July 2023 Newsletter

Regulatory disclaimer: This newsletter is provided solely to enable clients to make their own investment decisions. The information within this newsletter does not constitute advice or a personal recommendation, or take into account the particular investment objectives, financial situations, or needs of individual clients. It may therefore not be suitable for all recipients. If you have any doubts as to the suitability of this service, you should seek advice from your investment manager. The past is not necessarily a guide to future performance. The value of investments and the income from them can fall as well as rise and investors may get back less than they originally invested. Certain Investment Trusts will permit using gearing as an investment strategy. Gearing is a strategy which involves borrowing money to increase holdings of investments or investing in warrants or derivatives. Such a strategy is likely to result in movements in the price of the relevant security being amplified significantly and may be subject to sudden and large falls in value and investors may get back nothing at all. Any tax rates and reliefs are those currently applying, are dependent on individual circumstances, and could be subject to change. All estimates and prospective figures quoted in this newsletter are forecasts and are not guaranteed. Within our advisory service we offer advice on a wide range of investments including shares, corporate bonds, gilts and managed funds. Within the RDR our advisory service is recognised by the FCA as a ‘restricted’ service as we do not offer advice on the whole of the financial planning market which includes products such as life policies and personal pension schemes.  Barratt & Cooke is the trading name of Barratt & Cooke Limited. Registered in England No. 5378036. Barratt & Cooke Limited is authorised and regulated by the Financial Conduct Authority, who are based at 12 Endeavour Square, London, E20 1JN.

Source: Iress and FTSE International Limited (‘FTSE’) © FTSE 2023. ‘FTSE®’ is a trademark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. All rights in the FTSE indices and /or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and /or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.

Gilts – the ugly duckling?

I tried to spice it up a little, but it was rather like pretending you had a great day at the cricket even though it rained all day and you’ve given up drinking! If you are looking forward to a nice vibrant publication, perhaps wait until Will Mellor writes the one in October, as he does each year now. Hopefully that newsletter will not only provide you with words that dance off the page but images too, and a bit of colour, as we are soon to launch some new branding. There are only so many ways one can write about stubbornly high inflation, rising interest rates and the crippling cost of living crisis. That said, when I first started to contribute to these pieces approximately fifteen years ago the narrative was typically about low inflation, falling interest rates and quantitative easing; the exact opposite of what we are experiencing now. And yet the world has kept turning, and so it will continue.

If you believe the press, Covid-19 and the Ukrainian war are to blame for the current inflationary backdrop. Of course these events caused significant bumps in the road, but it is the effects of policies adopted during the banking crisis and subsequent years of loose monetary policy that is ultimately the cause of high and persistent inflation. Since 2009 the Bank of England and Government have stimulated the economy through artificial means with a near zero interest rate environment (close to free debt) and a seemingly endless supply of newly ‘printed’ money (quantitative easing).

This huge increase in the money supply initially caused asset price inflation (land, property, equities, bonds etc) but has taken time to filter through to the ‘everyday economy’ via the cost of products and wages. But as Will Mellor wrote back in the October 2012 newsletter the consequences were inevitable, ‘quantitative easing will eventually cause high and persistent inflation’. Perhaps recent events have been the triggers which have lit the touch paper, but let’s be in no doubt the UK is now suffering from past policy error. I fear in the future we will suffer further due to current policy error. We wrote at the time about the UK population being lured into an addiction, hooked on cheap debt, being the new ‘drug’ of choice. Few knew what we were talking about, but sadly this has come to fruition, but the drugs have now run out, indeed the party is over.

This personal debt is principally in the form of mortgages. The mortgage crisis is a conversation I have had with CWLB and many of my more senior clients who, themselves, managed to negotiate interest rates of up to 17% during the early 1980’s, which is quite extraordinary. As they say in cycling ‘chapeau’ to all of you for holding firm through what will have been an incredibly challenging time financially. As you are probably aware, I am fairly ‘old school’ and have little time for many of the youth of today’s struggles. I firmly believe a little more constitution would help so many. That said, where appropriate I will fight their corner as well (sadly as I approach my mid 40’s I am no longer ‘the young’) and I believe the financial backdrop we currently face, in terms of mortgage costs and property values, is even more penal now than it was back in the 1980’s. Why?

The UK is now suffering from past policy error. I fear in the future we will suffer further due to current policy error.

Narratives on markets require a disclaimer along the lines of ‘past performance does not guarantee future results and investments may fall as well as rise’. This newsletter comes with a different disclaimer: ‘it is fairly boring’.

