The UK equity income market is facing the double challenge of falling share prices and suspended dividends in 2020, but the sector has always been a rich source of yield for investors. Aviva Investors' Chris Murphy and James Balfour explain why a long term and consistent investment approach is essential for income investors today
Consistency, patience and discipline: The key to riding out an equity income storm
Stocks are volatile, yet to generate long-term returns investors must ignore the market furore and abide by their investment discipline, according to Chris Murphy and James Balfour
Stock conviction and having the humility and discipline to learn from poor investment decisions is essential for long-term returns. But how does this work in practice?
This document is for investment professionals only. It is not to be distributed to or relied on by retail clients. Except where stated as otherwise, the source of all information is Aviva Investors as at 30 April 2020. Unless stated otherwise any opinions expressed are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. The UK Listed Equity Income Fund is a sub-fund of the Aviva Investors Portfolio Funds ICVC. For further information please read the latest Key Investor Information Document and Supplementary Information Document. The Prospectus and the annual and interim reports are also available on request. Copies in English can be obtained free of charge from Aviva Investors UK Fund Services Limited, St Helen’s, 1 Undershaft, London EC3P 3DQ. You can also download copies from our website www.avivainvestors.com Issued by Aviva Investors UK Fund Services Limited. Registered in England No. 1973412. Authorised and regulated in the UK by the Financial Conduct Authority. Firm Reference No. 119310. Registered address: St Helen’s, 1 Undershaft, London EC3P 3DQ. An Aviva company. RA20/0700/22082020
The art of cutting stock losses
‘Slow and steady’: Is consistency the key to riding out the storm?
Aviva Investors UK Listed Equity Income Fund
An insight into Fund performance and strategy, portfolio make-up and management team
Fund manager engagement with businesses can encourage positive change and also ensures ESG remains prevalent throughout the investment process
ESG: A driver for company change?
So far, equity markets have borne the brunt of investors’ coronavirus-related concerns. In this Q&A, Chris Murphy explains why he believes the reaction is overblown in the UK and where he sees the opportunities and risks emanating
“There is too much fear about the short-term outlook for UK equities”
The value of investments and the income from them will change over time. The Fund price may fall as well as rise and as a result you may not get back the original amount you invested. Equities Risk: Equities can lose value rapidly, can remain at low prices indefinitely, and generally involve higher risks — especially market risk — than bonds or money market instruments. Bankruptcy or other financial restructuring can cause the issuer's equities to lose most or all of their value. Target outcome risk: Any outcomes stated as targets are not guaranteed and may not be achieved. Capital at risk: The value of an investment and any income from it can go down as well as up and can fluctuate in response to changes in currency and exchange rates. Investors may not get back the original amount invested.
Key Risks
Important Information
2020 MARKET OUTLOOK
FUND PROFILE
PORTFOLIO INSIGHT
ESG AND ENGAGEMENT
MANAGER PROFILE
CONTENTS
For professional investor audience only, not to be distributed or relied upon by retail investors.
While the IA UK Equity Income sector returned 78.5% over the past ten years,* the decade has been marred by politics making it difficult for investors to ignore market noise and shun herd-like behaviour. In the UK, Brexit led to ongoing uncertainty over the health of the UK economy, and the global pandemic has resulted in significant share price volatility across global markets as a whole.
Over the past decade Murphy has made a name for himself as a manager who has been able to ignore such short-term noise and, to an extent, systematic biases. Instead, he focuses on the long-term potential of companies over multiple investment cycles. His approach, he notes, means he tries as much as possible to invest in what he describes as “dull, boring businesses”.
“A lot of investors have a tendency to value businesses when they are doing really well with high returns. All that means is that they value them inappropriately. What is needed is discipline to understand company behaviour based on facts”
Murphy and Balfour invest in stocks on the basis that any business, no matter how successful it appears to be today, will become “average or worse over time”. Their approach therefore aims to pick stocks based on businesses’ cash flow and their ability to invest that cash over the long term.
