TB Wise Multi Asset Income Year End 2017-8 Review
The price of Wise MAI fluctuates from one year to the next – after a 33% gain last year, we are now reporting on a year which produced a return of just 5.3%. But the process, and the principles which inform the management of the fund, do not change, and it may be useful to reiterate them here.
Whether investing in companies or in funds, we invest primarily in people. We don’t know what the future has in store, but we believe that we are best equipped to cope with it, if we place our shareholders’ money in the hands of experienced people with energy and sound judgement, who we believe care deeply about the institutions they manage, and who are able to explain their plans to us in a clear and credible way.
We aim to invest in these companies and funds at times when their share prices are significantly below our estimate of their fair values, and even though our respect for them doesn’t change, we will sell once the valuations rise to levels we aren’t comfortable with.
We believe we can serve our shareholders best by adopting the widest possible investment remit, so that when certain asset classes become dangerously expensive, we have the best chance of finding value in others.
We prefer not to invest in the tobacco and gambling industries, or the arms trade, and have avoided these areas for many years. We strongly believe in renewable energy, though even in this area we will not invest when the assets do not meet our valuation criteria.
We prefer to invest in entities which serve people’s needs rather than their whims.
Though the fund’s remit is global, we will not invest in areas where we can’t be sure that property rights or the rule of law will be upheld – Russia, for example.
As this is an income fund, we do not invest in any asset which doesn’t pay an income, with an unofficial minimum of 2.5 – 3.0%.
The period from the middle of February 2016 to the end of May 2017 produced returns for the fund in excess of 40%, and lifted some of the fund’s assets to levels at which we felt compelled to reduce or sell them. Among the funds, we reduced the private equity trusts Princess and Foreign & Colonial, as well as Picton Property, and CC Japan Income & Growth. We reduced our holdings in Alliance Pharma and Stobart, and sold Savills, Morgan Sindall, XP Power, and McColls, all on valuation grounds. We also sold Quarto, where we had lost faith in the company’s strategy, and Harvey Nash, which became too small for the fund. We have an unofficial policy of not investing in any company or fund which is smaller in size than Wise MAI.
The political and economic woes of the UK
We identified a number of opportunities for new investment, mostly in the UK, which is one of the world’s cheapest markets, avoided by overseas fund managers on account of Brexit.
The Conservatives had called an election, mis-handled their campaign, and were only able to form a government with the help of the Democratic Ulster Unionists. Far from the promised ‘strong, stable government’ the UK appeared to be led into the Brexit negotiations by a weak and divided party, where it was completely at the mercy of the better-organised EU negotiators.
At the same time a re-invigorated Labour party rolled out a hard-left agenda, promising to scrap the Private Finance Initiative (PFI) and re-nationalise the railways, together with the water and power sectors. The Government countered by dialling up the rhetoric against the power companies, threatening to impose draconian price caps.
Then Carillion announced a profit warning, which led to administration several months later. Carillion’s troubles were due in part to the fixed-charge, all-risks construction contracts they had accepted, where wafer-thin margins, typically 2.0%, disappear altogether if costs rise above budget. Carillion ran a number of projects for infrastructure funds such as HICL and John Laing Infrastructure, which had to make provisions against losses. Other construction companies were compelled to take on extra work on projects in which they were in joint venture with Carillion, for example Galliford Try and Balfour Beatty on the Aberdeen West ring road. Many investors now believe that the construction sector is un-investable.
Last year was a difficult one for the UK consumer. Inflation was pushed up by the rising cost of imported goods, following the fall in sterling in 2016, and nationally, wage rises failed to keep pace. High street retailers were battered by a combination of falling demand, online competition, increased business rates, the National Living Wage, and the apprenticeship levy. Commentators began to talk of the ‘death of the High Street’.
The above issues have offered us opportunities in several sectors.
Utilities are seen as highly indebted, and as price-takers from their regulators. However, the debt is an integral part of their long-term investment programmes, which make them the owners of unique assets without which society could not function. There is maximum uncertainty in the water sector in advance of the five-year price review, due to be implemented in 2020, which is currently weighing on prices. Also, utility companies are seen as ‘bond proxies’ – assets you would own as alternatives to bonds, and bond prices have started to weaken. After researching the sector, we identified long-term value and invested in Pennon and National Grid.
We also see value in the construction sector. The bankruptcy of Carillion has worked well for the remaining companies, partly through the removal of a competitor, but also specifically because the remaining companies are no longer prepared to accept the fixed-price contracts which become loss-making so frequently. Galliford Try is a good example. The company has announced two profits warnings relating to the Aberdeen road scheme, most recently following the Carillion failure, which have caused the company’s share price to fall by around 40% over the last year. However, the Aberdeen scheme is the last of the old-style contracts the company has to work through, and there is the potential for a substantial claim against the client, who caused the delay which led to the original cost over-run. Galliford Try also owns Linden Homes, the UK’s sixth largest house builder, together with a fast-growing affordable housing and urban renewal division. On a standalone valuation, Linden Homes is worth perhaps 125% of the whole of Galliford Try, which means that the market values the construction arm at less than nothing, at a time when it may be entering a period of lower competition and higher margins, and the other divisions continue to trade profitably.
