Avoiding defensive, reliable dividend-paying stocks and opting for holdings in out-of-favour sectors is a better tactic to adopt despite building market fears due to excessive valuation risks, according to James Lowen.
The manager, who co-runs the £2.6bn JOHCM UK Equity Income fund alongside Clive Beagles, says that too many investors are focusing on short-term market headwinds and side-lining valuation risk at the expense of their portfolios.
Investor sentiment has been bruised over recent months due to fears surrounding China’s slowdown and the potential devaluation of the renminbi, collapsing commodity prices and concerns that central banks are no longer able to manipulate the current market cycle.
Because of this most indices have taken a hit since the start of the year, including the FTSE 100 which is down 1.7 per cent year-to-date.
Performance of indices in 2016
Source: FE Analytics
Despite many the nervy backdrop, Lowen says that investors need to prevent themselves from focusing purely on the current macroeconomic risks, which also include the impending US election, a potential currency war, a potential Brexit and conflict in Syria.
“These [headwinds] are dominating market commentary and that’s why we’re facing the valuation picture that we are. As an aside, some of these as well as being issues, such as the falling oil price, are actually positives,” he said.
“In the case of oil it’s been a big stimulus to the western world consumer sector and we’ve seen that here in the UK in terms of where the petrol price is.”
“We’re cognisant of this and all the other risks including structural risks, but we have to link this to the valuation agenda in the market. There’s no point in us populating our fund with stocks that have very low fundamental risks but very high valuation risk.”
Given this backdrop, the manager is finding financials, mining and the oil & gas sector to be offering up the best opportunities in the UK market at the moment, and many of these lie in the domestic-facing space further down the cap spectrum.
“Notwithstanding short-term risks such as Brexit, we want to retain exposure to this [domestic-facing] part of the market but we only want to do it if the valuation is right, and that’s where the bank sector was quite helpful because we were able to remix some of the capital,” he said.
Financials currently have a 39 per cent weighting in the portfolio, and this mostly consists of holdings in banks, life insurance companies and UK property. One of the biggest changes the managers have made over the last nine months is to reduce their insurance exposure and sell successful investments, and subsequently move to an overweight in banks.
According to Lowen, this is the first time the fund has been overweight banks since 2008’s financial crisis.
“In terms of valuation in the European bank sector, we’re back to a low level and in terms of the UK banking sector it’s an even cheaper picture,” he said.
“The second point is we’ve seen a dramatic change in the political attitude towards banks since the election. We saw that in the FCA leadership change in June. We’ve seen what the government has done to keep HSBC in the UK and we’ve also seen what they’ve done putting a time-bar on PPI claims.”
Not only this, the manager points out that the regulator has indicated that banks have enough capital, which he says should mean that rather than rebuilding capital, companies will pay out dividends to shareholders. This was already demonstrated with Lloyds on Thursday, following its announcement that it will start to pay dividends earlier than expected following a reported underlying profit of £8.1bn for 2015.
Performance of stock in 2016
Source: FE Analytics
In terms of property, Lowen and Beagles have reduced their exposure to due to rising valuations, but have reshuffled the holdings they have left and have moved further down the cap spectrum to find opportunities.
“Part of the reasoning for the reflation of property prices is that bond yields have fallen, and part of the reason is there have been big inflows into open-ended property funds. Those funds had to buy assets particularly regionally and that’s pushed up property prices. This trend could reverse as inflows into this area flatten out and subside,” he explained.
The other unloved sectors that Lowen and Beagles have been increasing their exposure to over the last 12 months is oil & gas and mining – Lowen points out that oil & gas has actually been one of the leading sectors so far this year despite negative investor sentiment.
He says this is likely to be the result of how low valuations became and adds that, while most of these stocks have outperformed the market year-to-date, there are also stand-out companies such as Shell which have delivered a positive return on an absolute basis.
“The P/B of the sector is at a low point and the percentage of the market cap represented by the oil sector is back to top levels. This is a time when it’s worth focusing on these things and considering the issues,” he explained.
“This isn’t the case during the other extreme when there are no fundamental issues and it looks like all is rosy. What might change is that, while we’re cognisant of some of the structural issues in this area of the market, there are other factors we need to bring into the picture and look at where supply and demand trends could go in the near term.”
The manager says that there has been a significant decline in the new rig count in the US, and he expects this data to feed through to production levels at some point this year.
He says that this, coupled with a significant capex cut from oil companies across the board will cause any excess supply to fade out and will therefore pave the way for higher oil prices.
“We don’t think we’re going back to $100 [per barrel] but we don’t think that $30 or $20 is where the balance will be, because if oil remains that level, there won’t ever be any new production because of where the cost curve is,” he continued.
“It’s a similar picture within the mining sector. We’re at an all-time low for margins within the mining sector and we’re at an all-time low for return on capital. The mining sector is at an all-time low in terms of its P/B ratio. If there’s any form of normalisation in margins and returns as capital gets sucked out of this sector, there’s a significance in material upside.”
Over the last 10 years, JOHCM UK Equity Income has provided a total return of 84.38 per cent compared to its sector average’s return of 63.1 and its benchmark’s return of 59.42 per cent.
Performance of fund vs sector and benchmark under Lowen
Source: FE Analytics
The fund has clean ongoing charges figure of 0.67 per cent and yields 4.29 per cent.
