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Three themes Simon Brazier is playing in Investec UK Alpha

02 March 2015

The UK equity manager explains some of the investment themes running through the portfolio he took over at the start of the year.

By Simon Brazier ,

Investec Asset Management

With the UK equity market trading at all-time highs, the question on investors’ lips is whether there is further upside from here. There has been significant profit growth from UK companies since 2009 as the global economy has recovered and companies have expanded margins.

But the market growth has also been driven by a re-rating in valuations which without doubt has been aided by the unprecedented injection of liquidity into the financial system from quantitative easing (QE).

Continuing our strategic focus on finding quality corporates in established markets which can succeed in a low-growth environment, below we outline three themes informing our views on the investment landscape ahead:


Volatility

One could argue that volatility, to a degree, has been absent from the UK market in recent years as evident through UK equities’ steady and consistent performance since 2009. However, we can no longer rely on the rising tide of a valuation re-rating to lift all ships, as stock specific risk has increased and valuations in many cases now leave little room for disappointment.

The recent re-emergence of volatility need not be feared though. In fact, for stock pickers like ourselves who are prepared to take a long term view, and who conduct detailed analysis on companies to understand their longer term intrinsic value, short term market volatility can actually be used positively to exploit longer term valuation opportunities.


QE

With the Federal Reserve’s (Fed) monumental QE programme finally concluding, just as the European Central Bank expands its own monetary easing measures, we must not forget that we have been through a remarkable period of experimental monetary policy and unconventional economics, and that the scope for policy error remains high as we continue to venture further into uncharted territory.

With record low interest rates and record high debt levels, the ability for monetary policy to influence growth is becoming increasingly debatable. We cannot rely on QE to perpetually boost equity markets therefore as, in the words of John Maynard Keynes, it has become like ‘pushing on a string.’ We believe it is the companies who are in charge of their own destiny that are most likely to succeed from here.


Deflation

As the US starts to wean itself off its monetary morphine, we must also be wary of the looming deflationary threat. Taking into account the vast quantities of cash which have been pumped into the global economy, it is fair to say that it has not readily translated into excess inflation, especially within developed economies. One could argue that inflation is evident in real assets, such as bonds, equities and real estate, but there is less evidence of it in our shopping baskets.

So where has it all gone? While large quantities of printed cash have circulated into the global economy, a large amount has also been used to shore up balance sheets through widespread global de-leveraging. Banks have bolstered reserves, the general public has been more conservative with discretionary spending and corporates have trimmed excess fat and strengthened their balance sheets.

In effect, the increase in the money supply has been offset by a fall in the velocity of circulation, significantly dampening the overall impact on real economic growth and inflation. By adding to this the short term deflationary effects of lower food, fuel and energy costs, the danger is that consumers and corporates put off spending leading to a downward spiral in prices affecting growth, profits, wages and employment.

In reality though, lower food, fuel and energy costs in the short term may actually help drive increased consumption and growth in the medium term – this reinforces the importance of having a longer term perspective, and maintaining a focus on those companies best able to navigate through this environment and emerge stronger. 
 

Our valuation framework focuses on a company’s business model, financial model, and the quality of company management’s capital allocation. While it might seem that focusing on strong, profitable companies with solid balance sheets and management teams does not sound terribly ground-breaking, we must first take a step back and remind ourselves why we invest in equities in the first place.

The answer is simple and forms the backbone of our investment philosophy: we invest in equities to benefit from the compounding effect of the reinvestment of cash flows. We strive to find high-quality companies with sustainably high and/or improving returns on capital that generate cash and can re-invest that cash to achieve self-funded growth.

With most companies having spent the past few years consolidating assets and cutting costs, we believe there remain good opportunities to find these sorts of companies in the current climate, and that these are the companies most likely to be the long-term structural winners and succeed in a low growth, more volatile and more uncertain world.

Simon Brazier is portfolio manager of the Investec UK Alpha fund. The views expressed are those of the contributor at the time of publication and should not be taken as advice or a recommendation.

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