The bubble over the past forty years, from Thatcher selling off council houses through to the accumulation of buy to let portfolios by individuals, has pushed house prices far beyond the means of so many individuals as a multiple of earnings. Between 1970 and 2000, houses were generally purchased on multiples of 3.5–6 times salary, giving rise to manageable monthly payments over a 20–25 year mortgage term. i.e. individuals were sensibly geared in terms of their home exposure and could reasonably expect to finance the roof over their head. More recently we have seen an extraordinary increase in property valuations, yet wage growth has significantly lagged. Therefore, individuals with exactly the same aspirations (the same three bed detached house for example) are being asked to pay multiples closer to 10 times salary (or 12 times in London). Whilst interest rates were very low and a whole generation was forced into this market, it may initially have seemed achievable, but following the rapid rise in UK base rates it looks increasingly grim for so many.

I do not believe ‘mortgage holidays’ are the answer. It is counterintuitive for the Bank of England to try and reduce spending whilst the Government increases capacity to spend; monetary and fiscal policy should be aligned, instead of pulling at either end of the tug-of-war rope. Furthermore it seems unjust to those who, responsibly, chose to rent rather than ‘gear up’ for fear that the current forces would come to fruition; indeed it may be deemed a case of ‘all animals are equal but some are more equal than others’, with the prudent suffering.

Regarding the overall inflationary problem, those in charge of financial policy should concentrate on supply side economics (increasing productivity) rather than demand side economics (reducing capacity to purchase). Such a quick and aggressive rise in interest rates for both individuals and businesses seeks to reduce demand, rather than helping stimulate growth; a backward looking scenario which lacks ambition for the UK. I liken it to fishing in a stagnant lake versus a fast-flowing stream, though to be honest I personally prefer chasing mackerel where you can land eight in a oner! Perhaps interest rates standing at 5% is the right equilibrium, but the speed at which we have got here is unprecedented and debilitating. Moreover, most economic data is backward looking and the effects of such a rapid increase in the cost of capital will not become apparent for several months.

I am, however, encouraged to report that companies have actually fared much better than individuals over the last 18 months. We went into the recent reporting season (February, March and April) with a degree of apprehension. Whilst we believe in the companies on our buy list, with so much negative news it was important not to be complacent. Fortunately, the vast majority of the stocks we favour delivered on forecasts, or even beat them. It is earnings ‘beats’ that really drive share price performance and this is where prudent company management with achievable guidance is so important. Furthermore our positioning towards higher quality, less economically sensitive businesses with low or manageable debt, visibility of cash flows, strong brands and market leading positions in structurally growing sectors has stood portfolios in good stead through this challenging period.

Such a quick and aggressive rise in interest rates for both individuals and businesses seeks to reduce demand, rather than helping stimulate growth; a backward looking scenario which lacks ambition for the UK.

The vast majority of the stocks we favour delivered on forecasts, or even beat them. It is earnings ‘beats’ that really drive share price performance and this is where prudent company management with achievable guidance is so important.

Over the winter months, we battened down the hatches ready for the storm, but like a flower coming into bloom in the spring we repositioned some of the investments as good opportunities arose.

During the long period of almost zero interest rates many other investment management firms, in the pursuit of greater returns, diversified into more esoteric investments, whereas we rarely deviated from our investment philosophy of quality global equities, supplemented with fixed income where appropriate (on risk management and liquidity grounds) with modest diversification via infrastructure funds, private equity and gold. Following the return of interest rates to historically ‘normal’ levels such esoteric investments (where some even delve into music royalties, space exploration and private jet leasing!) have performed very poorly.

For the year to June 2023 mid single-digit total returns are not something to ‘whoop and holla’ about, yet we are somewhat encouraged that portfolios have performed relatively well, with acceptable levels of volatility; particularly given the inflationary pressures and that ‘mini budget’ which caused the UK Gilt Index to fall in excess of 15%, an unprecedented collapse.

Over the winter months, we battened down the hatches ready for the storm, but like a flower coming into bloom in the spring we repositioned some of the investments as good opportunities arose (in addition to moving on from some rather ‘dead wood’ as well as some strong profit taking). Recently you may have received details relating to a sale of Dechra (more on this below) following corporate activity, the purchase of some new holdings funded by the sale and top slicing of some older positions (e.g. Novo Nordisk), the purchase of fixed interest where conventional Gilts finally offer attractive returns after over fifteen years in the doldrums, or the sale of Amazon to buy Mastercard. Each of these transactions fit with the appropriate risk profiles and objectives for each individual portfolio but work towards a common goal of increasing the quality of your underlying investments, seeking to provide better returns both in terms of capital and/or income whilst simultaneously trying to reduce volatility. It has been busy, but ‘good busy’ not ‘bad busy’!

