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R&M’s Lough: Why the value recovery isn’t just dependent on inflation

10 April 2017

Will Lough, alternate manager of the top-performing R&M UK Equity Long Term Recovery fund, tells FE Trustnet why investors should opt for value over growth despite the rotation’s recent pull-back.

By Lauren Mason,

Senior reporter, FE Trustnet

Investors should continue looking at cyclical and value stocks despite the recent pull-back in the recent growth/value rotation, according to R&M’s Will Lough (pictured).

Lough, who is director of research at R&M and the alternate manager of the £136m R&M UK Equity Long Term Recovery fund, warns investors that mega-cap stalwart stocks could still knock investors with a double hit of valuation and return risk, despite being cheaper than they were at the end of last year.

As such, the largest individual underweights in the fund include the likes British American Tobacco, Reckitt Benckiser and Diageo.

“People are saying these stocks must be attractive now because they have underperformed a bit but, as a group, they’re priced at near-peak levels of profitability,” Lough said.

“In fact, what’s really happened is that they’ve started to underperform operationally. They have delivered downgrades and the timing factor has been weak. They score poorly in our screens, they don’t seem to be fundamentally good PVT [potential, valuation, timing] ideas.

“If you’re delivering downgrades on 20 to 25 times earnings and your growth rate is around GDP, it’s quite hard to justify that type of earnings multiple.”

R&M’s potential, valuation, timing (PVT) philosophy aims to unearth any market anomalies to generate medium-term outperformance.

This involves sourcing a profitable investment dynamic, a valuation gap between stock market price and medium-term worth of the company, and optimising the entry and exit points of each investment. This is done through a combination of qualitative and quantitative stock selection. 

The process has clearly worked for R&M UK Equity Long Term Recovery as, over five years, it has been the sixth-best performer in the IA UK All Companies sector with a total return of 126.94 per cent compared to its average peer’s return of 66.53 per cent. It is also the second-best performer in the sector over one year with a return of 36.64 per cent.

Performance of fund vs sector and benchmark over 5yrs

 

Source: FE Analytics

“The other thing you’ve seen happen recently with these mega-caps that shouldn’t be played down is the enormous acquisitions they are doing; most of which seem to have a low return on capital on the actual investment being made on the acquisition,” Lough continued.


“While they are sweetening the deal to investors by telling them about all the synergies that are going to be made, there’s a question over who those synergies are accruing to. Are they accruing to the shareholders of the people that are being bought, or to you as the shareholder in Reckitt Benckiser, for example?

“There’s a fairly long history as well of these mega-caps doing large acquisitions and ringing the bell for their particular industry. TMT did it in the late 1990s/early 2000s, the banking sector did it in 2007. There’s a lot of poor capital allocation when you have a high multiple being given to you.”

Not only this, the director of research says the rolling 10-year relative return of the MSCI Value versus MSCI Growth index suggests the spread between the two is minimal compared to previous years. As such, he believes the strong performance of value stocks is far from over just yet.

“On one side, I think inflation is generally pro-cyclical. I think people are pointing to oil being the only factor that has driven it. What was most likely to generate inflation at this time last year though was capacity constraints,” Lough said.

“US unemployment is at very low levels, which generates wage growth, and there are lots of circular effects arising from China shutting down capacity. You have producer price inflation in China which, this time last year was minus 6 per cent and this year is plus 6 per cent. The dynamic of exporting deflation has changed.

“But, value stocks outperforming once more is not wholly reliant on inflation. I think the fact the debate has moved away from deflation is important, because deflation kills a lot of these companies – particularly financials. So, some inflation is helpful.

“The level at which it comes is open to debate but, ultimately, what will drive our companies over the longer term is that they are PVT investments as opposed to just value investments, so it will generate better-than-average shareholder growth over the medium-term.”

On a stock-specific basis, the director of research says the fund’s positioning hasn’t changed significantly compared to the end of last year at the peak of the value rally. However, its exposure to UK banks has increased. For instance, R&M UK Equity Long Term Recovery’s biggest individual overweight relative to the benchmark is currently Lloyds, which accounts for 3.7 per cent of the portfolio.


“What we were saying this time last year is that the risk to the upside on inflation was probably the thing people were mispricing most in the market generally. In that sense, banks and other real asset-backed plays for us, by extension, were likely to be the most undervalued areas of the market,” he continued.

Performance of indices over 5yrs

 

Source: FE Analytics

“Banks were and still are very high-scoring stocks in our recovery and asset-backed screens. If you take Lloyds as an example it’s a pretty good yard stick for our general investments in banks.

“Lloyds has done everything we would want and expect a recovery stock and a recovery company management team to do. They have large areas of their core business where they have extremely strong market positions, which they have managed to protect over many years and in fact grow, and where they earn very high returns.

“What they’ve done in the past is, like everyone else, diversified into areas they didn’t really have a strong franchise and they therefore ended up generating lower returns. They’ve sold off those businesses and they’ve retrenched to the areas where they have core strength, so their return on capital over the medium-term should be attractive and there are high barriers to entry.”

Lough also says a lot of work has been undertaken to bolster balance sheets both in terms of Lloyds and the UK banking sector generally.

“Ultimately, risk to us is permanent impairment of our capital as shareholders. I think the risk of that happening is much lower because, even in the bad times, the likelihood of Lloyds having to raise a load more capital from you as a shareholder is very low indeed at this point,” he reasoned.

“What that means is we can focus on firstly the business’s strengths and, secondly, on the fact that people still don’t seem to fully appreciate those strengths in valuations which are at around book value.”

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