“Markets have always been inefficient in that fear or greed end up driving a lot of investment decisions,” says Chris Murphy, manager of the £1bn Aviva Investors UK Listed Equity Income Fund. “When investors do not know the outcome of a major macro event it creates a sell-off in stockmarkets. On the other hand we see periods of share price escalation as styles of companies become overvalued and bubbles form very quickly. Those movements are all related to fear and greed. Why would you want to get sucked into that cycle of fear and greed?”
Yet despite this rather sober label, the fund is one of the best performing UK equity income funds in the market today. It has returned 107.1% over ten years to 31 May 2020, ahead of the FTSE All Share benchmark which returned 80.2%.** The Fund has earned notable external recognition including topping the most recent Sanlam White List half-yearly Income study in January 2020, being A rated by Square Mile, and is on Hargreaves Lansdown’s Wealth 50. Murphy manages the fund alongside his co-manager, James Balfour who joined Aviva Investors in 2012.
“Markets are driven by short-term news flow, earnings upgrades and downgrades. And a lot of investors have a tendency to value businesses when they are doing really well with high returns. All that means is that they value them inappropriately. What is needed is discipline to understand company behaviour based on facts.”
“We want to base our decisions primarily on if the cash they hold can pay the bills, fund capital expenditure and ultimately pay dividends,” explains Murphy. “To understand how companies do that we split the lifecycle of a company and its cash flows intro three broad silos of: future cash flow, cash compounding businesses, and those in the recovery process.”
Future cash flow businesses tend to focus on companies that have clarity on returns and are able to generate capital growth. These are typically more ‘balanced’ businesses and will thus generate higher yields in the future.
Cash compounding businesses are what make up the bulk of the portfolio and are comprised of strong, reliable businesses and stable cash flows. This includes stocks such as Compass Group which aims to reinvest or return cash to investors each year.
The third silo focuses on recovery or out-of-favour stocks, either for macro or company-specific reasons. However, companies in this bucket must have a clear path to recovery and the opportunity to turn strategic value into future cash flow. Murphy and Balfour refer to this as ‘cheating fade’, whereby a business can reinvest or develop a new product to enable growth again (see chart, below).
“Companies can do what we call ‘fade’, whether that is because of a shock in the market or mismanagement of the business itself. By fading a company’s returns and prospects will look poor and the valuation will fall. Yet there can also be a proper business model that just needs to get back on track.”
“If you can invest in the right business, with something unique about them then the ‘fade’ rate is much less so we call it ‘cheating fade’. The company will either reinvest in the business to help it recover or is a strong brand that is able to bounce back with the right management in place. While investors might ignore it because typically it would not represent ‘high’ growth, not ‘fading’ is a valuable tool that retains the terminal value of the business.”
Though the focus on cash flow may mean the portfolio is perceived to be a little dull in terms of its stock selection, this is not an issue for the managers. Indeed, Balfour notes that this shouldn’t be seen as a negative.
“Typically, the stocks in our portfolio are better-established businesses, mature even and can have slightly higher valuations too. But they do also have the potential for a decent amount of compounding growth which means they often deliver ahead of the market. And because they are more established they can pay out a slightly higher yield and return cash to investors rather than consuming it.”
In addition, by honing in on company fundamentals and not the macro outlook, the focus remains on the long-term prospects of the stock: “We don’t chase stocks. We don’t want to or need to. We invest in businesses for their potential to generate cash over a number of years, therefore the entry price and trying to tie into that doesn’t matter as much. It also means we don’t need to turn over our stock in the portfolio as often; because we are not trying to time the stock to go up a certain amount before selling. It really is about conviction of ideas rather than valuations, and the consistency of our portfolio returns shows that.”
Faith and discipline in such an investment philosophy is particularly important in periods of stress or extremes such as those being seen today.
While at the start of the year the world economy was beginning to take off again in a conventional boom-bust cycle, the arrival of the COVID-19 coronavirus saw stock markets plunge as fears of a slump in global economies becomes increased. Though central bank and government stimulus measures have been announced, the long-term impact of a pandemic is a market unknown and it remains to be seen how deeply the UK economy will be impacted.
“It is very easy to get sucked into market movements and forget your own beliefs at the moment,” says Murphy. “I have a lot of different charts on my screen of the impact of COVID-19, and it is an unknown that is not going to suddenly go away. Governments and health organisations are trying to flatten out the peak of infections and that will create a period of dislocation in economies. It makes it difficult to predict when investors will gain confidence again.”
