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What you don’t want to see in your UK growth fund

14 October 2016

Nick Train, Richard Buxton and Mark Slater are some of the top-performing UK fund managers revealing to FE Trustnet which areas they are keen to avoid in their portfolios.

By Lauren Mason,

Senior reporter, FE Trustnet

Banks, oil & gas, housebuilders and mining are among some of the market areas that top-performing UK growth managers are completely avoiding in their portfolios.

While the FTSE 100 has achieved strong returns year-to-date bolstered by the weakness of sterling, domestic-facing FTSE 250 and FTSE Small Cap indices have also achieved stronger-than-expected returns, given the uncertainty surrounding Brexit.

Performance of indices in 2016

 

Source: FE Analytics

With a number of macroeconomic and geopolitical risks on the horizon though – the potential tapering of loose monetary policy, the US election and the implementation of Article 50 to name but a few – many investors are treading particularly carefully as we head into the fourth quarter.

Of course, choosing which areas of the market to omit from a portfolio is equally as important as choosing which areas to buy into.

In the first of a series, FE Trustnet speaks to some of the highest-rated and top-performing fund managers in the IA UK All Companies sector about which areas of the market they’re completely avoiding.

 

Nick Train: “Never invest in any company that makes anything out of metal”

FE Alpha Manager Nick Train (pictured), who heads up the five crown-rated Lindsell Train UK Equity fund, has achieved top-decile total returns over one, three, five and 10 years.

He said: “One of my favourite pieces of investment advice is attributed to Leonard Licht, the great investor who helped build up Mercury Asset Management. He is reported as saying: ‘Never invest in any company that makes anything out of metal.’

“This is brilliant in its concision and usefulness, notwithstanding. Of course, we can all think of exceptions to his rule. As a general proposition though, avoiding what you know to be low value-added businesses, like - let’s be specific and cruel, cyclical metal-bashers - is sensible. 

“Investment is tricky enough already without making it more so by knowingly committing to a mediocre company.”

 

Jeremy Lang: “Banks still have risks lurking off their balance sheet”

FE Alpha Manager Jeremy Lang, who co-manages the five crown-rated Ardevora UK Equity fund, has more than doubled the returns of both his sector average and benchmark since the fund’s launch in 2011.

Performance of fund vs sector and benchmark since launch

 

Source: FE Analytics

The team, which aims to exploit human error and learned behaviour in markets, remains sceptical of the banking sector.

“In our view, the banks that survived the fallout from the 2008 crisis still have risks lurking off the balance sheet. There are indications the amount of off-balance sheet assets and liabilities accumulated prior to 2008 was so huge that the banks cannot afford to bring them back on for the foreseeable future,” he said.

“However, from a behavioural point of view this approach is potentially biased. Traumatic events can lead to bias even when the circumstances no longer hold. Many investors were badly burned in 2008 and are now strongly biased against banks. But when these institutions are run in a sensible way, the sector is a low-risk way to make money.”

 

Richard Buxton: “Investors have turned a blind eye to bond proxy valuations”

Manager of the £1.2bn Old Mutual UK Alpha fund Richard Buxton, who has achieved an ‘AA’ Square Mile rating, is avoiding bond proxy companies across the board in his portfolio.

He said: “Up until now, bond proxy companies, those that have produced solid, dependable earnings growth, irrespective of the vagaries of the economic cycle, have been well bid.

“In their search for quality yields and earnings streams, many investors (ourselves not included) have turned a blind eye to valuations. It is too early to say whether or not some of the performance of defensive stocks will unwind relative to their financial and cyclical counterparts.

“However, it is encouraging to see how the slightest shift in bond yields (as we saw in the first week of September) can have an almost disproportionate effect on ‘bond proxies’.”


Mark Slater: We avoid companies “that have to accept rather than set prices”

Bottom-up stock-picker Mark Slater, who is an FE Alpha Manager and runs the five crown-rated MFM Slater Growth fund, has achieved higher returns than every one of his peers over the last decade.

