Leading Edge April 2019 by Royal London Asset Management

LEADING EDGE RLAM’S REGULAR REVIEW OF INVESTMENT MARKETS • APRIL 2019

2019 Investment Conference special The global economy has been struggling and some believe a storm is coming. Senior economist Melanie Baker considers the outlook and forecasts that while there may be dark clouds, we don’t face a recessionary storm. FOR PROFESSIONAL CLIENTS ONLY, NOT SUITABLE FOR RETAIL INVESTORS.

Welcome

In our industry, it is easy to start every year thinking that this is a period of uncertainty. But 2019 is without doubt on another level. Politics is certainly very ‘interesting’ after a couple of decades where managers could almost ignore Western politics as there was a clear consensus between major parties in Europe and the US that meant major changes were unlikely. I think it is fair to say that is not the case right now. We held our fifth annual investment conference in March and many of the sessions were based on the premise of uncertainty and how to manage it.

Get in touch We welcome your thoughts on the e-zine and our communications with you in general, so please do give us your feedback by emailing: leadingedge@rlam.co.uk T: 020 7506 6500 W: www.rlam.co.uk

Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of April 2019. Information derived from sources other than Royal London Asset Management is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice. For more information on the funds or the risks of investing, please refer to the fund factsheet, Prospectus or Key Investor Information Document (KIID), available via the relevant Fund Price page on www.rlam.co.uk

We’re now around a decade on from the global financial crisis that was a defining experience for many of us: things that we ‘knew’ to be true – that banking crises happen in emerging markets, that printing money was stuck in 1920s Germany – suddenly proved not to be. The subsequent decade has actually been pretty easy for markets. Investors in risk assets have done rather well – helped by the calming medicine of ultra-low interest rates, central bank bond purchases and policymakers desperate to make sure it doesn’t happen again (or at least, not on their watch). But if there is one thing we know about economics and markets, it is that change is inevitable. The growth in the US economy is one of the longest expansions on record. The S&P 500 is only around 4% off its highs and two-year bunds still pay a negative yield. Will this change? Almost certainly – we just don’t know when. Admitting you don’t know is anathema to many fund managers. At RLAM we’ve been shaping portfolios to try to reduce the potential impact of volatility – in effect, removing or reducing risk where we feel that it either cannot be quantified or where you are not being compensated for that risk. Many of the articles in this edition of Leading Edge are based on this principle. In a world where concerns over trade wars and Brexit are dominating concerns, how do you position a portfolio in key asset classes? I hope that the articles here will give you an insight into how our managers are managing the risks in their particular market, in order to give you and your clients better outcomes. In this edition we have a range of articles – from big picture issues such as managing volatility in a multi asset sense, to the analysis of the asset backed securities that our corporate bond funds invest in. I hope you enjoy the issue.

Rob Williams Chief Distribution Officer

LBOs pct of HY/ Loan Issuance

40 35 30 25

▼

STOCKS

COMMODITIES

BONDS

CASH

TA P

▼

LES

, H E A LT H C A

▼

Leveraged buyouts

P.18 Mike Fox and Richard Nelson explain how our sustainable investment process covers equities and credit.

Dark clouds, but no storm

P.08 Martin Foden and Matthew Franklin explore the Wonderland of asset backed securities.

US 10 year Treasuries offer among the highest yields in the market today, at 2.60%, far higher than the 1.20% 10 year gilt yield. Sterling investors might therefore naturally be inclined to go overweight in US government bonds. Yet consideration of the currency hedging cost renders the sterling hedged equivalent yield of 10 year Treasuries just 0.87%. By contrast, while the German 10 year Bund has a yield of just 0.07%, when it is translated into sterling terms it rises to 1.39%. Perversely, a sterling investor seeking a pickup in yield would be better served choosing a German

As such, we are diversifying away from sterling into global index linked assets to both pick up yield and protect ourselves against a potential sterling appreciation should a deal be struck.

Also in this issue

Deciding which markets to invest in was a relatively simple matter a few years ago, when central banks ubiquitously kept interest rates on hold. An investor would only need to judge the attractiveness of a bond’s yield and the outlook for its market. With central banks now at different stages in their tightening cycles, another confounding factor has been added to this decision process. Relative interest rate differentials are the main drivers of currencies, meaning that the differing pathways of US QT and Japanese QE have had pronounced currency hedging effects.