“We don’t believe we can call when it will end. What we do have is a portfolio of quality stocks with strong business models, and we will investigate if we need to make small changes to those holdings. What we are looking at now are stocks that might miss a year of profitability. The question of course is at what point can they survive through that and still generate cash, and we do not know this yet.”
The team will not, however, be calling the bottom of the market and taking on risk in new stocks, says Balfour. “For us this is a binary event that is causing a lot of volatility. If we get the call wrong, it will heavily impact returns.”
The fundamentals of an income fund remain, despite all market dips. Income funds generally, and more so Murphy and Balfour’s style of focusing on cash flow is not just for people that want to take out an income. In fact, net income reinvested can provide much more consistent and less volatile long-term returns.
“The macro outlook will always move up and down,” says Balfour. “But how businesses change and adapt to ongoing wider challenges is also important. Being at the forefront of new opportunities and changing trends is actually what will help companies reduce their cost of capital and prosper for longer.”
Chris Murphy (left) and James Balfour
Avoiding short-termism
Quality businesses
Stable portfolio
Long-term outlook
“For us, [COVID-19] is a binary event that is causing a lot of volatility. If we get the call wrong, it will heavily impact returns”
Chris Murphy
James Balfour
Chris Murphy: Fear and greed end up driving short-term stock movements
James Balfour: We don’t chase stocks. We don’t want to or need to
Aviva Investors UK Listed Equity Income Fund returns over ten years to 31 May 2020. In the same period the FTSE All Share benchmark returned 80.2%.*
107.1
%
Ultra Electronics Ultra Electronics is an example of a cash recovery story the Fund invested in last year. It provides solutions and products for a number of sectors, including defence and aerospace, by applying electronic and software technologies. Company management has undertaken a number of acquisitions over the years which saw the business lose its way for a period, however Murphy notes things have improved: “The management didn’t consolidate the business quickly enough and they lost a bit of control. Yet the core businesses fundamentals remain strong, it just needed to be managed in the correct way. Since new management came in the business has done exceptionally well.”
Sources: * Lipper; Aviva Investors UK Listed Equity Income Fund; share class 2; Inc. income reinvested; net of fees in GBP. As at 31 May 2020.
Investments added to the portfolio - company cash flow lifecycle
Compass Group Compass Group is a British contract food service company and one of the world’s largest catering firms. This stock was added to the Fund in 2011. The group typically uses equipment and facilities owned by its clients which means its capital requirements remain low and allows for stronger returns. The group also operates among a broad customer base, many of whom have followed the trend of outsourcing catering solutions in recent years.. This has helped the group to grow and improve its operating margins. It outperformed the FTSE All-share (the Fund’s benchmark), highlighting the ‘quality’ aspect of the stock.
Ashtead Rental company Ashtead leases construction equipment around the world, with most of its revenue (around 85%) coming from the US. This stock was added to the Fund last year. Structural growth drivers in this market are strong with firms looking to rent construction equipment rather than endure significant capital expenditure in buying their own. In addition, Ashtead’s chip technology helped them to optimise the use of the equipment they were leasing in a fragmented market in the US.
Source: Aviva Investors, 30 April 2020
click on
symbols for examples
Past performance is not a guide to future performance.
Chris Murphy operates under the philosophy that many investors are habitually driven by fear and greed and therefore tend to overpay for what they perceive to be exciting growth opportunities. He believes that a more mundane approach to investment is appropriate and that steady, simple businesses that have the ability to compound returns over time are the types of companies that investors should seek. The fund benefits from the lengthy experience of Mr Murphy alongside the challenge and views of James Balfour, who has made a very promising start to his investment career. The pair seem to enjoy a collaborative working relationship and despite favouring what could be described as dull companies, have the courage to match their conviction. Therefore, at times, they will construct a portfolio which, at a sector level, can look markedly different from the UK market.
The FUND View from Square Mile Investment Consulting and Research
“We think this is a solid offering within the UK equity income space and one that benefits from a well defined investment process and a complementary pair of fund managers, blending youth with experience”
John Monaghan, Head of Research, Square Mile
For illustrative purposes only, not intended to be an investment recommendation.
