Investors who want protection within their portfolios should actually turn to the oil, mining and banking sectors, according to Invesco Perpetual’s Martin Walker, who is concerned that too many investors are turning to now very expensive “defensive” companies which will only underperform from here as the global economy improves and bond yields rise.
FE Alpha Manager Walker, who heads up the five crown-rated Invesco Perpetual UK Growth fund, recently told FE Trustnet that while there were headwinds facing the market, investors were putting their capital at severe risk by over-paying for safety in bond-like mega-caps.
Performance of fund versus sector and index over 5yrs
Source: FE Analytics
While the manager, whose fund has comfortably outperformed over one, three and five years, notes that valuations on defensive sectors like consumer goods, utilities and pharmaceuticals are very high, he says the outlook for those stocks looks bleak as well.
The major reason for that is because he expects inflation to trend upwards, GDP data to improve and bond prices to fall as a result.
Speaking at the FE UK Growth event last week, Walker said: “Fund managers’ Pavlovian reaction to a market that he or she is getting twitchy about is to run to defensive shares, that’s the instinct in all of us.”
“However, I think that is the worst thing you can now do – in fact I think it is a trap. It has been defensive shares which have been driving the market valuation up. Investors, in my view, should look to take shelter from any kind of bond market rotation by looking at value areas of the market – now more so than ever.”
He added: “Particularly value areas that have exposure to global growth.”
With that in mind, the FE Alpha Manager highlights the three areas he has been buying instead of overvalued defensive shares which also mean his funds can take advantage of a global growth surprise shock.
Oil companies
First up are oil majors. BP and Royal Dutch Shell currently make up roughly 10 per cent of his £1.4bn fund and though the oil price has fallen massively over the last year, he is bullish on the two companies.
“I’ve become increasingly interested in oil companies for a number of years, even before the oil price cracked.”
“That’s become more topical over the past couple of weeks when Shell bid for BG Group – which I think validates my thesis. I think the reason why they bid for BG, other than strategically it gives them better access to deep water drilling, is because it’s cheaper to buy barrels on Wall Street than it is to drill for them.”
According to FE Analytics, both BP and Shell have been through a tough 12 months thanks to the 40 per cent fall in the oil price.
Performance of stocks versus indices over 1yr
Source: FE Analytics
Concerns have also been raised about the future of the two businesses, as some have warned that their dividends are at risk if the oil price remains below $75 a barrel for any length of time.
However, Walker thinks this is nonsense and says they will be some of the major beneficiaries when inflation and economic growth improves. He also says that even if the oil price remains low for a year or so, it would be wrong to write-off BP and Shell.
“Looking at static valuation measures is missing the point. Looking at whether they are covering their dividend this year or what the free cash-flow yield will be this year is an irrelevance. These are strong companies.”
“BP, for example, has paid out $35bn worth of fines since the 2010 Gulf of Mexico disaster, yet its gearing is now lower than when it entered that period and it hasn’t issued any shares. The reason it has been able to fund that is because its assets are fungible – they are sellable.”
“Global oil companies and nation states want access to resources whether it is at $50 or $150 per barrel. There is real, intangible value to these businesses.”
Other UK funds with decent exposure to the oil majors, and the oil sector in general, include Investec UK Special Situations, M&G Recovery and UBS UK Equity Income.
Mining companies
“The other area I am increasing exposure to is the mining sector,” Walker said.
Mining companies have been hit by a swathe of issues over recent years, such as poorly timed capex, slowing economic growth in emerging markets and falling commodity prices.
Performance of indices over 5yrs
Source: FE Analytics
Mining companies have been a contrarian play for some time now and haven’t yet rebounded significantly. However Walker – who holds Rio Tinto and Glencore as top 10 holdings – says that they are now very lowly valued and will be an obvious beneficiary of improving economic data.
“Three years ago I didn’t hold any miners. The first stock I started buying was Rio Tinto, which has held up remarkably well given the iron ore price has gone from $130 to $50 a tonne. There are reasons for that; firstly its very strong balance sheet and secondly it is one of the lowest cash cost producers in the world.”
He says, for example, that it costs Rio Tinto $24 a tonne to mine and ship out to China.
“Even with depressed iron ore prices, you can see this is a business which still generates significant cash.”
Walker also points out the likes of Rio Tinto, BHP Billiton and Vale are acting like OPEC by increasing supply into falling prices to knock out the competition of smaller or regional miners, which means they will take greater market share when global growth picks up.
The likes of Old Mutual UK Alpha, CF Miton UK Value Opportunities and Neptune UK Opportunities – which is now headed up by FE Alpha Manager Mark Martin – all have 14 per cent or more in the mining sector.
Banks
The final sector on the list is banks, which Walker says are an obvious winner from a brightening macroeconomic backdrop.
“HSBC is really interesting and I own Lloyds – though I’m a bit twitchy about it going into the election because of the politics. However, it too looks interesting and it could pay a big dividend, but that is fairly well-known.”
“I’ve also been buying Barclays and I still have significant positions in non-bank financials like Legal & General.”
Banks, following huge falls during the financial crisis and the PPI scandal, went through a rebound period during the risk-on markets on 2012 and 2013.
However, with a hotly contested election on the cards and the banking system one of the major battle grounds, the outlook for the sector looks uncertain over the short term. Walker is willing to look past this, however, as he thinks they will continue to perform well for him.
HSBC is the one stock Walker is most excited about within the sector, though, as he says it is very lowly valued despite its global presence.
Shares in the banking giant have gone through a tough six months which means the dividend yield is now more than 5 per cent, for example.
Performance of stock versus index over six months
Source: FE Analytics
He is also bullish as he thinks regulatory pressures on HSBC will start to ease over the coming years given its history of being well-financed and that it will receive a huge boost when the US and UK start to raise interest rates.
“I wonder, how many times over the next 30 years are we going to be able to buy HSBC at one times book value?”
He says that while no bank is without risk, due to the economic backdrop and current valuation HSBC is in bargain territory.
“Clearly, it is still geared and if there is a banking crisis in China being called the Hong Kong Shanghai Banking Corporation isn’t going to play out well that day – but overall we think it is very attractive.”
HSBC is Walker’s largest individual position as he holds 5 per cent in the stock. He also counts Legal & General and Friends Life as top 10 holdings.
Other UK funds with a high weighting to the banking sector include Fidelity Special Situations, Schroder Recovery and Jupiter Undervalued Assets.