Recently, with regard to equity investment, I have been asked by three clients if the acronym TINA (There Is No Alternative) which has featured in previous newsletters is still valid. In short, no. TINA has been dumped and replaced by TANIA (There Are Now Investment Alternatives). Indeed, Gilts now provide attractive, lower risk returns, particularly relative to bank deposits which have been somewhat slower to reflect the higher interest rate environment. Of course, as evidenced during 2022, Gilts can exhibit capital volatility, but that is why we stand steadfastly resolute in our conviction that the shorter end of the curve (with a maximum redemption date of 2030) is the place to be. These investments are interesting not only for income but capital growth and are of increasing relevance to clients looking to make cash work a little harder than retaining it on bank deposit, though of course there is the associated risk of sensitivity to further interest rate increases. Do contact your advisor if you’d like to discuss fixed income investment within your portfolio or from monies currently held away from Barratt & Cooke, as there is certainly opportunity in Gilts at current levels.

For the year to June 2023 mid single-digit total returns are not something to ‘whoop and holla’ about, yet we are somewhat encouraged that portfolios have performed relatively well, with acceptable levels of volatility

Takeovers by Alastair Jackson

M&A activity has long since been an important factor in equity markets with companies such as SAB Miller, Arm Holdings, Rexam, Shire, and Sky being a handful of the ‘quality’ UK companies that have been taken over since I joined Barratt and Cooke 15 years ago. The trend of increasing private equity offers for UK businesses continued following the Covid pandemic as firms took advantage of depressed valuations and the weakness in sterling in a wave of ‘pandemic plundering’. This led to record takeover activity in the UK equity market in 2020 and 2021.

2022 was a more challenging year as global macroeconomic pressures, constrained debt markets and general stockmarket volatility reduced the appetite for M&A activity. This continued into the start of 2023 with figures from the Office for National Statistics showing that foreign investors spent £12.7bn acquiring UK firms between January and March, £4.1bn less than the corresponding period last year.

However, there has recently been an uptick in activity in the UK mid and small-cap areas of the market where companies have faced a challenging 18 months and many now trade at low valuations as demonstrated by comparing the P/E ratio for the FTSE 250 to the average over the last 10 years.

FTSE 250 P/E Ratio 12.1x

FTSE 250 10yr Average P/E Ratio 17.7x

Among the activity in the second quarter there was:

• A cash offer for Investment Bank Numis by Deutsche Bank, which has been approved by shareholders.

• Private equity group Apollo Global Management’s approach for engineering consultant John Wood Group, which was subsequently withdrawn following further due diligence.

• Canadian asset management firm Brookfield’s offer for payments company Network International Holdings following initial interest from a consortium of private equity firms.

The period also saw a takeover approach for Dechra Pharmaceuticals from the private equity firm EQT which provides an interesting case study.

Dechra Pharmaceuticals

Dechra first announced that they had entered discussions with EQT regarding a potential cash offer of 4070p per share after the market closed on 13th April 2023 and the chart below illustrates how the share price has subsequently moved.

share price

The initial offer represented a premium of 47% to the previous closing price and immediately following the announcement Dechra’s shares rallied to 3694p. At this level the shares stood at a discount of approximately 9.2% to the potential offer price. A discount this wide indicates that the market has a degree of uncertainty around an official offer actually being made once due diligence is completed. When a potential acquiring company walks away without an offer being made the share price of the company subject to the approach typically falls below where it was trading prior to the announcement. Indeed, this happened with the forementioned John Wood Group Plc where the shares are now 10% below the price they were trading at before details of the takeover approach were disclosed.

We therefore took the decision to sell half of clients’ shareholdings at 3746p which removed a proportion of the downside risk should EQT walk away, this meant that clients benefitted from the increase in the share price and still had ‘skin in the game’ should the offer be made at 4070p or if another bidder materialised.

While EQT were completing their due diligence Dechra issued a trading update which contained a profit warning due to destocking from wholesalers in the US and UK. Following this the shares fell to 3102p. Although the profit warning did not cause EQT to walk away they reduced their offer and submitted a bid of 3875p, circa. 5% below the original suggested price.

While the offer has been recommended by Dechra’s Board of Directors, and there is no prospect of another bidder, the shares continue to trade at a discount of approximately 5% to the recommended offer. One of the reasons for this is that the takeover will be reviewed by The Competition and Markets Authority (CMA).