The fund is actively managed by Chris Murphy and James Balfour who run a high-conviction portfolio of stocks capable of generating higher levels of income and growing their dividends over the long term.
While Murphy and Balfour aim to build a diversified portfolio of UK listed companies, the managers do not take into account a company’s weight within the index when choosing investments. Instead they focus on identifying strong and steady businesses that are able to generate high levels of income.
Sector breakdown versus benchmark
How does the Aviva Investors UK Listed Equity Income Fund differ from its peers?
The Aviva Investors UK Listed Equity Income Fund aims to deliver an income return of 110% of the income return of the FTSE® All Share Index, annualised, over 3-year rolling periods, whilst also aiming to grow your investment over the long term (5 years or more) by investing in shares of UK companies.
Source: Aviva Investors UK Listed Equity Income Fund. Total net return GBP source: FE Analytics. Ten year performance data to 31 March 2020.
Consistent performance profile Murphy and Balfour assess and analyse companies consistently, from a broad idea set (see below). This has seen the fund consistently outperform the index over the past ten years. The fund is also top quartile over 1, 3, 5 and 10 years, and its rolling 5-year sharpe ratio has consistently been in the top two quartiles since portfolio manager inception. Its distributions paid out have grown by 70% since portfolio manager inception*.
*Source: Lipper, JP Morgan/Bloomberg, Morningstar. As at 31 December 2019 for the income share class 2 of the Aviva Investors UK Listed Equity Income Fund.
Chris Murphy Senior Fund Manager Chris joined Aviva Investors in 2006 from Framlington Investment Management, where he was responsible for managing the firm's UK income and growth retail portfolios. He began his career in 1988 as a graduate UK equity analyst for Lehman Bros before joining James Capel in a UK equity analyst role. At Aviva Investors Chris manages the UK Equity Income strategies and also has lead sector coverage responsibilities for capital goods and materials.
James Balfour Fund Manager James joined Aviva Investors in 2012 as part of the Aviva Investors Graduate Training scheme, initially as a UK equity analyst covering the industrial, food retail and consumer staples sectors. In May 2016 he was appointed co-fund manager of the Aviva Investors UK Equity Income strategy. He is also fund manager of the Aviva Stewardship UK Equity Income Fund.
Fund performance: Ten years versus FTSE All Share
Historic yield
4.26
Fund size
£950m
Number of stocks in portfolio
51
Average stock holding period
5yrs
ESG is also integrated across the investment process, and the team actively engages with every stock investment to help create change and enhance returns.
This often results in the portfolio deviating from the benchmark, both in terms of sector and stock weighting levels, as can be seen in the charts below.
1 Year
24.58
3 Years
16.29
5 Years
13.77
Annualised volatility (%)
Source: BlackRock Aladdin, Explore, Aviva Investors. As at 31 March 2020. Active positions shown relative to the FTSE All-Share, ex. cash.
Murphy and Balfour assess and analyse companies consistently, from a broad idea set. This has seen the fund consistently outperform the index over the past ten years
Past performance is not a guide to future returns.
Herd-chasing Valuations off short-term numbers Earnings noise Expensive stocks Low barriers to entry Quasi indexation
Exploit opportunities Focus on through-the-cycle returns Invest, not speculate Examine at cash flow Buy sustainable franschises, not just a business Ignore the market
• • • • • •
Financial Services
Industrials
Telecommunications
Utilities
Technology
Oil & Gas
Basic Materials
Consumer Services
Healthcare
+2.3%
Smith (DS)
+2.5%
St. James Place
+2.6%
Ultra Electronics Holdings
+2.9%
Schroders
Legal & General Group
-3.1%
Diageo
+4.0%
Phoenix Group Holdings
+4.2%
Intermediate Capital Group
-5.2%
HSBC Holdings
-5.4%
Astrazeneca
Top ten active stock weights
The portfolio aims to invest in companies with high barriers to entry – focused on future cash flow, cash compounders and recovery stocks – meaning the fund is naturally more resilient, with lower levels of volatility versus its peers.