The infrastructure sector offers us exactly the kind of long-term, inflation-proofed, secure income streams which Wise MAI was set up to provide, but the investment trusts through which we can access the sector have been expensive for years. Investors bid the shares of the infrastructure trusts up to the point where HICL, the largest fund in the sector, was on a premium of over 20% to its asset value (so you pay £120 for £100 of assets). Today, the threat of Mr Corbyn re-nationalising the PFI, the demise of Carillion, who were a contractor to the trust, and the rise in bond yields, have created an aversion to the sector, which has caused HICL’s price to fall by almost 30%, its dividend yield to rise to almost 6%, and the 20% premium to turn into a 9% discount. Finally, there is an attractive entry point for the long-term investor.
Will Jeremy Corbyn’s Labour party come to power? Perhaps. Will they re-nationalise the PFI? Possibly, but not without a plethora of legal challenges, and hence, long delays. Re-nationalising the PFI isn’t a vote-winner, and wouldn’t be a top priority. The sector would have to be tackled piecemeal, targeting the most obviously failing contracts first – not, that is, the ones owned by HICL and its peers. We see a significant opportunity here, but for now the prices are still falling.
We see opportunities in the retail sector, or more broadly in the sector that sells goods and services to consumers in the UK. However, there have already been casualties in this sector (Maplin’s, Toys ‘R’ Us, Conviviality Retail, Jamie Oliver) and there will be more, so great care is needed. In evaluating such companies, we ask three questions – ‘Do we trust the management, is the company capable of withstanding competition, particularly online competition, and is the balance sheet strong enough to cope with a prolonged period of pressure on margins? For a company to be considered investable, the answer needs to be a confident ‘yes’ to all these questions.
Our largest holding in this sector, Shoe Zone, is a small company. Shoe Zone, a discount retailer, imports shoes, mainly from China, and sells them through its shops and increasingly online. The company was family owned until the listing a few years ago, but continues to feel like a family company, and has a large family shareholding, runs a highly efficient operation with tight control of costs, and keeps a large cash buffer, with no debt.
Our next largest holding, Halfords, is roughly one-third cycle shop, and two thirds auto spares. New car sales have slumped in the past year, but that favours Halfords, as auto spares sales tend to grow with the increasing age of the UK’s car fleet. Customers tend to order their parts online, and then go to the store to have them fitted. Halfords are also looking to grow in the car repair market. We added a new holding, Photo-Me, towards the end of the year. Photo-me, another company with a substantial cash pile and no debt, best known for its photo booths, is rapidly expanding in the unmanned laundry segment worldwide, with new installations being paid for by cash flow. Photo-me is the kind of company we want to own – it has talented, committed, experienced management, strong brands, and plenty of cash. It is diversified both globally and by market segment. It sells things that people need – passport photos and a cheap way to wash your clothes, and it pays investors a handsome dividend.
It might be imagined that, at a time of growing geo-political risk, of growing tension between Iran and Israel, China and the US, and between Russia and the rest of the world, a style of investment which has become, at least for now, increasingly domestically-focussed, investing in things like the power grid, waste recycling, and the sale of car spares, might appeal to investors. This has not proved to be the case. In the last few months, the prices of our holdings in construction, infrastructure, utilities and retail have all continued to decline.
When events reveal errors in our judgement, our practice is to make adjustments. The most painful of these occurred in the summer, when we sold our holding of Carillion following the profits warning, which revealed the extent of the management’s failure up to that point to reveal what had really been going on in the company. Carillion cost the fund 1.6% of performance during the year, and was our biggest detractor during this period. Other significant losers were the utilities National Grid, Pennon and Centrica, the pub company Marstons, and construction companies Kier and Galliford Try. Our biggest positive contributors were Princess Private Equity, Henry Boot (construction, land sales to house builders), Stobart (biofuels and owner of Southend Airport), Alliance Pharma, and the financials Legal & General, Polar Capital and Numis.
At the end of February 2017, we reported reduced value in the Wise MAI portfolio following a period of unusually strong performance. Today’s portfolio contains more earnings and more dividends, and therefore, we think, more value than that of a year ago. Our focus is on producing a robust stream of income, which is as far as possible insulated from legal, regulatory, political and economic challenges, and from changes in fashion, both in consumer demand and in financial market perceptions. We continue to question our assumptions, correct mistakes, and to look for new income-producing assets with the right characteristics.