Labels such as growth or value are actually two sides of the same coin and even managers who describe themselves as stockpickers are really looking for companies that are attractive on both measures
Labels can be dangerous ' their convenience stops us from thinking. For example, value and growth are not actually two distinct styles but two sides of the same coin. Stockpicker is another common label and we have all heard those who say proudly: 'I don't pay any attention to macroeconomics, I'm a stockpicker.'
Such simple statements beg bigger questions: What do you pick? Why have you picked it? What have you paid for it? How will macroeconomic factors affect the profitability of the company and the valuation placed on its shares?
One cannot pick stocks without being concerned how the economic environment will impact on businesses. Will optimism yesterday lead to overcapacity tomorrow? Will a strong currency hinder profits? Will margins be squeezed? Will sales growth be strong enough to overcome rising costs? Stock pickers cannot absolve themselves from the responsibility of taking a view on the economic matters of the day.
Some managers are happy to tell you they are prepared to pay for growth. That's fine when everything in the garden is rosy but it's a strategy that I carefully avoid. The most important issues remain simple: where are the growth opportunities? Which companies do you back? And what price do you pay for their shares?
Identifying businesses that will grow is not too difficult. The tricky thing is to estimate a value for such growth. A few years ago, valuations had become increasingly subjective and relative measures abounded.
So, what might fair value be for the UK market under normal conditions? A rough rule of thumb suggests an overall earnings yield of around 8% ' 4% gilt yields plus 2% inflation plus a 2% equity risk premium. This implies a median market P/E of around 12-13 times. However, these are not normal times. There are a number of issues of concern.
In an environment in which growth is scarce, and likely to remain so for the next few years, it seems sensible to set the P/E for the fund at much lower levels ' around 12-13 times. Current market conditions suggest the nasty surprises are more likely than, say, missing out on a sudden rally.
Some worry that consumers, those stalwarts of our economy, might cease to consume. Well, maybe. Our economic analysis does lead us to believe there are opportunities to be had from exposure to an ABC of low-ticket, recession-proof consumer items: ale, betting and ciggies.
The fund is very parsimonious about the price it is prepared to pay for assets. My concern is to limit the downside risk for investors by building in a decent margin of safety. Oddly enough, such caution builds in greater potential upside for the holdings.
Yes, growth is scarce but there are still growth stories out there. As the market comes to recognise these, the absolute gains in the fund will be greater by virtue of the low prices we paid. Buying stocks at well below the median P/E will give investors more of the upside and some protection against any downside. Closet tracking funds do not seek to offer investors this margin of safety. These are among the toughest market conditions I have experienced since I began running money in 1986. The recession of 1990-91 was understandable: interest rates were simply too high, sterling was overvalued and one could own defensives ahead of a move to catch cyclicals for a traditional recovery.
This time around, things feel very different and defensive stocks have been weak. The absence of inflation has removed the traditional camouflage that once produced gently rising profits for these businesses. Meanwhile, the specific risk associated with individual companies has increased as the market tries to sort the wheat from the chaff. Does this create volatility? Yes. Can we take advantage of this volatility? Again, yes.
We appear to be at a real turning point, not unlike that of 1973-74. The current stock market level is telling us that either stocks are a steal (quite possible) or that dividends are about to be cut. So, if dividends are to be the major part of our total return, what might threaten them and how is the fund positioned to avoid this?
As a house, we are particularly mindful of corporate pension funding. FRS17 has, for the first time, placed the liabilities of final salary schemes directly onto the balance sheet. Some of these liabilities are huge.
There are seven FTSE 100 companies (including Rolls Royce, British Airways and GKN) that have deficits of more than half their market capitalisation. Short of reneging on pension promises, the problem appears insoluble. We actively screen companies to avoid such situations as cash required for pension funds is cash unavailable for dividends.
Avoiding index losers is just the start. It is also important to seek out businesses that have robust balance sheets, for a high degree of asset backing, together with low debt levels and substantial interest and dividend cover.
Companies with such assets include British ports. Our interest in ports goes right back to their privatisation. You can't build them that easily. Besides being toll bridge businesses, many also have substantial property assets, the long-term development of which will help real value emerge.
However, assets do not have to be physical. Intellectual property is also a form of asset backing. Legal and scientific publishers, who own the rights to their back catalogue, are other long-term growth opportunities.
The fund also holds housebuilders, a sector that deserves a long if slow re-rating. The shares seem cheap, in part because the market remembers the collapse of the housing market in the late 1980s.
When interest rates were high, the cost of holding unsold houses on the books was crippling. Housebuilders also had wider exposure to the economic cycle as many owned low-quality building contractors.
Contrast this with the present situation. Low interest rates mean it is much less costly to retain unsold units on the books, the contracting businesses have gone, land banks are substantial and there is a supply squeeze exacerbated by strong demand. In the event of any trouble, very low P/E's would limit the downside and probably trigger consolidation.
Around one third of the fund is invested in banks and other financials. The valuation on banks has become very low as pessimism is priced in. Part of this relates to fears over the housing market and appears overdone.
Most of the large banks ought to be able to maintain their dividends over this difficult period. They are run much better than during the last downturn and their customers, UK consumers, are in better shape. Irish Banks also offer undervalued growth opportunities.
Speciality finance is a mishmash of a sector with some good growth opportunities. Business is booming for Man Group, a quoted hedge fund manager. This is likely to continue as more people come to realise they can get reasonable returns for lower volatility. ICAP, an inter-dealer money broker, is a fairly low-risk business growing on the back of the derivatives market ' cash on margin has to be placed somewhere.
Intermediate Capital provides mezzanine finance for companies doing LBOs and MBOs, a lucrative area for lending combined with the possibility of gains from equity kickers.
Every stock in the fund has to earn its place and there is absolutely no obligation to hold a share just because it happens to be the component of some index. Nevertheless, it is important to get the big four sectors (oils, banks, telecoms and pharmas) correct, even if one ends up holding none of them.
It is important to remain flexible. In the past, the fund contained no Vodafone, whereas today it is the biggest holding because the cashflows and growth are increasingly attractive.
During periods when growth is hard to find, investors should be happy to be paid for their patience. It's an underrated virtue.
P/E ratios are set to remain at lower levels for the time being.
Current downturn is more serious than previous ones and is leading to more volatility.
Pension fund liabilities are causing increasing problems for many FTSE 100 companies.
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