Consistent approach Murphy and Balfour's consistent investment approach aims to look through ongoing market noise, as well as the fear and greed that can often drives investor behaviour. This avoids ‘herd chasing’ and allows core, change-led investment opportunities, backed by robust fundamental analysis, to be identified. Stock selection is focused on three silos based on company cash flow, as seen below.
Recovery stocks Out of favour for macro or company specific reasons Strategic value Paths to recovery
• • • •
Good to high returns Stable cash flows High barriers to entry Companies re-invest or return money to investors
Future cash flow
Companies have good investment opportunities Clarity on future returns
• •
Cash compounders
Cash flow recovery
SEEKING TO
AVOIDING
Meet the team
-0.11
Other
-7.29
-3.92
+1.94
-0.71
Consumer Cyclical
-3.61
Energy
+1.69
Communication Services
-7.28
Consumer Defensive
+7.25
+12.04
Sector relative to benchmark (%)
fund breakdown by sector (%)
Excludes cash and equivalents and the weights have been rebalanced
4.74
4.68
5.10
5.89
6.77
7.47
8.71
9.76
16.97
29.92
-6.8%
-3.9%
-3.8%
-3.4%
+1.0%
+1.6%
+2.1%
+8.3%
+8.8%
active SECTOR weights
Connected thinking The investment strategy benefits from both scale and dynamism. While the UK Listed Equity Income Fund is itself relatively nimble, at around £950m, the broader global active equity team manages £36.1bn. This experienced team of over 40 equity investment professionals shares a common investment language, philosophy and process across both geographic regions and industry sectors, facilitating effective connected thinking.
This is enhanced by high levels of direct company access and seamless information flows from GRI (Global Responsible Investment), credit and multi-asset & macro teams, as well as support, oversight and challenge from our independent investment risk team. This framework enhances idea generation.
With a heritage rooted in insurance, Aviva Investors’ firm stance on governance should come as no surprise. And as long-term investors, the group believes investments are more successful if managers understand how the companies they invest in perform on any environmental, social and governance (ESG) issues, ranging from board diversity to climate change.
Aviva Investors operates a firm-wide approach to ESG and adopts a Responsible Investment Philosophy underpinned by an overall belief and firm set of commitments that all investment managers abide by.
Responsible Investment Philosophy
“It isn’t a surprise that businesses that practice good governance and operate good structures on the board, or those that run open management and value staff wellbeing are less risky at an investment level,” explains James Balfour, co-fund manager of the Aviva Investors UK Listed Equity Income strategy.
These commitments go further than simply modelling data, and focus the investment approach across four core pillars: integration, stewardship, avoidance (which includes divesting positions when unmanaged ESG risk factors fall out of the firm’s tolerance or where company engagement fails), and market reform.
Supported by the 20-plus strong Global Responsible Investment team, the firm operates its own proprietary ESG data modelling tools to provide fund managers with an assessment of ESG risks on an absolute and relative basis. The group also takes its roles as stewards seriously and undertakes extensive ‘proactive’ and ‘reactive’ engagement with management and boards to monitor ESG factors and encourage best practices. In addition, Aviva Investors encourages its fund managers to use their positions to advocate for policy reforms that address market failures and help build more sustainable capital markets.
It is important to remember the fund is not an ethical fund, and both Balfour and lead manager Chris Murphy are in control of the final say on stock selection. This means that often the portfolio will include stocks that may not have a ‘perfect’ ESG score. Murphy says some stocks may also be revalued by the managers if they believe their ESG plans will impact their bottom line, for example.
“While the insight into ESG issues and trends help us to understand the risks and open the door to new opportunities, I believe off-the-shelf ESG scores can also be misleading,” explains Murphy. “We will come across companies with fairly good scores that still undertake shocking business practices.”
Engagement and change
Balfour believes engagement is the key to ensuring ESG remains prevalent in the investment process, and is more powerful than simply using ethical screens to avoid stocks: “We need to use our position, and the firm’s influence as a large institutional investor, to support these companies. It is far better that we as fund managers are able to meet with them regularly to engage and encourage change, rather than walk away from them completely and ignore wider environmental or governance issues.”
