Given recent market moves, a natural question that we are hearing from investors and debating internally is whether this is an opportunity to invest in UK equities, and if so in what areas.
Performance of indices in 2015
Source: FE Analytics
As the trusts we manage have a broad spectrum of investments (ranging from small companies of approximately £50m market cap to the FTSE 100), there is a big range of stocks to choose from.
In our view the recent market volatility is throwing up interesting opportunities in which to invest. As bottom-up investors driven by company fundamentals, we base our investment decision on whether valuations look attractive, whether margins are sustainable and whether strong cash generation can continue. On a P/E basis the FTSE 350 is roughly in-line with its historic average, making it look neither particularly cheap nor particularly expensive, however the underlying quality of companies has improved.
Since the downturn, corporates have remained incredibly focused on running lean organisations and have taken a cautious approach to capital expenditure and M&A decisions. This has left many of the companies we hold in a net cash (or near net cash) balance sheet position with high operating margins.
During the recent results season we did not see evidence that this cannot continue – in many cases operating margins have continued to grow. Taking chain manufacturer Renold as an example, management have done an excellent job improving operating margins to a high-single digit level, but earlier on this year they announced medium-term plans to achieve a mid-teen level for margins. This is not a one-off case – we think there is still good scope for margin growth in many of our holdings, such as Scapa Group and Avon Rubber.
The message we are hearing when meeting companies is one of cautious optimism. I think in particular we can see that in the level of dividend growth which boards are approving. Companies such as Churchill China, Hill & Smith and Johnson Service Group have all increased their dividends at a double-digit rate in recent weeks. In all cases this leaves neither the dividend pay-out ratio nor the balance sheets stretched, so they are all still capable of further dividend growth in future.
While we have not made any significant portfolio changes this year, we have been adding at the margins to existing positions. Looking down the list of purchases I would classify these broadly into two types: companies undergoing recovery such as Tesco and Balfour Beatty and differentiated companies broadly unaffected by macroeconomic events, such as Revolymer.
Taking the first category including Tesco and Balfour Beatty, both have had a new management team come in with the aim of returning the company to near historic operating margins. In both cases we think the measures the new management teams are taking are sensible – for example in Tesco’s case reducing the range of goods on offer (but making those left more competitively priced) while putting more staff back into stores.
Performance of stocks in 2015
Source: FE Analytics
The second category of stocks, those which are differentiated from the wider market, are a newer category for the trust. More broadly within Lowland we try to invest in areas where the UK excels, such as high quality industrial companies and the insurance sector.
Another category where the UK has an excellent foundation is science, but historically it has been quite difficult to invest in this area as start-ups from the UK were often bought by, for example the US, before reaching commercialisation. This is now starting to change with the growing category of university spin-outs listing on the UK stock market.
We have held companies that take a portfolio approach (with holdings in many different companies across the sector), such as IP Group, for a number of years, however more recently have added to individual companies such as speciality chemicals company Revolymer and early stage pharmaceutical company 4D Pharma.
These are companies that are high risk in that the technology either will or will not become commercially viable (in that aspect they are quite ‘binary’) however they have the potential to be hugely disruptive in their respective end markets.
To find the cash for these purchases (as in Lowland we already have a mid-teens level of gearing), we have been reducing some of our holdings that have been strong performers in recent years. A good example of this would be logistics provider Wincanton. The management team has done an excellent job of reducing debt and scaling back to its core business within the UK, however the shares have strongly re-rated and therefore we have used the cash to fund investments elsewhere.
We have also been fortunate in receiving a cash bid for one of our biggest positions, non-life insurer Amlin. While it is a shame to see Amlin go as it has been a good contributor to capital and income growth in recent years, it will provide us with the opportunity to invest in a number of attractive opportunities currently within the UK.
