Elevated valuations and questions over the longevity of the current market cycle make it a difficult environment to navigate, according to Troy Asset Management’s James Harries, who remains cautious despite a more auspicious start to 2019.
Harries, who manages the £149.2m Trojan Global Income fund, said that after more than 10 years of extraordinary monetary policy we are at a “very unusual juncture of capital markets”.
“It feels like we’re just traipsing along day-to-day, but, actually, the unusualness of the backdrop is almost hard to identify,” he said. “We have had such aggressive stimulus that we’ve reached a point where the opportunity set is pretty unfavourable.”
Valuations remain elevated, boosted by a tide of liquidity from central banks in response to the global financial crisis. As the below chart shows, the MSCI World has risen by 241.69 per cent, in sterling terms, over the past 10 years.
Performance of index over 10yrs
Source: FE Analytics
There seems little support for a big structural upturn for markets too, said the equity income manager, the last of which occurred in 1981 when conditions were very different.
Coming off a difficult decade, conditions in the 1980s were much more conducive with high interest rates, high US 10-year Treasury yields, high inflation, lower public debt, higher savings rates, more attractive equity valuations and a supportive demographics.
“Unfortunately, today none of that is the case,” he said. “We have a much lower bond yield, low interest rates that can go up a little bit but not very much, pretty low inflation, much lower savings rates and much less attractive valuations.
“‘So what?’ you might say. Because of all this, we think the Federal Reserve has had to press very hard on policy acceleration. They’ve had to pull the levers very hard to generate demonstrative growth and inflation in the real economy. And it’s created something that we think is anything but moderating in the financial economy.”
As such, this has created an environment where investors need to be more cautious, particularly in a market where disruption of traditional business models has increased with the rise of new technologies.
Given this cautious backdrop, Harries noted that Troy is concentrating on companies that display high and sustainable returns on capital employed, free cash flow generation and long-term dividend growth potential while trading at reasonable valuations.
Trojan Global Income also avoids companies and sectors that are limited in terms of cyclicality and capital intensity. Altogether, Harries said, this should lead to long-term returns.
However, that can take some time to appear.
“When we launched two-and-a-half years ago the entire quality element of the market was pretty fully valued; it certainly was not apparent at the time but we know in hindsight that was the case,” he said.
“We tend to try and keep up performance when markets are good and outperform when they are less good.”
Harries added: “We launched at a relatively unfortunate time just before the ‘Trump bump’ as they call it – before Trump was elected – which made our initial performance somewhat pedestrian, but we’ve come back with a vengeance.”
Performance of fund vs sector & benchmark in 2018
Source: FE Analytics
In 2018, Trojan Global Income outperformed both its benchmark and the IA Global Equity Income peer group, albeit making a 0.96 per cent loss.
Harries’ approach to management also means that the fund might not look like a traditional equity income fund at times, something he attributes to allocating away from the benchmark.
“If you concentrate your efforts and resources on particular sectors you think are inherently attractive, that takes you away from the benchmark approach,” he explained.
“Where all companies are deemed equally worthy of investment it comes down to trust. We think you need to consider whether a business is inherently good before you invest.”
Launching at a time when quality businesses appeared fully valued meant taking some tough decisions to start with, said the manager.
“In order to generate a reasonable income, we augmented these view with some lower quality but more predictable businesses at that point in time,” he said.
“What’s been encouraging is that our whole premise was the market would give us opportunities to upgrade the quality of the portfolio without compromising any income yield and that’s exactly what happened. We’ve been able to sell some of the lower quality businesses and reinvest.”
The Trojan Global Income manager added: “We’ve got lots of ideas that we’re looking to invest in at more attractive valuations and we’re just waiting to do that.”
Not all decisions are based on a deterioration in quality, however.
A more recent development in the portfolio, the manager said, was its decision to sell of US tobacco company Altria following its $13bn investment in vaping company Juul, which he said was a “sub-optimal allocation of capital”.
Some of this capital was recycled into Philip Morris, which the manager said was trading at extremely attractive valuations for a company with a high quality global franchise.
Harries also added to the fund’s holding in UK company Domino’s Pizza Group despite a public row with its franchisees over sharing of profits, which has sent it to more attractive valuations.
“We’ve held that business for a while and we expect to hold it forever,” he said. “Ultimately, it’s a very high return on capital business, lots of long-term growth prospects, lots of sustainable competitive advantages and it’s a lovely business, frankly. Its conflict will be resolved one way or the other.”
The Trojan Global Income fund has made a return of 17.93 per cent since launch in October 2016, underperforming the MSCI World benchmark’s 21.12 gain. Over the same period the average peer has made a 16.52 per cent total return.
Performance of fund vs sector & benchmark since launch
Source: FE Analytics
It has a yield of 2.93 per cent and an ongoing charges figure (OCF) of 0.96 per cent.