Murphy agrees, and points to oil companies such as Royal Dutch Shell or BP as an example: “With oil companies, we haven’t for most of our lives had an alternative and while we don’t hold a lot of [the sector] in the fund for a number of reasons unrelated to ESG, we do have some exposure. That allows us to talk to them about their commitment to things like green power, and ask if they are going far enough.
ESG : A driver for company change?
In particular, he notes well-run businesses and those that promote responsible and sustainable investment practices and values are proven to be more efficient over the long term. This typically translates into superior long-term share price performance, and therefore client outcomes.
On the other hand, some companies are flagged as being poor on the ESG front. Often there is a reason for that, notes Murphy: “They may not have certain details about their carbon footprint in their accounts for instance, or they may have screened badly for succession planning or diversity. This is where our ESG analyst team can step in and help us actively speak to them and fill in some gaps, or engage with the business and encourage change. It is one of the advantages of having such a large ESG analyst team to support us because together we can drive that engagement properly.”
“By engaging with them in their plans we can better understand how they plan to still be relevant to the world in 50 years’ time. It is still an oil company we are investing in, of course, but we are trying to shift the focus of that business to future proofing and limiting the business’s environmental impact in the longer term.”
Investments are more successful if managers understand how companies perform on ESG issues, ranging from board diversity to climate change, according to Aviva Investors
By investing in oil companies such as Royal Dutch Shell and BP, Murphy and Balfour can engage with the business about their commitment to green energy
“It isn’t a surprise that businesses that practice good governance and operate good structures on the board, or those that run open management and value staff wellbeing are less risky at an investment level”
JAMES BALFOUR
Chris Murphy and James Balfour on incorporating ESG into their investment portfolio
BP We co-filed a resolution at BP this year, asking the company to disclose how material capex decisions are line with the goals of the Paris Agreement and to set appropriate emissions reduction targets. We met with the company’s CEO and Chairman to discuss the implementation of the resolution which was adopted with 99% of all votes at the last AGM.
CIRCULAR ECONOMY
1 / 7
Unilever Announced a new plastic strategy in October 2019, making it the first major global consumer goods company to commit to an absolute plastics reduction across its portfolio. We engaged both directly on this issue with the new CEO Alan Jope when he came in to see us in July, and also collaboratively as part of the Plastic Solutions Investor Alliance (PSIA).
CLIMATE CHANGE
4 / 7
BHP We voted in favour of a shareholder resolution asking the company to sever its membership of trade associations which actively lobby against climate policies.
5 / 7
Compass Group We engaged with the CEO on the issues of plastics and climate change.
2 / 7
Housebuilders Increased press/government emphasis on quality of build and customer service initiatives. Ongoing dialogue with Countryside (and Bellway) to understand their strategies and priorities for investment.
3 / 7
Ted Baker (previously held in the fund) Voted against the Chairman due to lack of independence and concerns over his handling of the recent controversies.
BOARD COMPOSITION
6 / 7
Cineworld Voted against the significant proposed increases in 2018 following the Regal acquisition, preferring to see evidence of success first.
REMUNERATION
7 / 7
With a focus on long-term growth and cash generative companies, Chris Murphy does not believe in trading stocks on a short-term basis as a result of market noise or following ‘herd-like’ behaviour. Within the Aviva Investors UK Listed Equity Income Fund this long-term conviction means stock turnover in the portfolio is low, and on average a company is held for five years – more than triple the fund market norm of around 18 months. Indeed one of the best performing stocks in the portfolio is Intermediate Capital Group, which Murphy bought in 2009 (see stock example below).
Intermediate Capital Group has a strong track record, with the firm not having recorded an annual net outflow since it was formed. The global company invests in private debt, credit and equity, bridge financing, acquisitions, and other financial instruments. Its operations have flourished since 2008 as smaller businesses, shut off from global banks, sought alternative sources of cash.
“Many people try to second guess the market or company results and end up trading in and out of stocks as a result. I do not think I can do that because few, if any, managers are ever able to accurately predict just how well a stock is likely to perform over the short term,” he explains.
