Markets are climbing a wall of worry but that doesn’t mean to say the bull market won’t continue to run, according to Asset Value Investors’ Joe Bauernfreund, who heads up the £999m British Empire trust.
While the manager said investors are enduring a hated bull market, he pointed out that there is still an abundance of capital looking for a home and few alternatives, given that fixed income assets remain unappealing.
“Dividend yields are still higher than what you earn in a bank so, from that perspective, I could create an argument that the market could continue to rally. Equally, valuations aren’t particularly cheap, and that’s dangerous,” he reasoned.
Performance of indices since 2008
Source: FE Analytics
“I think the danger is if we get some kind of shock to the system, then that’s when investors wake up to the fact they actually own expensive assets and that’s not healthy.
“The question is what one does about it. If you’re running a capital preservation mandate, I think you have to have less invested in the markets and you have to hold more cash and more assets that are going to preserve your capital.
“If you’re running an equity fund measured against a benchmark, it’s a big risk to be massively in cash and underweight the market. What do investors want from you and what task have you been set?”
Bauernfreund explained that British Empire trust has a great deal of flexibility in terms of asset class weightings. In 2001, for instance, the trust was 50 per cent net cash due to toppy valuations across the board. The market environment proved to be a particular headwind for the team at Asset Value Investors, given it adopts a value approach to investing.
Now though, the trust is fully-invested and is actually 6 per cent geared; while discounts have indeed narrowed over recent years, the manager said valuations are not as high as they have been in the past.
“Discounts have narrowed but valuations in the cases of some underlying assets were crazy back in the line-up to 2001,” he reasoned.
“That’s not to say we’re ready to go to 50 per cent cash, but we’ve taken a bit of money off the table and we are in situations where we have quite good visibility on the return of capital in coming weeks and months, which is useful.”
The manager aims to find companies trading at discounts to net asset value which are also high-quality businesses.
As such, the team is restricted to certain types of companies that have these characteristics and these fall broadly into three categories: family-controlled investment holding companies, discounted investment trusts and special situations companies with asset backing.
“It’s about finding companies trading at discounts to net asset value, but that’s half of the story. If you’re going to buy something trading at a discount, it would be nice if the discount disappears or narrows substantially,” Bauernfreund continued.
“It’s about finding companies where there is an event which could catalyse that narrowing of the discount. In the case of closed-end funds, often we can be that catalyst or mechanism for narrowing. But where companies are controlled by families we can’t be forcibly activist.
“It’s about aligning our interests and finding companies that have certain events which are likely to occur at various points in time that will serve to narrow the discount.”
One of the big advantages of investing in holding companies, according to the manager, is that they’re overlooked by many investors because they are family-controlled. He said the companies are also very widely diversified, with many family-controlled holding companies consisting of several different businesses across an eclectic mix of industries and geographies.
“Investors like to pigeonhole their investments and this doesn’t easily fit in any pigeon holes. So, you could have a family-controlled holding company that is listed in France and has businesses in Africa, Europe and America – it doesn’t really fit neatly. For that reason they don’t like the diversification,” he explained.
Within the investment trust space, Bauernfreund sees the best opportunities in the private equity sector. While it has come under fire in the past for being illiquid and opaque, discounts within the sector have indeed been narrowing (albeit the average fund in the IT Private Equity sector is still trading on a 12.2 per cent discount).
Performance of sector over 5yrs
Source: FE Analytics
Andrew Lebus, manager of private equity trust Pantheon International, told FE Trustnet earlier this year that there are many misconceptions regarding the private equity market, with many long-term investors paying for levels of liquidity they simply don’t need.
Bauernfreund also argued that, because there is less visibility of the valuations of underlying assets, there is a greater opportunity to identify under-valued holdings. He said these have been magnified by the fact that so many trusts in the sector – which are performing well – are nevertheless trading on wide discounts to NAV.
“The path of the listed private equity funds was interesting. A lot of them launched in 2006, so at the end of the last bull market and after institutional investors had made lots of money out of private equity. People came up with the idea to allow the retail investor to get in there, hence you saw quite a lot of IPOs,” he explained.
“The IPOs took place, as they often do, at the top of the market and then within two years the private equity market along with the rest of the equity market collapsed.
“Investors found themselves, not only nursing losses in NAV, but finding companies and funds trading at discounts which, in some cases, were as wide as 50 per cent.
“So yes, they were battered and bruised, fell very quickly out of love with the sector and didn’t trust it because they had a very short and bitter experience investing in it. But, I think the evidence post the financial crisis is very much in favour of most of these private equity funds.”
For instance, the manager reasoned that they tend to be less geared at both a fund level and an underlying level, they have made good investments and they have been conservative when it comes to reporting the valuation of investments, which means they have often surprised to the upside.
Over the last five years alone, the IT Private Equity sector has returned more than 100 per cent to investors.
“With the sector trading at discounts of between 10 and 15 per cent, retail investors are falling back in love with the sector,” Bauernfreund said. “The valuations aren’t as excessive as they were the first time round and I think it’s a good sector for retail investors.”
Given British Empire invests in companies trading at a discount to NAV and is trading on an 11.7 per cent discount itself, the manager said investors will receive a double discount of approximately 30 per cent if they were to buy in today.
“In a market where investors are perhaps worried and are looking for cheaper ways to play the market, this - and in fact our whole universe - is a cheaper way of playing the market,” he added.
“When you put all of the assets together in their funny places and in whatever the world constructed from a bottom-up, look-through basis, you start to get is something that is quite diversified and akin to a broader market index.”
Benchmarked against the MSCI ACWI ex USA index, British Empire has outperformed by 12.79 percentage points over Bauernfreund’s tenure with a total return of 56.68 per cent.
Performance of fund vs sector and benchmark under Bauernfreund
Source: FE Analytics
It has a five-year dividend growth of 4.3 per cent per annum, yields 1.7 per cent and has an ongoing charge of 0.9 per cent.