As such, we are diversifying away from sterling into global index linked assets to both pick up yield and protect ourselves against a potential sterling appreciation should a deal be struck.

UMER DIS ONS CR &C ET IO

CURRENCIES

Head of Rates and Cash

This currency effect is particularly prominent in inflation markets. Sterling index linked bonds have been strongly influenced by the currency gyrations of sterling, with its sharp depreciation since mid-2016 driving UK index linked assets to become extremely expensive relative to their global peers. Compared to their European or Japanese counterparts, sterling index linked assets are between 100 and 150 basis points overvalued.

▼

This has simultaneously reduced the default risk and at the same time increased the potential impact of defaults. The greater sophistication with which covenants are now crafted means that credit selection has become very important, giving active credit investors, like us, ample opportunities to add value.

Head of Global High Yield

bond with a 0.07% yield than a US bond with a 2.60% yield.

IALS & ENE TER RG MA Y

buyouts (LBOs) in the market is markedly lower today than in 2006/07. Issuers have become increasingly savvy by issuing less debt while using trickier covenants and protections, instead of simply pumping their capital structures with low grade debt as used to happen.

LOGY & INDUSTR NO IAL CH S TE Y AR N

Craig Inches,

CE N

Azhar Hussain,

FIN A

Contents

15 10 5 0

06 1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

2017

2019

Currency considerations Hedge Cost

United Kingdom Germany

Japan

Domestic 10 Year Bond Yield

GBP Hedged Equivalent Yield

Yield Pick up

1.20% -1.32%

0.07%

-1.22%

-0.04%

USA

1.73%

2.60%

0.87%

Canada

0.92%

1.75%

0.83%

-0.37%

Australia

1.06%

1.96%

0.90%

-0.30%

-1.00%

0.45%

1.45%

0.25%

Sweden

1.39% 1.18%

0.19% -0.02% -0.33%

Where the risks are in 2019, and how to manage them

Weathering volatile markets with multi asset strategies

Head of Global High Yield, Azhar Hussain, and Head of Rates and Cash, Craig Inches, reveal how they are dealing with three key threats to markets.

Volatility is back and here to stay. Trevor Greetham, Head of Multi Asset, shows how investors can thrive in this environment.

Dividend discipline and contrarian investing

The attraction of income

How to invest in a world that isn’t short of anything

Senior economist, Melanie Baker, considers the global economic outlook and argues the cloudy sky doesn’t mean we face a recessionary storm.

P.22 Khuram Sharih and Shalin Shah disclose their methods for generating positive absolute returns in challenging markets.

Senior fund manager, Richard Marwood, and assistant fund manager, Niko de Walden, demonstrate their process for discovering outstanding income investments.

Senior economist, Paula Binns and Rachid Semaoune, senior credit fund managers, describe their approach to credit investing and why income matters.

Senior fund manager, Will Kenney explains how our Corporate Life Cycle model helps the global equities team to invest in a world with excess capital.

4 | LEADING EDGE | APRIL 2019

DARK CLOUDS, BUT NO STORM After 18 years at Morgan Stanley, largely focused on the UK economy, Melanie Baker joined RLAM in June 2018 as our senior economist. The global economy has been struggling and some believe that a storm is coming. This isn’t just about recessionary forces – there is an element of just watching the clock. Roughly every eight years, there is a global recession or major global slowdown. We are overdue some stormy economic conditions. Melanie Baker,

Senior Economist

Parts of the world are already in recession, or very close to it. Italy slipped into recession late last year, and Germany got perilously close and remains so. While this is very different from 2008, it looks similar to the last big global recession scare in 2015/16. Compared to my forecasts from November, global growth has been more in line with my downside scenario, not my base case. Much of the reason for the sharp market falls in December was an upsurge in worries about global growth. It isn’t just one economy that has slowed – China, the eurozone and UK stand out. Conversely, the US continues to outperform. When you look at the global sector PMIs, the downturn appears to have been led by export orders and manufacturing more generally, although spreading into services. Something has been pulling down trade between countries. The global economy had a great export-led recovery in 2017, which faded entirely over 2018. The threat of an all-out trade war between the US and China, broader trade tensions and higher tariffs all dampened down global trade.

