The Grand Old Duke of York – backwards
Blog June 15th 2018
Part 1 – market background
The Grand Old Duke of York – normalising interest rates – the new technology boom – Donald Trump – Brexit
Part 2 – the fund - TB Wise Multi-Asset Income
We will regularly publish a full list of our holdings – bond proxies – retailers – construction – summary
This blog will look at TB Wise Multi-Asset Income in more detail than we are able to put into our short monthly commentaries.
The first part will look at various influences on today’s financial markets, the challenges facing anyone trying to run a business today, and how we try to avoid their worst effects in constructing our portfolio.
The second part looks at the fund, and why we believe some parts of it are performing in the way they are.
Following a period of very strong performance between February 2016 and the end of May 2017, the fund has moved sideways for a year, with a modest capital loss being offset by the income received.
Part 1 - Influences on the market
The Grand Old Duke of York - backwards
The Grand Old Duke of York, you may recall, he had ten thousand men. He marched them up to the top of the hill, and he marched them down again. In the first half of 2018, financial markets have performed the same manoeuvre in reverse. From mid-January, they went down by roughly 10%, and then recovered from late March till, at the time of writing, markets are, in aggregate, more or less back where they started. At an individual stock level, it is noticeable that some assets fell and haven’t recovered, while others have shot to new highs well above previous levels. The patterns which have emerged aren’t as we would have expected. These patterns have held the fund back in the last few months, but what’s good is that the low prices of some assets are presenting us with opportunities which are far more attractive than we could have expected at this stage of a market cycle.
Normalising interest rates
Almost a decade ago, in the wake of the financial crisis, the world’s central banks needed to restore confidence and set the world economy on a path to recovery. One way of achieving this result was by cutting interest rates almost to zero, where they have stayed ever since. Interest rates are a tool for controlling inflation, and so at some point they need to be raised. When inflation is 3.0%, no one wants to lend money at 0.5%, and under the Zero Interest-rate policy (ZIRP) no one is being rewarded for saving. And, come the next recession, it won’t be possible to stimulate the economy by cutting interest rates, if rates are already at zero.
However, given the unprecedented amount of debt in all developed world economies, interest rates have to be increased very gingerly to avoid widespread bankruptcies, and the inevitable recession which central banks were trying to avoid a decade ago.
On June 14th, The US central bank (known as the Federal Reserve, or ‘Fed’) raised interest rates to a target level of 1.75 - 2.0%. This was the seventh raise in the current cycle, and though this level is still very low by historic standards, the US has made far more progress in rate normalisation than any of the other central banks – in the UK the base rate is 0.5%, in the EU it is 0.0%, and in Japan, minus 0.1%. The normalisation process has barely started anywhere except the United States. Even there, rates have been raised partly because policy is so accommodating in other areas – for example, Mr Trump has announced tax cuts worth $1.5 trillion, as well as $300 billion of federal infrastructure spending.
The financial markets know that the direction of interest rates must be upwards from here, even though the pace of rises may be slow and their extent limited, and rising interest rates will put pressure on the valuations of all financial assets. For example, if you own a fixed-rate government bond paying 1.0% a year, a rise in interest rates from 0.5% to 1.0% will reduce the attractiveness of your bond relative to a cash deposit. If you and other investors sell your bond and place the proceeds on deposit, then the price of the bond will fall. The weakness in financial markets that we saw in the first quarter of this year, was, in our view, a response to the prospect of higher interest rates.
The subsequent recovery in market sentiment may have been caused by the reflection that, given the probably rather modest extent and pace of the normalisation, the fall in asset prices was an over-reaction.
To what level might we expect interest rates to rise? Commentators expect a further two interest rate rises in the US this year, followed by another three next, which would take the US base rate to 3.00% - 3.25%. Interest rate rises in the other three main centres will be more modest.
You might therefore expect that if you own good assets which pay high levels of income (the aggregate dividend yield across the 45 assets in TB Wise Multi-Asset Income is a little over 5.0%), and if that yield can reasonably be expected to rise over time, then the prospect of a few quarter-point interest-rate rises, spread over a couple of years, wouldn’t make too much difference to the long-term attractiveness of the asset. This was, in fact, what we did expect, and still do. However, some of the worst-performing assets in 2018 have been high-yielding ones, while some of the best-performers pay no income at all.
The new technology boom
Technological change has never been faster than it is today. Machine learning and the internet are transforming every area of our lives. In ten years’ time, instead of driving cars powered by petrol, we will be driven around by electric cars, which we probably won’t own. What effect this one change will have on the oil, automobile and car insurance industries remains to be seen, but as investors it makes sense to be on the right side of the changes, and give our money to the disruptors, rather than to legacy companies which are in danger of extinction. And that’s clearly what’s happening – every day the Nasdaq index in the US hits new highs, and the technology sector has out-performed all others over the last couple of years.