When a takeover transaction raises competition concerns, the CMA conducts a thorough investigation to assess its potential impact on competition and consumer welfare.

The CMA has the power to intervene and take appropriate action to prevent or mitigate any adverse effects on competition. This may include imposing remedies, such as divestments or behavioural changes, to address competition concerns and ensure that consumers are not disadvantaged. Where the CMA deems that there are not remedies that can alleviate their concerns, they have the power to block transactions as they did earlier this year in regard to Microsoft’s attempted acquisition of Activision Blizzard.

EQT already owns a veterinary clinic chain in the UK and has stakes in pet insurance companies so the CMA will review the takeover of Dechra closely with completion potentially not expected until the first quarter of 2024. Therefore, there is potentially an ‘opportunity cost’ of retaining the holding until completion should other stocks that we are monitoring fall to attractive valuations. We will therefore keep the position under review through the summer should an opportunity to redeploy the funds arise.

While the rise in interest rates will limit the extent to which private equity groups/companies are able to rely on debt to finance takeovers there remains a large number of prospective ‘bidders’ that sit on significant cash piles. This coupled with UK midcap equities continuing to trade on cheaper valuations means that there is scope for further M&A activity through the remainder of the year.

While the rise in interest rates will limit the extent to which private equity groups/companies are able to rely on debt to finance takeovers there remains a large number of prospective ‘bidders’ that sit on significant cash piles.

Conclusion

The last three months have given us much to cheer, not least the Coronation of King Charles III. On searching for a bit of inspiration ahead of penning this newsletter I read all five verses of the national anthem and stumbled across a lyric in one of the lesser-known verses: ‘frustrate their knavish tricks’. I wonder if Australia’s dismissal of Jonny Bairstow was just a ‘knavish trick’? Plenty of members of the honourable institution of the MCC found it a little more than ‘frustrating’!

Speaking of Bairstow, what a hero he was carting off the Just Stop Oil idiots who seem to appear everywhere. Frankie rode some winners at Royal Ascot in the year of his retirement and Rory is back in form, we dare to dream that he follows up on his last visit to Hoylake, the only time he has lifted the claret jug.

I mentioned branding in the introduction and we are near the conclusion of a fairly large rebranding project which will enhance the ‘image’ of our presentation. Feedback from clients, our nonexecutive Directors and London professionals has noted that the way in which we portray ourselves (both via printed literature and online) does not do justice to our overall offering in terms of investment process and service levels.

I do, however, think that it is important to highlight that whilst you will see a change in image, which hopefully you approve of, the nuts and bolts, the investment rationale and the ethos by which we act for you absolutely will not change.

There is no getting away from the fact that times are tough. Harrold Wilson spoke of the pound in your pocket, few have many of these now and that is not just a metaphor for the ‘cashless’ society in which we now live. Tough decisions are being made by central banks with a foot on the accelerator which is punishing UK individuals, it is very challenging indeed.

Mortgages are the biggest problem, partly because of the structure of the UK mortgage market where most fixed term deals are for up to 5 years, whereas in the US terms are fixed for 20 years. Consequently, few UK mortgage holders will escape the rising cost of debt for long.

The FTSE100 still stands around 7,500 points, not far off its 8,000 peak, although as I continually highlight the FTSE100 is not a particularly relevant comparator index given our international equity bias. Of course company margins are being squeezed due to higher raw material costs and increasing costs of production, and not all of this price pressure can be passed on to the consumer, but they are still reporting profits and growing dividend payments.

The key is to hold well capitalised businesses with sensible management, visible cash flows and robust brands. That is what we have always done and will always do. Sometimes this means we miss out on a little bit of upside when markets behave like a runaway freight train but, currently, I am so glad this is where we are positioned and there remains plenty of opportunity in equity markets.

Whilst it has never been a ‘rock and roll’ market, finally Government Gilts look like they might just turn from ugly duckling into beautiful swan!

William Barratt Chairman 1st July 2023

It is important to highlight that whilst you will see a change in image, which hopefully you approve of, the nuts and bolts, the investment rationale and the ethos by which we act for you absolutely will not change.

July 2023 equity suggestions

* Equivalent Gross Redemption Yield for Index Linked Gilts assuming RPI inflation averages 3% or 5% to redemption. ** Price adjusted for inflation (please note the published price may be different as it does not include accrued inflation)

Source: Iress

FTSE 100 – previous quarter

FTSE 100 – 1 year

FTSE 100 – 5 year