes. For example, the Federal Reserve’s actions to shrink its $4.5trn balance sheet resulted in the US 10-year Treasury bond yield – an asset often likened to behaving in a similar way to growth stocks – rising at an alarming rate. Previously such rises have only ever been associated with financial stress and risk-off events – or, crucially, when value investing has done well. “As and when the profit cycle peaks, we believe it might present an attractive entry point for the contrarian minded value investor,” says Lance. “This is because as the cycle peaks, companies that have been pulling out all the stops to keep earnings growth going often begin to struggle and have to re-set profit expectations. This can lead to a sharp price decline, sometimes to a change of management and strategy, and occasionally a financial restructuring as well. As Warren Buffett said: ‘Only when the tide goes out do you discover who has been swimming naked’. We believe that as the cycle rolls over, more than one bare backside will be exposed in the corporate world.”

Since the start of the US stockmarket recovery in 2009, growth stocks have been deemed the ‘place to be’. Ultra-low interest rates and ongoing central bank support for close to a decade boosted markets significantly, and pushed investors towards those companies that had the potential to grow faster than the market. It is no surprise therefore that growth stocks have outperformed most other styles of investing and is currently experiencing one of the longest rallies on record. Yet the continued - at times unjustified - rise of growth in recent months has begun to concern some investors. A deeper dive into the fundamentals of this sector suggests it is at a turning point for the first time in over a decade. “There are moments in everyone’s investing career - sometimes obvious at the time, sometimes only in hindsight - which are game changers,” says Ian Lance, portfolio manager of the TM RWC UK Equity Income Fund*. “Buying US government bonds yielding 16% in the early 1980s, selling TMT and buying old economy stocks in 2000, and shorting financials in 2007 would all be examples of opportunities that came at major turning points. "And today, we believe the opportunity to shift from growth to value after ten years of underperformance is of similar significance. What’s more, the process has already started.”

Having seen the rotation of growth and value stocks several times in their careers, Lance and Purves believe markets could be entering a similar point of change. This notion is supported by the dispersion of valuations across the cheapest and most expensive stocks in UK, which has become much wider in recent years and has resulted in the value universe of potential ideas expanding once again. However, in line with the growth/value shift seen during other core periods in history, Lance notes the key to successful value investing is to be prepared for the turning point in markets ahead of when it occurs. “Value investing has always felt pretty lonely, but surely that is the reason it works,” says Purves. “And one of the key lessons we have learnt through our careers is that when the shift from growth to value happens, it can be sudden and violent. Positioning needs to be made in advance of that move. So the time to act, and focus on the value style of investing, is now.”

Value opportunities

Source: Bloomberg, 01 January 1975 to 31 July 2018, as at 31 July 2018. Note: ‘World Value vs Growth’ is: MSCI World Value Index over MSCI World Growth Index.

The Record Outperformance of ‘Growth’ Versus ‘Value’

CONTACT

Find out more at www.rwcpartners.com

For more information visit http://www.incisiveworks.com

This document is directed at persons that qualify as Professional Clients and Eligible Counterparties under the FCA rules. This document is not a solicitation or an offer to buy or sell any fund or other investment and is issued in the UK by RWC Partners Limited. This document does not constitute investment, legal or tax advice and expresses no views as to the suitability or appropriateness of any investment and is provided for information purposes only. The views expressed in the commentary are those of the investment team. The Authorised Corporate Director is Thesis Unit Trust Management Limited, Exchange Building, St John’s Street, Chichester, West Sussex, PO19 1UP. Authorised and regulated by the Financial Conduct Authority. No person may distribute, copy or publish this document or any of its contents, in whole or in part, for any purpose, without the express, prior written permission of RWC Partners Limited and only in jurisdictions and to investors where it is legally permissible to do so. Past performance is not a reliable indicator of future performance and the value of investments and the income from them may fall as well as rise. An investor may not be able to get back the amount invested and could lose all of their investment. The risks of investment are detailed in the prospectus and should be considered in conjunction with your investment adviser. The prospectus, Key Investor Information Document, other constitutional documents as well as annual and semi-annual reports of TM RWC Funds are available free of charge on request from RWC Partners Limited. This document is issued by RWC Partners Limited.