We avoid the sector for a number of reasons. The first and most obvious is that we are running a dividend-paying fund, and technology companies almost never pay dividends. But there’s more to it than that.
We remember Bill Gates’ saying that people always over-estimate the amount of change that will take place in the next couple of years, while under-estimating the amount of change that will happen in the next ten years. Current valuations in the tech. sector anticipate a lot of big changes happening very quickly. In practice, they may take a while longer.
Today’s successful technology innovator becomes tomorrow’s utility - large, high-profile, highly regulated, and paying its full share of tax. Compare the dynamic Vodafone of 1999 (P/E ratio 100, price £4 per share) with the same company twenty years later (P/E ratio 10, price £2 per share). The lesson of the late 90’s boom was that there can be many casualties at the cutting edge of change. The beneficiaries of new technology are often established behemoths, which adapt more slowly but more effectively.
And fashions can change. Average Facebook usage has already peaked.
Meanwhile, in the stock market, anything that isn’t a disruptive technology is at best irrelevant, and at worst doomed to extinction. TB Wise Multi-Asset Income owns a fair number of assets which are perceived in this way. While the current market conditions persist, we can expect our fund performance to remain dull. On the other hand, many of the assets we most want to own for their ability to pay robust and growing long-term income streams, are already cheap and getting cheaper by the day. We recall that after buying the unloved assets in the previous tech. boom of the late 1990’s, our funds out-performed the market in each of the next seven years.
Most people I know, liberal-minded intellectuals like myself, regard Donald Trump with a mixture of horror and disbelief. How, they ask, can a bullying narcissist with no redeeming human qualities become President of the United States, and then be allowed to destroy so much of the existing world order in so short a time? How, at a time when a single accusation of sexual harassment can end a career, can Trump get away with boasting about it?
Mr Trump never reads, and appears to be led entirely by his instincts. There appear to be two main guiding principles. The first is that the place of the US in the world needs to be reconsidered. You may not agree with Trump’s paranoid belief that the US is being exploited by its trading partners, or that it over-contributes to world peace-keeping initiatives such as NATO, but there may be a kernel of truth in his assertions. Certainly, enough US citizens agree with them to put Trump into the White House. It’s also true that America’s place in the world isn’t what it was. The US has been a great force for world peace in the last century, bailing Europe out in both world wars, and being a prime mover in setting up and maintaining the institutions that arose after 1945, but there are clear signs of malaise today. The American Dream, a naïve, outdated fantasy, prevents them from acting to control the appalling levels of gun crime. US life expectancy is remarkably low due to the epidemic of hard drug use. The government owes an astonishing $20 trillion, which will grow faster once Trump’s tax cuts are implemented.
Logically, then, the world order needs to be re-set, with other nations such as China, Japan and Germany assuming more power, and more responsibility. Whether the US will, on reflection, be happy with its new, diminished status in the world remains, like much else, to be seen.
Trump’s other guiding instinct is that bullying and shock tactics are effective negotiating tools. The problem is that people get wise to these antics, and find ways to respond. Trump will increasingly find himself facing coalitions, and the advantage of surprise will lessen with time.
However, he appears to have made a breakthrough this week in the battle to force North Korea to denuclearise. What he has brought to the debate so far is aggression - the threat of conflict, and the escalation of sanctions to new levels. These have helped to bring Kim to the negotiating table, but we have been here before. Twice in the last thirty years the US and North Korea have agreed to exchange aid for denuclearisation, and twice the North Koreans have cheated. Trump will only have succeeded once it can be proved by full inspection that North Korea has destroyed all its nuclear weapons together with the capacity to make new ones.
One of the pressures on Mr Kim is the increasing ubiquity of the internet. It’s increasingly hard to maintain the fiction that North Korea is the world’s happiest country, and not a vicious dictatorship with an appalling record on human rights. Will the benign Mr Trump help his new friend to transition to a market economy? Or will the new freedoms lead to rebellion, the collapse of the state and the mass exodus about which China is so concerned? If Trump can bring about this welcome transition, then maybe there is some merit in his ‘iron fist’ approach, after all.
The plot continues to thicken, as Mrs May attempts to reconcile the irreconcilable and keep everyone happy. Perhaps we have reached the point of maximum Brexit confusion.
Earlier this week, I came across the following statement in Palace Capital’s annual report.