Performance of fund vs sector over 10yrs

 

Source: FE Analytics

Given his stock selection process, he tends to avoid certain company characteristics as opposed to segments of the stock market.

“We tend to avoid low ROCE [return on capital employed] and low margin businesses, those which are particularly capex-intensive, companies that are highly dependent on one or two customers, those that have to accept rather than set prices and more cyclical businesses,” he explained.

“There is not a sector that I am especially conscious of avoiding at present, in the same way that we do not particularly favour any individual sector – the companies we own tend to be niche businesses that operate in a range of sectors.”

 

Richard Hallett: “Demand is weakening” for consumer-related goods companies

FE Alpha Manager Richard Hallett, who runs the four crown-rated Marlborough UK Multi-Cap Growth fund, is in the top decile for his returns over one, three and 10 years.

He said: “We are avoiding UK cyclicals. In the fund we don’t own any UK builders, construction-related companies or recruitment businesses. The UK has emerged with strong relative growth since the credit crisis and cyclicals have performed well, supported by relaxed monetary policies, but we believe they are now fully valued.

“We see Brexit as being a protracted and difficult negotiation that will present a significant headwind to domestic economic performance.

“We are also avoiding the more cyclical components of the consumer-related capital goods sector. Global growth is slowing and in our view demand is weakening for cars and products such as dishwashers and fridges.”

 

Ben Russon: “The revenue models of the [banking] industry are incredibly opaque”

The four crown-rated Franklin UK Managers’ Focus fund, which is co-managed by FE Alpha Manager Ben Russon, has achieved top-decile returns over three, five and 10 years.

The fund holds no banking stocks, which is a significant underweight given that the sector accounts for approximately 10 per cent of the FTSE All Share. 

“We have a negative stance on this sector due to the highly leveraged business models that deliver extremely volatile outcomes,” Russon said.

“The revenue models of the industry are incredibly opaque, particularly when looking at those engaged in investment banking; what is clear is that such revenues are highly challenged by persistently low interest rates and bond yields.

“UK banking stocks are now battling against structurally lower returns on equity that struggle to meet their cost of capital and have been subject to ongoing and penal regulatory scrutiny. During periods of financial stress additional issues with regards to contagion, interdependence and counterparty risk complicate the picture even further.”


Holly Cassell: “Valuations in the highly illiquid housing market are at elevated levels”

Holly Cassell, assistant manager of the four crown-rated Neptune UK Mid Cap fund, says the team has been defensively positioned with low exposure to domestic cyclicals, particularly housebuilders where they have zero weighting.

“After such a strong run, we now believe the risks associated with the sector are skewed to the downside. Whilst some may take comfort from superficially low price/earnings multiples, we question whether the earnings are sustainable over the long term. Instead we prefer to look at book values, which tend to be more stable over the long term,” she explained.

“In recent history it may have felt like the only way is up for house prices, but we believe that it is very dangerous to rely on that assumption, especially in the current environment.

“Valuations in the highly illiquid housing market are at elevated levels, relative to both history and to other major developed markets.”

 

Thomas Wilson: Banks and resources keep producing “unacceptable cash flow return”

Thomas Wilson has headed up the F&C UK Alpha fund since the start of 2015. It has comfortably outperformed both its sector average and benchmark over his tenure and is in the top decile over the last 12 months.

Performance of fund vs sector over 1yr

 

Source: FE Analytics

He currently holds no resources companies or UK banks whatsoever.

“Both have many parallels, in that they generate poor returns on capital and the main driver of their profitability is a variable or a number of variables totally out of their control and entirely impossible to forecast for an investor,” he said.

“Both sectors are littered with companies that continue to generate an unacceptable cash flow return on investment. HSBC and Barclays both generate mid-single digit returns on capital, despite a huge amount of leverage inherent within their business model, whilst Shell and BP fall even shorter when it comes to judging return on capital.

“This is driven by a number of factors, such as poor capital allocation, weak barriers to entry and tough end markets.” 

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