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Musings of a fund manager 12/05/21

Wednesday, 12th May 2021 09:49 - by David Harbage

Two weeks ago, the author commented in this blog, that "Investor sentiment seems to be changing direction, as equity markets' ‘risk on’ momentum would appear to be slowing – notably on concerns that central banks will begin to pare back their bond purchases as economies emerge from lockdown in the second half of 2021. As inflationary forces build, investors are searching for other asset types to preserve the real worth of their capital – notably gold or precious metals and digital cryptocurrencies – at a time when fiat currencies offer negligible actual returns, which readily turn negative on any consideration of their purchasing power.”

- Musings of a fund manager 28/4/21

The article went on to discuss the relative merits of such alternate assets – and in particular the miners of gold and crypto currencies, along with potential investments. This week has seen investors’ appetite for risk ease, most obviously evidenced by sharp falls amongst highly rated technology stocks on Wall Street on Monday and Tuesday. Overnight weak sentiment extended from the US into Japanese equity and onto European bourses, with the FTSE 100 index - which had barely moved on Monday - falling 2.7% today.

The pace of growth in commodity prices, benefitting from actual and anticipated spend on infrastructure projects, has exceeded the most bullish commentators’ forecasts.

For instance, exacerbated by insufficient supply to meet Chinese demand in particular, the price of iron ore has jumped by 40% since the beginning of April reaching new highs of US$200 per ton and coking coal has risen by 30% over the past two months. As a consequence of such inflation, economists are reconsidering their prime case prognosis of central banks maintaining monetary policy – and are moving towards an expectation that a rise in short-term interest rates will emerge sooner, rather than later.

Yesterday’s announcement of Chinese producer price inflation (PPI) reaching 6.8% is a real concern, as surely some of that will pass through to consumer price inflation (CPI) in due course.

Current medium-term interest rates – evidenced by 5 year plus US government bonds - indicate that the gap between the yields available on inflation-linked issues, as compared to conventional fixed coupon bonds, has reached an extraordinarily (15 year) high level.

Although both Janet Yellen, the Secretary of the US Treasury and Jerome Powell the chair of the Federal Reserve (equivalent of the governor of the Bank of England) have promised to keep rates low this year – irrespective of inflation – in acknowledgement that the economic damage wrought by Covid-19 has yet to emerge, this could yet be broken if CPI were to spiral upwards and seemingly out of control.

Looking at the second half of 2021, this is the market’s prime concern. Financial markets (foreign exchange, bonds and shares) prefer ‘to travel, rather than arrive’ – as evidenced by the equity rally which began in November, upon announcement of success in developing a vaccine for the Covid infection.

If it is now considered, based on high levels of vaccination in the US and the UK, that we have ‘arrived’, perhaps the focus of investors’ attention will turn to the next thing on the horizon – which may be rising inflation and higher interest rates – and begin to travel in that (negative, downward) direction.

Certainly the consequences of higher short and medium-term interest rates could be very damaging, as they would adversely impact:

1. Public finances – prompting a larger fiscal deficit, potentially persuading for a return to austerity measures (lower public spend, higher taxation)

2. Consumer confidence – as personal spendable incomes are squeezed by higher mortgage and borrowing costs

3. Corporate investment – as companies’ profitability is reduced, leading to a contraction in capacity rather than expansion (impacting employment et al).

Clearly, such damage would be determined by the pace and magnitude of the increase in the cost of this borrowing. Public finances are particularly stretched, post HMG’s financial support over the past year. The cost of servicing corporate indebtedness is not particularly high, after significant financial engineering to lock into low rates. While increasingly polarised, the personal sector has reduced net debt over the past year.

Looking beyond the short term trader who might seek to ride the prospect of more negative momentum, driven by the above considerations, how should the longer term personal investor be positioned?

Experience of the past eighteen months points to the importance of retaining a longer term perspective on the various assets available for such investment as pensions. An emotion-driven decision to exit risk assets, such as equity or property - in March 2020, as economic lockdowns were introduced – in favour of cash was understandable, but probably flawed. Rather, endeavouring to address the exceptional Covid-induced uncertainty by progressing diversification (owning different assets that can perform in complimentary as well as divergent ways) and placing a focus on undervalued assets would make greater sense.

In equity or company share terms, that might mean choosing businesses whose share prices were below the underlying worth of their tangible assets and avoiding firms whose balance sheet featured high levels of expensive debt. Clearly, some stocks have a strong growth bias – such as US electric car manufacturer Tesla Motors (TSLA) - and others are more defensive, perhaps via low economic sensitivity such as water & waste business Severn Trent (LSE:SVT).

