UK-listed oil giant Shell, emerging market bank Standard Chartered and pest control specialist Rentokil are among the best value opportunities globally, according to Alasdair McKinnon. 
The manager of The Scottish Investment Trust said he is trying to find unfashionable, undervalued companies that have compelling turnaround potential.
To do this, there are three buckets he uses – ‘ugly ducklings’, ‘changes afoot’ and ‘more to come’.
‘Ugly ducklings’ are stocks that have done badly for a prolonged period of time and that as such investors have given up on.
Mckinnon (pictured) said: “We say while we agree they have done badly, we think they are very cheap and although the outlook isn’t great it just needs to get a tiny bit better, or just not get worse in fact, for us to see value on the table.”
In this space, the manager said a good example is oil titan Shell, which plummeted following the black stuff’s price drop in 2014.
Performance of stock and oil price over 5yrs
Source: FE Analytics
“People thought two things. First of all that the oil price crash was permanent as there was this new supply of US shale and emerging market demand had fallen,” the manager said.
“We also looked at US shale and it was always a three-year story. There is a three-year payback. You drill the well and you get most of your return in the first year and then there is a very rapid decline.
While you do get production for 20 years most of the production is in that three-year spell, McKinnon added.
“There is a lagged effect that will begin to kick in and this has started to happen to some extent but really what people need to realise is while shale works as a way of producing oil, it is capital intensive and relies on cheap money,” he said.
The other issue investors had was with Shell’s acquisition of BG Group for $52bn in 2015, something many people thought the company had overpaid for.
“People were worried they had stretched their balance sheet and that would therefore imperil their dividend but we were never worried about that,” he said.
Indeed, despite the merger the firm has continued its track record of never cutting its dividend and since then has rebounded strongly, more than doubling since its low point in January 2016.
It has been boosted by its overseas earnings following the Brexit referendum and its favourable yield in a low income environment.
“[However] we are keeping it in the ugly duckling category because it is still not a liked company,” McKinnon added. “It has doubled from its lows but people still have all sorts of longer-term concerns about it whether it is electric vehicles or the fate of renewables.”
Next up is ‘changes afoot’, which are companies that have done very poorly over a shorter time period but where there are signs of improvement.
Crucially, however, the market is still looking backwards and remembering the pain the company has previously caused investors.
An example in this category is Asia-focused bank Standard Chartered, which was a good stock for many investors during the emerging market boom in the early 2000s but came back down to earth during the financial crash of 2008 and in the subsequent years.
Performance of stock and MSCI Emerging Markets index over 15yrs
Source: FE Analytics
“It grew very swiftly in the emerging market boom but when the growth stopped the skeletons came out of the closet,” McKinnon said.
“What they found was actually they were in a lot of silly things. So there was a change at the senior management and a new chap called Bill Winters came in and they had to do a rights issue.”
The manager bought into the stock in May 2016 in the belief that if emerging markets could turn around then the bank could as well.
“We just thought that this is essentially a commodity company to some extent given their loan book and people have decided that it is unfixable,” he said.
“They are expected to restart their dividend having cut it, are well capitalised now, are going through a very sensible plan and have turned from being a basket case that people thought was in dire trouble to the situation now where its loan book quality is improving.”
Scottish Investment Trust’s third bucket is ‘more to come’ where a company has been through change but is still being underappreciated by the market.
“These companies might have worked their way through our portfolio but because they have been through this journey often people overlook what they can get back to or what they can become,” he said.
An example in the portfolio for this bucket is pest control specialist Rentokil, which started in the fund as a ‘changes afoot’ but has since recovered sufficiently.
The firm was run by former chief executive Clive Thompson for 20 years during the 1980s and 90s, who promised – and delivered – 20 per cent earnings growth every year.
“But he did so in an increasingly odd manner so that by the time it all went horribly wrong it turned out he had a wonderful core business in pest control and a load of junk,” McKinnon said.
As such, Rentokil struggled for almost a decade as investors understood that the previous growth levels were unsustainable.
Performance of stock over 20yrs
Source: FE Analytics
A new management team came in five years ago and begun divesting businesses leaving just two areas – pest control and textiles.
“Textiles is a pretty rubbish business because it is low margin but pest control is an absolutely brilliant business,” the manager said.
“Rentokil are a hugely international business – mainly a US and European business – on 12-13x earnings compared to its US peers on 30-40x earnings.
“That’s not to say that we think any company should be on 30-40x earnings, it is more to say that the reason they were those earnings is because people said these are brilliant businesses.”
As well as the turnaround in businesses, there is potential for the company to grow the earnings of its core business by improving logistics.
However, the stock has performed strongly of late, up 133.44 per cent over the last three years, and the market has recognised that it is a much better business than it was 10 years ago.
“We are hanging on but this is the time we are starting to sell as well. Yes, there is more to come but now it is well recognised,” he noted.
Overall, the £639m Scottish Investment Trust has a 29 per cent weighting to UK stocks – more than any other region.
Since taking over the investment company in 2014, it has returned 55.63 per cent versus the IT Global sector average peer’s 63.63 per cent.
The Scottish Investment Trust’s shares are on a discount to net asset value of 7.4 per cent, according to the Association of Investment Companies. The trust has a 2.5 per cent yield and ongoing charges of 0.47 per cent.