“The operations of the business were perhaps unnoticed by the market – the company has progressed from the FTSE 250 to the FTSE 100,” explains James Balfour, co-manager of the Fund. “Over the past decade the business has not only diversified its offering by fundraising for a number of new vintage funds, it has continued to expand its team and build up its sales and marketing efforts. By scaling up, demand for its strategies has remained high. It is one of the only fund management style of businesses that we know of that is actually maintaining fees or even putting them up.”
WPP
As the world’s biggest advertising holding company, fears surrounding the future direction of WPP have been well documented. The main concern has focused on how the creative and communication giant ensures it remains relevant in the new world of digital advertising and media.
“What I can do however is judge good business models and use that analysis to decide whether to buy or sell a company. That is why when we see a new opportunity, we will typically start with a fairly small position, around 1%, and only add to the investment if the case becomes materially stronger.”
However, Murphy adds that as fund managers it is important to learn from negative stock decisions and experiences too. For example, when the team can see a stock story is beginning to deteriorate, they move quickly to limit performance cost and dampen (in some cases negate) negative portfolio returns. This was the case with WPP (see stock example below).
“We take pride in our ability to quickly recognise if an investment thesis isn’t playing out as initially expected and make a change. Embedding the possibility of investment error into portfolio construction will continue to be integral to our success.”
“This is a stock that deals in what we call ‘sticky capital’ because it’s typically locked into those long-term vintage funds.”
The stock accounts for 4.9% of the Fund’s holdings (as at 31 December 2019) and makes up a weighty part of the portfolio’s allocation to financials. Although it is top relative contributor to performance, Balfour notes it is the fact ICG is a ‘compounding business’ in terms of future growth that could make it a viable long-term contributor to the portfolio.
ICG has also shifted its focus to the growth of the asset management business. This is reflected in the company’s AUM which, driven by high revenue margins, have delivered profits that are double the sector average.
Murphy explains he saw WPP as a business that “understood the digital world changes, but there was a question over how it migrated through those challenges.”
The team bought into the stock in the spring of 2017 confident it would be able to make the structural changes it needed to adapt to the new world of advertising. Further driving the purchase was the fact the company had begun to yield a dividend above 4% for the first time in several years.
“We were acutely aware of the downside risks and therefore restricted our entry position to 1%, with a view to only increasing it if the structural story materially improved,” Murphy explains. “[But] within six months or so, it became apparent the company wasn’t making enough progress and we exited the position in February 2018.”
Sir Martin Sorrell, the CEO at the time, left in April 2018 causing further share price falls.
Murphy believes that while it can be argued it may have been a mistake to buy the stock, it is important to note that not all companies are equal. In addition, it is imperative as a fund manager to understand when you have made a mistake: “There are many risky companies available, and because we could see there was a risk in buying this yield we started with a small position that was appropriate for the fund. Although we do always take a long-term view, by having the discipline to admit it was not the right call for us at the time, we were able to limit the performance cost of our position significantly by getting out early.”
Bought: April 2017 Sold: February 2018
Bought: April 2009
“Within six months or so, it became apparent the company wasn’t making enough progress and we exited the position”
Stock return to date vs. Financial Services Index of 353% and FTSE All-Share of 195%
1,252
“This is a stock that deals in what we call ‘sticky capital’ because it’s typically locked into those long-term vintage funds”
“Few, if any, managers are ever able to accurately predict just how well a stock is likely to perform over the short term. What I can do is judge good business models”
What are your current thoughts on the COVID-19 crisis? The world is going through an unprecedented shock; it is quite different to anything we have ever experienced in that a forced lockdown resulted in many companies closing their doors overnight.
When markets dip in a ‘normal’ economic cycle, businesses have the opportunity to cut costs and adjust their underlying models. But there was no real warning of what would happen to the economy as a result of this virus spreading and the situation means companies have not been able to adjust their costs quickly enough as revenues collapsed. It really is, here is that word again: unprecedented.
Well-known names we have added to in the portfolio include Intermediate Capital Group, Schroders and Prudential. Other more stable businesses that have held up well, such as Tesco and Unilever, we have reduced positions in.