‘How one views the year ahead will depend on whether you are a ‘glass half full’ or ‘glass half empty’ person. The latter view is supported by negative views on Brexit and sluggish GDP growth which puts a squeeze on consumer incomes. The former positive approach, and one which the Board hold, is that the UK has a robust labour market, is seeing rapid growth in technology and rising export demand for manufacturers. Regeneration and reinvention through public and private investment is delivering results, with new spaces being created. New investment is forthcoming for UK-wide infrastructure projects’.
We agree wholeheartedly with the sentiment – we can find a lot to be positive about in the UK, and many assets which believe will continue to thrive, regardless of the outcome of Brexit.
The regeneration theme is an interesting one, and we will return to it below.
Part 2 – the fund - TB Wise Multi-Asset Income
We will publish all our holdings
We have recently decided to publish all the holdings in both our funds, TB Wise Multi-Asset Growth and TB Wise Multi-Asset Income, on a monthly basis. The lists will appear on the Wise Funds website after the end of each month.
TB Wise Multi-Asset Income makes direct investments in the UK markets, and uses investment trusts to access overseas markets and specialist sectors such as private equity, infrastructure and clean energy.
In our valuations, holdings are grouped under investment themes, and below we will take a closer look at some of the themes in the fund.
Bond proxies (9.3%)
‘Bond proxy’ is a catch-all term which is used to describe assets into which you might invest as an alternative to government bonds, which have become expensive since the central banks introduced the policy of Quantitative Easing (QE) in 2009, at the same time as slashing interest rates to zero. Under QE, central banks bought hundreds of billions of Pounds’ worth of government bonds, forcing their prices up and yields down. The common characteristic of bond proxies is that they offer a secure income stream, as bonds do.
For many years, TB Wise Multi-Asset Income has been unable to invest in bond proxies, because they were all too expensive, but that has started to change.
Perhaps the best example is the infrastructure investment trust HICL. The fund was launched in 2006, and invests in infrastructure assets, mainly but not exclusively in the UK. The assets in the fund are long-term in nature, for example hospitals, offering a long-term revenue stream where the counterparty is a government body, and the risk of default is low. The fund performed well in the 2007-9 crisis, losing around 20% of its value while the overall market was down 50%, and gained in popularity after the introduction of QE, offering investors a lower-risk and steadily rising income. HICL grew in size to £2.5bn, regularly raising new money to invest in new assets. It became a standard portfolio recommendation for income-seeking clients, so much so that at one stage in 2016, shortly after the referendum, the shares were trading at a premium of over 20% to their asset value. The dividend yield at the time was exactly 4.0%.
Since then, three things have happened. The interest rate cycle has turned. HICL’s ‘yield premium’ to cash will reduce as interest rates rise. Second, the Labour Party aims to re-nationalise some of the assets which HICL and its peers own. Finally, the bankruptcy of Carillion hurt HICL, as Carillion managed a number of its assets, and the fund had to take an £11m provision.
In less than two years, HICL’s share price has fallen from £1.84 to £1.40, and it has de-rated from a 20% premium to a discount of 5.0% to its asset value. In the process, while UK interest rates have risen from 0.25% to 0.5%, HICL’s dividend yield has risen from 4.0% to 5.6%.
Is it good value at this level? We think so. UK interest rates are unlikely to rise higher than 2.0% in the foreseeable future. HICL already pays nearly three times as much, and, as much of its revenue is indexed, the dividend continues to rise. We have recently invested 2.3% of TB Wise Multi-Asset Income in HICL. The shares are still falling, and we hope to buy more in due course.
Renationalisation is a threat, but a Labour government would concentrate on the most badly managed PFI assets, which aren’t in HICL’s portfolio. Also, renationalisation would be a legal minefield, probably lasting longer then a Labour government.
The company is a viable size, and has no need to find more assets for the next two decades.
HICL is a particularly good example, but other bond proxies are de-rating, and we are keeping an eye on a number of them, and have taken small positions in Bluefield Solar, John Laing Environmental, and International Public Partnerships.
Bond proxies are an ideal investment for a fund which aims to offer a high, secure and growing income. The fact that many of these assets have started returning to investable levels is hugely positive for us.
People are shopping online more and more, but there are still some things you can’t do online, including sleeping in a hotel, having a drink in a pub, getting new tyres or wiper blades fitted on your car, and having work done to your house. In addition to online shopping, challenges to the retail sector include higher business rates, the apprenticeship levy, the National Living Wage, sluggish wage growth, and Brexit, which may deprive the companies of staff. Retailers are in trouble, and many are closing shops, including House of Fraser and Marks and Spencer, while Maplins and PoundWorld are in administration.
However, there is also an opportunity. Today’s successful retailers have an omni-channel approach, combining welcoming physical stores with a straightforward and friendly website and a mobile app. They need to be competitive on price as well. Retailers who have decided to maintain a high street presence are discovering that the rents come in around 20% cheaper at each review. It may be that the government will offer some help to retailers in the autumn Budget, to mitigate the high-profile job losses and the Death of the High Street.
