Sports Direct, Bellway and Tesco account for some of the highest individual weightings of Phoenix Asset Management’s Aurora investment trust, despite being deeply unloved by many UK investors.
Tristan Chapple, director of the investment trust and of Phoenix Asset Management itself, believes all three to be great businesses with the potential to offer high returns on capital, yet are valued at less than half of their intrinsic value.
“We won’t pay more than 50 per cent of what we think something is worth and, because of that, it means we’re drawn to things that look ugly,” the director explained.
“That often means there’s a lot of people who would not agree with what we hold and that’s almost a necessary part of the approach. If we had a lot of people in consensus with everything that we held, we would be worried.”
In the below article, Chapple tells FE Trustnet about three of his ‘ugliest’ stocks and why he believes they have been significantly mispriced by the broader market.
Troubled retail firm Sports Direct has been in the limelight for all of the wrong reasons over the last couple of years, following an exposé about staff wages in December 2015 and a profit warning last year due to the fall in sterling.
Just yesterday, it was revealed that the company fell victim to a cyber hack last September, which led to the theft of 30,000 employees’ details.
Given the negative press the company has received, alongside the stock’s 58 per cent fall over the last two years, Chapple says the firm is more unloved than it has been in more than a decade.
As a result, he is using this as an opportunity to increase his weighting in the stock given its strong bottom-up fundamentals. Sports Direct currently accounts for 8.2 per cent of Aurora investment trust’s overall portfolio.
Performance of stock vs index over 2yrs
Source: FE Analytics
“We’ve owned Sports Direct for about 10 years but in different weights. We were first drawn to it in 2007 when it floated at £3 per share. It had a profit warning, it had loads of bad PR, it felt quite a lot like it does at the moment and the City had a very negative view of the business,” he explained.
“When we met the management and saw their head office operations though, it appeared to be a really great business. Then you had several years of them being rehabilitated and delivering better results, forging better relationships with the City, so the shares became much more highly rated.
“Then after several years, they had a small profit warning, the PR started to turn, The Guardian had their campaign about some of the working practices in their warehouses, the chief executive ended up leaving.
“Yet, when we walk up the high street anywhere in the UK, we don’t feel their competitive position in the UK has changed at all. In fact, if anything, they’re now in a strong position.”
According to data from Google Finance, the £1.7bn firm is trading on an 8x P/E ratio and has an EPS of 37p.
Tesco is another company that has suffered from bad press over the years following the announcement of a historic £6.4bn loss in 2015, its former CEO Chris Bush being charged with fraud last year in relation to its 2014 profit overstatement and its infamous horse meat scandal in 2013.
However, Chapple believes a change in management, combined with a positive macroeconomic background for UK supermarkets, means the stock has been significantly undervalued by the market. As such, it accounts for 12.7 per cent of Aurora’s overall portfolio.
Performance of stock vs index over 3yrs
Source: FE Analytics
“I think UK inflation is most likely to be a positive [for supermarkets]. If you look at the profits that have been earned by supermarkets over the last few years, they’ve had food price deflation. And food price deflation makes it very difficult to raise your prices as a tool for increasing your profits,” he explained.
“But if you have food price inflation and consumers are paying more for what they’re buying, then that is a much more conducive environment to put your own prices up.”
Much longer term, however, Chapple says UK supermarkets are attractive because of UK planning laws.
“If you go to Europe, say you have three or four competitors, there’s nothing to stop them operating right next to each other, which means operating margins across food retailers around the world are really low and have been for a long time,” he said.
“But in the UK, typically you would have a town with Tesco on one side and Sainsbury’s on the other and, if you live closer to the Sainsbury’s you’re a Sainsbury’s shopper, and if you live closer to the Tesco you’re a Tesco shopper.
“The other long-term factor is that, if you’re a really good retailer, you can copy the best ideas of your competitors in order to give your customers what they want. If you do what they ask, you’ll have a great business.”
The director says Tesco is a prime example of this and believes it has now “woken up” to the threat of German discounters which have previously sparked a price war in the sector.
“They have looked at why their customers were going to Aldi or Lidl and asked themselves, ‘what can we copy which would mean they don’t have that reason to go anymore?’ whether that’s lowering prices or tightening the reins in some areas,” he added.
Tesco is trading on a P/E ratio of 66.97x and has an EPS of 3p.
Housebuilders were hit particularly hard after the EU referendum as they are perceived to be more dependent on the health of the UK economy than their global-facing peers.
However, their valuations – combined with the current low cost of land and various government incentives such as the Help to Buy scheme and improved planning conditions – has led Chapple to believe housebuilders are now almost “too good to be true”.
“If you compare this backdrop to where we were in 2007 and 2008 when they were similarly priced – admittedly they had a lot of debt which is the big difference between then and now – there was not the number of positive tailwinds behind the housebuilders that you have today,” he reasoned.
“And yet, you can buy these businesses on P/Es of 7x at the moment which seems extraordinary. It all seems very positive except for the fact they are trading very cheaply.
“This is great because you get the opportunity to buy them if you don’t own them already, but we think they are worth in excess of twice of what they’re selling at.”
While Aurora has 4 per cent in Redrow and 7.3 per cent in Barratt Developments, its largest individual weighting is in Bellway at 14.7 per cent.
Performance of stocks over 1yr
Source: FE Analytics
“Bellway is extremely well-managed, it is large enough to be nationally-diversified, yet it’s still small enough that it has a lot of room to grow,” Chapple explained.
“Out of all the major housebuilders, it has the strongest-stated growth prospects which is great because it’s buying land at really attractive prices.
“Bellway, while they have a London business, operates at much lower price points, so the factors that are making some high-end areas of the London market difficult are not being experienced by the firm.”
Bellway is trading on a 7.3x P/E ratio and has an EPS of £3.28.
While the Aurora investment trust is in the bottom quartile for returns over five and 10 years, it must be noted that Phoenix only took to the helm of the trust at the start of 2016 with the task of overhauling the portfolio.
Since it has been managed by Phoenix, the trust has achieved a second-quartile total return of 17.27 per cent compared to its average peer’s return of 15.17 per cent over this time frame.
For those wanting a longer term track record as a reference point, Phoenix’s offshore UK fund has comfortably outperformed its sector and benchmark since its launch in 1998.
The trust is trading on a 0.4 per cent discount to NAV and has an ongoing charge of 2.38 per cent.