Identify the theme, and a potential beneficiary

Friday, 25th October 2019 08:35 - by David Harbage

Active fund managers are those who endeavour to outperform a particular benchmark, such as UK equity’s FTSE100, as opposed to passive investors who seek to track or match an index. The reader might be interested in a brief insight into some of the thought process of this active fund manager.

The portfolios that the writer manages seek to preserve their real worth by trying to beat the Bank of England base rate plus a specific return (between 1.5% and 5%) each year. Maintaining the real worth – ahead of local inflation – of one’s capital, ideally boosted by the receipt of a steadily growing income, represents most personal savers’ long term objective. Company shares represent one of the portfolio’s prime investments (equity accounts for between 25% and 60%, according to the mandate chosen by a client) because of its historic record of delivering high and rising dividend income.

In terms of UK stocks, the fund manager currently has a bias towards smaller and medium sized businesses (as compared to those in the FTSE100 index), typically achieved via the likes of collective investment vehicles, to procure the desired diversification. The larger a business becomes, the more closely observed and assessed its prospects; trying to outperform an index such as the FTSE100 therefore is difficult because, in theoretical terms, ‘all information and a high number of opinions’ are already reflected in the price. But, logically, news flow develops and unforeseen events can impact.

The active manager will possess views ranging from which asset class to favour and, necessarily as a consequence, be under or overweight (compared to portfolio guidelines or benchmark) through to the selection of individual securities or investments. Such perspective will probably take account of both macro (global economic & political developments) and micro issues (local specific trends), before assessing the relative valuation (by contrast with history) of each asset compared to another (as each effectively competes for capital or a position in the resultant portfolio of investments). Such an exercise will help the investigative investor to determine what is already in the price and where (if expectations are realised) there is upside or downside potential.

It is not wrong to have few non-consensual opinions - there is an element of truth in the saying that ‘the market is never wrong’ – but investors will probably want to focus on their contrarian (as compared to current market pricing, in particular) views. According to the amount of risk and reward (of underperforming or beating the return of a particular benchmark index), so a fund manager will decide on the magnitude of exposures. For example Royal Dutch Shell and HSBC are two of the largest listed companies on the London stock exchange and so a decision has to be taken on the extent to which each is owned (and therefore the magnitude of the active exposure). The fund manager will have to possess a view on the oil & gas and banking industries in making a decision on whether to own 0%, a neutral index weighting or a seriously large company-specific position.

It might be helpful to share detail on the most recent trade in the writer’s fund – the purchase of Carnival shares - as a guide to some of the potential thought processes in active investment selection. Carnival is a FTSE100 constituent, but also listed on the New York stock exchange, which owns the cruise line of the same name plus Cunard, Holland America, P&O and Princess amongst others (more than 10 lines and 100 ships). The cruise ship industry has expanded dramatically over the last twenty years and capacity is set to rise further in the next decade. Such increase in supply should be viewed critically, but is countered by supportive demographics featuring a rising, ageing population – which, with the exception of the lowest socio-economic groups, possess the ability and propensity to spend on such leisure pursuits – particularly mindful of Asia’s growing middle classes.

In terms of assessing the future profitability of this cyclical business, analytical fund managers will have a view on the price of oil as fuel represents one of the company’s prime operating costs. The prospect of a slowing global economy, highlighted by China’s recent announcement of 6% growth in GDP (respectable in any developed country, but a 30 year low point for the world’s second largest economy) and exacerbated by the US-China trade war, is likely to mean that demand for oil will ease.

In the absence of any significant reduction in supply, the price of crude and oil’s refined products is likely to fall. The stock market listed beneficiaries of such a development would feature corporate consumers for whom fuel is a major expense – such as airlines and cruise ships (amounting to nearly a fifth of Carnival’s non-fixed costs). Both of the UK equity market’s major transport industry companies, Carnival and International Consolidated Airlines Group (owner of British Airways) have suffered over the past four years from a stronger oil price (crude has risen from US$30 in January 2016 to touch $88 a year ago). However, while there are dissenters (such as Goldman Sachs), most forecasters suggest that the current sideways-gently downward trend is set to continue.

The oil price is difficult to call correctly – with geo-political tensions and unpredictable supply sources a perennial backdrop – and the sensitivity to profits of such cyclical industries as air and cruise lines means that a fund manager requires a greater degree of conviction about individual equity investments than might apply in a less volatile industry. Seeking comfort that industry developments and anticipated trends makes the equity valuation of Carnival anomalous, consideration was given to the following:

1. Carnival is an Anglo-American company (the only one who features in both the S&P 500 and the FTSE100 indices), but its shares currently appear undervalued by contrast with the overall UK equity market - by reference to its single figure price-to-earnings (PE) multiple and 5% dividend yield. More pertinently, the consensus of 21 UK-based analysts forecast that earnings per share (EPS) will rise by 1% and 3% in the years to 30 November 2019 and 2020 respectively to put the shares on a PE of 8.6x next year’s profits with a 5.4% prospective dividend.

2. Of those broking houses publishing a view, 6 say Buy, while 13 suggest Hold and 2 recommend Sell. Such a mix prompts this viewer to anticipate an improving trend; with so many neutral (in reality, biased towards having negative) views, there is plenty of scope for upgrades. Price targets from London-based, Sell-side institutions currently average 3625p, there is only one ‘short’ position (of just 0.92%, by Blackrock) but, it should be noted that many City fund managers have limited enthusiasm for the 24^th largest company in the FTSE100 index. On Wall Street, there has been a positive move in the direction of State-side research houses’ recommendations since 26 September – encouraged by the company’s quarterly results, which beat expectations.

3. There appears to be a move – away from highly priced Growth-oriented companies towards firms for whom Value would best depict them - in equity portfolio management. Within the UK stock market, this has become more evident since July, to the point that higher yielding Value stocks (within the FTSE350 index) have outperformed lower yielding Growth businesses in that universe in 2019 to date. After five years of Growth dominance, it would seem that Value is making a comeback. This trend has also been seen in the US and, if it continues, should help the likes of lowly valued Carnival

4. The shares of International Consolidated Airlines Group have risen by almost 25% from their low spot last month and, while there have been other significant issues – beyond the oil price or transport industry – impacting, perhaps the upward bounce can be a helpful indicator of a similar re-rating of Carnival’s equity. Closely watching the latter’s price, technical indicators suggest that it has ‘bottomed’ in the last week and may have found a new base from which to progress.

In summary, the diligent active fund manager will consider the positive and negative aspects (by reference to strengths, weaknesses, opportunities, threats) of every asset class, equity segment and individual investment. Taking a view on each of the major influences, before focusing on those where he or she has the greatest conviction – and valuation would seem to disagree, in order to provide the opportunity to see a change in the price towards the outcome you envisage. In particular identifying strong, longer term trends which are likely to dislocate consensual views – before identifying the probable beneficiaries, as well as ‘losers’, as such a projection plays out.   

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.