As much of the developed world continues to open and economies get back into full swing, cyclically orientated stocks have enjoyed a strong rally.
Some of these cyclicals include companies in the travel, leisure and commodity sectors, which have rallied hard on the back of the economic re-opening as well as rising commodity prices.
But despite the recently strong performance of cyclical stocks, Blake Hutchins – who co-manages of the £2.7bn Trojan Income fund – said that much of the enthusiasm for the cyclical rally is mis-placed.
“The world has opened up at the same time and it is trying to open up quite fast – and that is inevitably causing bottlenecks,” he said. “But it's very important that the market doesn't extrapolate that into perpetuity.”
The disruption caused by the bottlenecks has been particularly evident in the freight market - which has seen rates increase over 500% in the space of one year.
Hutchins said: “Instead of obsessing about the reopening and the cyclical trade, I think it's much more important now to get into businesses that are just fundamentally becoming more valuable.
“The market has now had quite a long time to get its head around the fact that vaccines are in place, what that means for the recovery of various sectors, and what that means for the opening up of economies. A cyclical recovery is well discounted into markets now.”
He said this can be seen in the valuations of many companies that were severely impacted by the pandemic now trading back at their pre-pandemic levels, despite not yet making the same level of profits that they made before the pandemic.
“On the other hand, I can also see from companies that we own that are companies that were basically winners last year during the lockdown but are now finding life harder on a relative basis, because economies are opening up,” he said.
One such company he pointed to was Reckitt Benckiser, the British multinational consumer goods company that owns brands such as Dettol and Nurofen. The stock was boosted last year by its increased sales of disinfectants and medicines to people at the height of the Covid-19 pandemic.
Performance of Reckitt Benckiser over 2yrs
Source: FE Analytics
However, Hutchins said the FTSE-100 listed company has experienced a relative slowdown in sales of its hand sanitizer and flu medicines in recent quarters. Reckitt Benckiser is Trojan Income’s fifth largest holding at 4.4%.
Hutchins said: “I look at the valuation and the enterprise value of Reckitt Benckiser - and it's lower than it was pre-pandemic.
“Yet I look at something like WH Smith – in which its biggest business is the shops that we all go to an airport before we board an aeroplane - is basically back to where it was pre-pandemic.
“Reckitt Benckiser - which is obviously was a beneficiary from Covid - is making profits higher than what they made pre-Covid, yet its enterprise value is at or lower than it was pre-pandemic.”
Hutchins finds it “very hard to believe” some of the very cyclical companies that are exposed to international travel, such as WH Smith, are going to be much more valuable in the next few years than they were before the pandemic.
He said: “On the other hand, I find it very hard to believe that Reckitt Benckiser is now a less valuable business than it was pre-pandemic, given everything we know about pandemics and cleanliness and health and hygiene, etc.”
Performance of WH Smith over 2yrs
Source: FE Analytics
Instead of trying to piggy-back an obvious cyclical recovery, Hutchins is focused on what he characterised as his “defensive growth” strategy.
He said: “What’s going to be important in driving our investors’ returns is finding those companies that can grow their free cash flow consistently over a long period of time, become more valuable businesses along the way on account of that, and pay investors growing dividends funded by that growing free cash flow.
“In a low-growth world where inflation is arguably ticking up, we need companies that can grow in real terms and grow their dividends.
“So it's that combination of defensive growth through quality companies that I think is absolutely relevant for today's market, particularly after the super cyclical rally that I think is starting to fade.”
The Trojan Income fund’s performance has lagged its peers recently, but Hutchins said this recent performance fails to show two very different stories that played out in a short space of time.
“2020 was a strange year,” he said. “It was almost a bit like 2007, 2008 and 2009 all rolled into one. When we have market drawdowns usually it is never clear when it's okay to buy cyclicals. It's never super clear when the recession is over, and the recovery starts.”
When the vaccines came out with better than expected efficacy in November of 2020, this was a very clear signal to markets that the worst case scenario was off the table and the recovery could begin.
As the cyclical rally starts to fade, Hutchins believes the market will start to see returns broaden out beyond the cyclical names - as it has in the past four months.
“I think in that four-month period, when looked at in the context of our 17-year history - we've been there before,” he said. “I think recent performance is a good indicator that the dispersion of returns is broadening, and that's playing out to Trojan incumbents benefit.”
Performance of Trojan Income over the past 15 years
Source: FE Analytics
Over the past 15 years, Trojan Income has delivered a total return of 194% compared to 124% from the IA UK Equity Income average, putting it in the first quartile of the sector.
It has an ongoing charges figure (OCF) of 1.01% and is yielding 2.4%.