Just as nature abhors a vacuum, investors abhor uncertainty. The global coronavirus pandemic has certainly delivered on this front. Chris Murphy, senior portfolio manager for the Aviva Investors UK Listed Equity Income Fund, shares his thoughts on the current market environment and where he sees risks and opportunities emerging
How concerned are you about company profits and dividends? For me it is not just about profits, but about how the pandemic impacts cash flow. Companies need cash flow to pay their day-to-day expenses. This doesn’t exist currently and unsurprisingly it has had a knock-on effect on dividends. Many have made the decision to defer dividends. Now even as an income manager I am fully supportive of that in the short term. It is much, much more important that businesses survive this crisis and look after their employees and supply chains. This is particularly important for bigger companies that help provide funding through working capital for smaller suppliers.
How have you adjusted the portfolio in the short term as the crisis has unfolded? We focus on the long term, and the key for us is to make sure the portfolio is in the best position once the market recovers. If we look after the capital account in periods like this, there will be a bigger pool of assets in the future for the unit holder to generate income from. I am not buying companies that are ‘cheap’ or because they are the only dividend payer in town. We have instead focused on ignoring the market noise (as much as possible) and tried to work out where companies are going to be in two or three years’ time.
Will you take advantage of opportunities over the medium to long term? We have intentionally not made wholesale changes to the portfolio: we feel it is far better to ‘drip feed’ money in a period like this as opposed to trying to second guess a market recovery or the exact bottom. A history of investor returns proves that retail investors in particular are quite bad at that, and currently we are a fair way from finding out the full extent of the pandemic’s effect.
Ultimately, the way we structure the portfolio, the way we analyse stocks and think about companies and cash flows over the long term has not changed. When clients ask if we are trading more as a result of prices falls my answer is always no: in a volatile market I am not going to try to be clever and guess where prices may or may not move to.
During the global financial crisis, we didn't change the way we ran the portfolio either and that comes back to having confidence in our belief structure and philosophy of what we are trying to achieve, as well as knowing the types of [quality] businesses we want in our portfolio.
Is there a concern some companies may not survive this crisis? To an extent, there is too much fear driving movement in the short term. Take the financial services sector where some company share prices dropped overnight. Intermediate Capital Group was around £11 [as of mid-April]; I trimmed some of the existing position on valuation and for portfolio construction purposes at £19 at the start of the year. It went as low as £6 at the end of March, yet its business model is unchanged – so we added to the position. The price movement is an example of fear and greed at work in the market, which we like to avoid.
It is also easy to lose sight of what is going on: this isn’t a black hole. There is a finite period of time for which this can go on and there is light at the end of the tunnel at which point we believe dividends will return. And we do expect the majority of companies, once this has crisis has ended, to return as dividend payers.
Is it possible to offset the volatility portfolios are experiencing? When the market moves as much as it has and as quickly as it has, it is very difficult to make changes to large positions. In a ‘normal’ downturn, whatever that may look like, there is better line of sight of volatility occurring and there is usually time to move the portfolio around to protect capital. Today, we can do this at the margin but I suspect most investors have either been on the right or the wrong side in terms of names held.
For example, we hold a number of ‘self-help’ story stocks which, in a normal slowdown would have continued to do very well. But take a stock like Melrose which bought GKN, an engineering and manufacturing company supplying the aerospace and auto sectors. Car sales have effectively stopped overnight globally, and therefore the short term is going to be very difficult for them. Most companies will simply write this year off, and so there is a need to keep an element of flexibility in portfolios.
There often has to be a big judgement call in the portfolio, too. I see myself as an investor rather than a spectator and I would rather support a business through a difficult time and buy more when the share price drops in anticipation of a recovery later when it comes through.
Chris Murphy: In a volatile market I am not going to try to be clever and guess where prices may or may not move to
Car sales have stopped overnight and therefore the short term is going to be very difficult for auto stock Melrose. Most companies will simply write this year off, says Murphy
“It is easy to lose sight of what is going on: this isn’t a black hole. There is a finite period of time for which this can go on and there is light at the end of the tunnel at which point we believe dividends will return”
“Many companies have made the decision to defer dividends....even as an income manager I am fully supportive of that in the short term”
Chris Murphy: There was no real warning of what would happen to the economy as a result of this virus spreading...companies have not been able to adjust their costs quickly enough as revenues collapsed