Beyond making selections based on individual objective, the prudent investor will consider the particular risks and potential rewards - as well as the stock market’s valuation - of various industries and individual companies before constructing an appropriate portfolio with the longer-term view in mind.

Trying to capture the best returns by owning only the current popular favourites and excluding neglected areas of the market may seem the ideal strategy, but it is very difficult to achieve in practice - taking a significant degree of luck, as well as skill – given the pace with which markets move.

For example, volatile, non-dividend paying Tesla stock rose from US$91 to $885 in 2020, but has fallen to $616 today; while staid 4% income yielding Severn Trent fell from 2526p to 2308p last year, but has recovered to 2452p today.

Some individuals will prefer to own assets based on passive replication of major indices of such assets – for example the i shares FTSE100 Exchange Traded Fund (ISF) provides exposure to the largest UK listed company shares. It therefore has a bias to successful firms, relegating and exiting weaker ones (like Marks & Spencer (LSE:MKS)) although many underperformers within the index can remain for a very long time owing to their size (such as BP (LSE:BP.) or BT (LSE:BT.A)).

Other investors may choose to delegate the selection within a portfolio to a fund manager who they believe can outperform a benchmark index or can produce an incremental return not offered by an index tracker.

Where appraising investment trusts, consideration should be taken of the performance of both the underlying portfolio (the net asset value, or NAV) and the share price – ideally seeking to buy shares when their discount to NAV is greater than their historic norm.

Typically, trusts investing in particular assets, or segments of the equity market, will be priced in accordance with their current popularity – but the smart investor will try to spot anomalies and, therefore, investment opportunities.

For example, UK smaller company investment trusts are favoured by many institutional and private investors at the moment – causing the traditional double-digit discount of many closed-ended vehicles to contract to low single-digits. Today the average discount on the constituents of the UK Mid Cap, UK Smaller Companies and UK Micro Cap investment trust sectors is 5.2%, as compared to 9.4% a year ago and a mid-teen % in 2017-19.

However, while the discount is currently less appealing today, by contrast with history, the investment may yet be attractive – compared to open-ended funds, which offer no such discount – if the underlying portfolio or NAV appears set to appreciate. As Brexit uncertainty recedes, international investors are beginning to take a more favourable view of the UK economy and smaller companies (found outside of the FTSE 100) could be a prime beneficiary.

Clearly both the longer term track record, as well as more recent performance, of individual fund managers will contribute to investor demand for specific trusts, but the following represent a few examples where the shares’ discount – as compared to their peers remains appealing:

1. Aberdeen Smaller Companies Income investment trust (LSE:ASCI) shares are priced on a 9.8% discount to NAV – almost double the 5.3% weighted average of UK Smaller Companies trusts’ discount, despite outperforming its peers over 1 month, 3 months and in 2021 to date.

2. Downing Strategic Micro-Cap investment trust (LSE:DSM) shares are priced on a 14.6% discount to NAV – as compared to the 6% discount of the weighted average of UK Micro-Cap trusts, despite outperforming its peer group in the current calendar year to date.

Both of the above funds are run by well-established management groups, but their relatively small size (ASCI has a market capitalisation of £80m, DSM is £40m) may mean that they have not attracted the media attention which might have aroused private investor interest and that institutional investors have been unable to buy a sufficiently significant position, so have looked elsewhere.

Beyond that segment of the UK equity market, the following trusts may have appeal to investors seeking to buy attractively-priced assets:

1. AVI Global trust (LSE:AGT) invests in international equities, but focuses on companies whose share prices stand at a discount to estimated underlying NAV. Besides featuring two UK listed firms as its two largest (Oakley Capital (LSE:OCI) and Pershing Square Holdings (LSE:PSH) each account for 6% of the total portfolio) holdings, this also leads to a significant exposure to Japanese businesses (25.6% of the portfolio, including 5% in Sony). Currently AGT shares are priced on a 6% discount to NAV, as compared to the 2.6% discount of the weighted average of Global Equity investment trusts.

2. Oakley Capital (OCI) invests in private, medium sized businesses primarily in digitally-focused technology, consumer and the education sectors in Western Europe. Despite an impressive track record, the shares are currently priced on a 22% discount to estimated NAV – as compared to the peer group’s average discount of 13%.

3. Herald investment trust (LSE:HRI) invests in smaller, quoted companies in communications and multi-media on a worldwide basis – biased to information technology (65% of total portfolio) and the UK & US (47% & 25% respectively in geographic terms. Again boasting an impressive track record, the shares are currently priced on an 11% discount to NAV – as compared to the peer group’s average discount of 3.9%.

Bottom line: diversification aids peace of mind, and seeking value in individual investment selection can add value in seeking to optimise returns.

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.

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