The fortunes for Anglo American, Spirax Sarco and TalkTalk look very poor, according to SW Mitchell’s Brian Cullen, as he is currently shorting all three within his top-performing UK fund.
Cullen launched the SWMC UK fund in July 2014 and FE data shows it is up 25.91 per cent over that time compared to a 0.54 per cent gain from the FTSE All Share. While it sits in the offshore universe, it has beaten all but two of the funds in the IA UK All Companies and IA UK Equity Income sectors over that time.
Performance of fund versus sectors and index since launch
Source: FE Analytics
The manager attributes that performance to his views on the market, which have led him to hold an overweight position in small and mid-cap stocks. These areas have benefitted from the improving UK economy and the increasing levels of consumer confidence.
However, Cullen also has the ability to short companies – the practice of borrowing an asset, selling it on and hopefully buying it back at lower price for a profit – within his fund. He says his short book has also aided returns and in this article he runs through three shares he thinks will fall over the coming months.
Anglo American
As mentioned earlier, the manager believes a UK domestic focus is the best way to outperform the market at the moment and by extension it means he is negative on most FTSE 100 mega-cap stocks given their exposure to international trade.
The likes of mining and oil & gas stocks have had a torrid time this year due to falling commodity prices and China’s slowdown, but over the last month or so they have come rallying back strongly largely as sentiment became so very low.
Performance of indices over six months
Source: FE Analytics
Cullen doesn’t foresee this lasting too long, though.
“Our outlook hasn’t really changed. We think a lot of those companies still have a lot of issues so we are short a couple of miners, for instance,” Cullen said.
He says the rally has been a technical one as many investors have locked in gains from rallying defensive and mid-cap names then tried to move their portfolios more in line with the index.
“I think that is what has driven a lot of this rally and as that has happened you’ve seen the broader hedge fund community has brought its risk-profile in a bit by covering a few shorts and sold a few longs.”
While he says being underweight the mining sector has led him to underperform during the month of October, he has put a short on Anglo American over recent weeks (which is down 52 per cent in 2015) as he sees further downside.
“The question is, do you buy into the idea that resources companies have found a bottom, that some of these more domestic companies have done what they are going to do and now is the time to move on?”
“We don’t believe that is the case. Everyone we speak to says it is still tough out there internationally. Does China get incrementally worse from here? Not necessarily, however in terms of the valuations of some of these companies like Anglo American, they still bake in that Chinese demand for commodities will increase next year.”
He added: “We don’t see any reason why that will be the case so we are still very cautious.”
He chose Anglo American in particular as the balance sheet is still quite stretched and a number of the major commodities it focuses on look challenged.
Spirax Sarco Engineering
Thanks to the falling oil price and a slowing industrial backdrop, Cullen had been short Rotork – the FTSE 250 manufacturing company – for much of this year. It paid off for him as the share price is down a hefty 92 per cent in 2015.
However, he has now closed that position and has used the profits to short Spirax Sarco – another FTSE 250 name.
“For a long time, there have been these mid-cap engineering companies which have been real darlings of the market. One example of that is Spirax Sarco, which we are short and looks very expensive.”
“For a long time, it traded in line with Rotork. They do slightly different things; Spirax Sarco is much more exposed to general industrial production, however, they have tended to trade in tandem but while Rotork has been weak, Spirax hasn’t.”
“In addition, what we have seen this year is a more generalised industrial slowdown, particularly in China, but also actually across the whole world like in the US as well. That backdrop is quite negative for a business like Spirax, which sells quite specialised kit into those markets.”
Spirax Sarco manufactures specialist steam systems, such as valves which are used around the steam process in industrial industry.
According to FE Analytics, the shares are up 8 per cent this year but have fallen some 14 per cent since their peak in June. While there has been a brief recovery over the last few weeks, Cullen is going to keep his short on.
Performance of stock in 2015
Source: FE Analytics
“The valuation has stayed very high because people say this is a great quality company, but it is quite expensive, there is a weakening industrial outlook and it has never had to cut its growth forecast. That’s just starting to come through now its shares are starting to come off and we think there is probably more to run on that.”
TalkTalk
The final stock on the list is TalkTalk, the FTSE 250 telecom.
Cullen isn’t a fan of the company and has been shorting it for most of this year. His main issues are that he feels the management isn’t incentivised correctly (such as delivering return on capital) and has been historically poor at disclosing information.
He also thinks that the company’s customer base is of a lower quality than the likes of BT and that as its product is also of a lower quality, if TalkTalk were “to stop giving them freebees, they are quite likely to move to a competitor”.
“TalkTalk disclosed very little in terms of what they saw in customer numbers, churn and other key metrics for a business like this, which is all about growing a subscriber base and cutting back on the cost you have had to grow that subscriber base,” he said.
“Therefore, seeing profitability increase whilst not losing customers and our thesis is actually the quality of their product is not very good. It’s quite a competitive market and every time they have tried to cut back on costs they’ve tended to see their churn go up and has lost subscribers.”
“That’s seems to be what is happening again now. The last time they updated the market they didn’t talk at all about subscriber numbers.”
Cullen admits this short didn’t work for him too well earlier in the year given the shares were up by 32 per cent by August.
Performance of stock versus index in 2015
Source: FE Analytics
However, the share price has fallen a huge amount since then and since talking to the manager the company has been in the press again following a “significant and sustained cyber-attack” which could have potentially affected all of its customers.
“TalkTalk is an example where, for a long time, the position went against us because they were on the road and talking about their very, very ambitious targets to increase profitability massively over the next couple of years – which looked absolutely bonkers to us.”
“However, we stuck with the position because we couldn’t see anything that was fundamentally changing for the better. Finally, we think a lot of people are starting to become aware of these issues which have been present for a while and sure enough the share price has been very weak recently.”