Meanwhile, people haven’t stopped spending money. After a year of lagging behind inflation, wages began to grow faster than prices in February this year. The UK has record levels of employment. The demise of their weaker peers is creating opportunities for the survivors in the retail sector.
TB Wise Multi-Asset Income owns Shoe Zone, a retailer of improbably cheap shoes which it imports mainly from China. Shoe Zone is tightly managed and highly cost-conscious, and has a solid balance sheet with no debt. The company is growing its online sales rapidly, and has benefitted from lower rents, and from the demise of competitor Brantano last year. The company continues to roll out its new ‘Big Box’ stores.
Our second largest retailer holding Halfords is these days roughly 70% car spares seller, and 30% cycle shop. Customers tend to order the ‘three B’s’ (bulbs, blades and batteries) online, then come into the store to have them fitted, a good example of the multi-channel approach. Sales of new cars have fallen in the last year, so the average car is getting older. Halfords, as a supplier of spare parts, is a direct beneficiary of this trend. The range of cycles has been extended to cover men’s, women’s and children’s, at all price points.
Halfords’ share price, at £3.42, reflects the City’s nervousness towards retailers. Less than three years ago, it was £5.00.
Our third largest holding, Marston’s, has transformed itself over the last seven years by disposing of its long tail of smaller, unprofitable local pubs, and building up an estate of out-of-town ‘destination’ pub-restaurants. Marston’s is affected by the ultra-competitiveness of the casual dining sector, but is insulated from the worst effects by its out-of-town locations – the most extreme discounting is in city centres.
Marston’s has begun putting lodges next to some of its larger pubs, a useful high-margin source of revenue, which also increases turnover at the pubs.
The company has also built up a dominating position in the UK’s craft beer industry, through its own brands (Pedigree, Wainwright, Hobgoblin, etc) and bottling for other smaller firms. The acquisition of the Charles Wells Brewery last year has extended capacity, and the company has begun exporting for the first time.
Marston’s’ operational improvements have not been reflected in the share price, which at 98p languishes 30% below its net asset value per share, £1.40. The dividend yield is almost 8.0%.
The City’s view of construction, confirmed by the recent demise of Carillion, is of a highly cyclical sector with dangerously low margins, and best avoided. The share prices of the companies in the sector reflect this view.
Large contracts were traditionally awarded with profit margins of 2.0%, meaning that the construction company would, if all went well, make a return of just £20,000 for every £1m of cost. When anything went wrong, contracts quickly became loss-making. This would happen, for example, when on a long contract, staff costs increased by more than had been foreseen at the outset.
Several of our investee companies have told us, independently of one another, that they are no longer prepared to work on this basis. The demise of Carillion has taken capacity from the sector and given the companies more bargaining power. Clients want to work with financially sound companies, and those that are, are in great demand. Companies prefer to work on framework contracts for government departments, which tend to produce a succession of smaller jobs on higher profit margins. The framework structure is far more civilised – in a longer-term partnership, it isn’t in the commissioning department’s interest for its chosen partners to become insolvent. Recently, our largest holding in this sector, Henry Boot, told us that it is quoting on around £1bn of new work, all of which has come to it this year, and all on acceptable margins. One of these projects illustrates the theme of urban renewal, which is driving a great deal of investment at the moment.
The scheme is a joint venture with the Enfield Council to redevelop a run-down thirty-acre industrial site which was built soon after the Second World War. The current business park was initially built in the 50s and 60s and, if it were to be comprehensively redeveloped to meet the requirements of, in particular, last five mile distribution, rental and capital values could be increased significantly. For a cash-strapped council, such a development makes excellent sense, financially as well as environmentally. U&I, which we hold under the Property theme, is another specialist in urban renewal, as is Galliford Try, another holding in the Construction theme, and to a lesser extent Kier.
This blog set out to give an idea of some of the current thinking behind TB Wise Multi-Asset Income. Our ideal holding is well-established, has good and stable management, sound finances, and the desire and the wherewithal to pay and maintain an attractive dividend. We also look for growth potential, and we want to pay significantly less for assets than we believe them to be worth.
Despite the over-valuation in large parts of the financial markets, we continue to find assets which meet all our criteria..
Another blog next month will cover other sectors of the portfolio in detail.
I hope you have enjoyed reading this piece and found it useful. I would be interested to hear your comments, and answer questions. My email is firstname.lastname@example.org
Please note – this blog contains the personal opinions of Tony Yarrow as at June 15th 2018, and is not intended as financial or investment advice.