• Policy support is being removed – the last Federal Reserve (Fed) rate hike was only in December and it continues to unwind its quantitative easing (QE) programme. We saw other interest rate rises last year in the UK, Canada and Sweden. Monetary policy acts with a lag, so we haven’t seen its full effects yet. • Brexit uncertainty – the UK and eurozone economies have seen quite a downturn in growth since 2017. The UK has been struggling to generate sustained growth since the summer. Business investment has contracted for four consecutive quarters. Even if a deal is agreed, we only enter the next stage of negotiations, plus there is every chance of political fallout. There’s another dark cloud on the horizon. The US economy solidly outperformed in 2018, helped by President Trump’s fiscal stimulus. By the latter part of this year, however, the best of the fiscal policy stimulus will be behind us.

China was also a factor. After the 2015/16 global recession scare, China stimulated its economy, helping to boost global growth in 2017. That effect then faded and its efforts to de-risk the economy and improve financial stability – reducing the size of the shadow banking sector for example – didn’t help global growth.

So why am I not forecasting a recessionary storm? Several factors have brightened the outlook for later this year. First, oil prices fell sharply in the fourth quarter and, while they’ve risen recently, they remain below the levels for much of last year. The impact of lower oil prices resemble a tax cut for consumers, lowering inflation. Meanwhile, pay growth has risen in the US, UK, eurozone and Japan. Faster pay growth, robust labour markets and lower inflation are good news for consumers.

There were also some temporary shocks to growth: auto sector problems in Europe; Italy’s budgetary stand-off with the European Commission; natural disasters, notably in Japan; and the US government shutdown. These concerns have since faded. However, some of the dark clouds that dragged on growth last year are lingering:

Another source of relief is China, which is actively stimulating its economy again. Rather than interest rates, the reserve requirement ratio is the main tool that the central bank is using and should encourage lending. We’ve also seen tax cuts announced, more government spending and exhortations to banks to lend more to private businesses. The impact of

APRIL 2019 | LEADING EDGE | 5

measures already implemented and those in the pipeline should be seen by mid-year, assuming no further rise in US tariffs. Just as fading Chinese stimulus was part of the reason why global growth slowed last year, by the second half of this year it should be positive for global growth. Another break has come in the welcome form of central bank caution. Language used by Fed Chair Jerome Powell in early January helped to lift market sentiment. Fed projections no longer show any rate rises this year. And we’ve seen caution and dovishness from many other central banks. Any further rate rises now look likely to be fewer and later than previously expected. But I am still on storm watch. The three things I worry most about at the moment are: 1 Trade relations – further US import tariffs are on hold while talks continue between the US and China, Japan and the EU. But the threats are still there. President Trump has declared himself a “Tariff Man” and any US-China deal seems very unlikely to return us to where we were several years ago. Trade matters – and trade tensions can be difficult to de-escalate. 2 Brexit – the outcome that implies the most downside risk to our forecasts, especially for the UK, is a no-deal, no-transition Brexit. The deal on the table would keep trade relations roughly ‘business as usual’ for a couple of years: without a deal, there isn’t such a transition period. Studies suggest sizeable negative impacts on the economy from ‘no deal’. These are often cumulative over a long period of time. However, most don’t consider the nearer-term disruption. Neither do they factor in that the economy already looks fragile and global growth has slowed.

Of course, the government can and is working to limit the damage and government spending and monetary policy stimulus would likely follow such an outcome. But these are sticking plasters. It would take a considerable amount of time and money for firms to adjust to the new realities and ways of doing business. 3 Policymakers – markets have put a lot of faith in policymakers, which could easily be misplaced. In China, so far stimulus is not on the scale of previous episodes as the authorities worry about existing levels of borrowing and financial risk in the economy. The message from China’s policymakers is not ‘do whatever it takes’ and stimulus could prove disappointing. What about the comfort markets have been deriving from central bankers? Labour markets are tight everywhere. As a result, pay growth is likely to rise further. Headline inflation has been falling rapidly in most major economies, reflecting lower oil prices. Yet core inflation, which is closer to underlying domestic inflationary pressures, hasn’t fallen much. If slack in the economy is basically zero (as measures from the likes of the IMF and OECD suggest is the case for major developed economies) and labour markets are tight, pay growth is rising and core inflation isn’t far from target, the hurdle for cutting rates is higher. Don’t count on monetary policy u-turns. There is a sizeable risk that policymakers end up needing to raise rates by more than currently expected. So, several dark clouds are still lingering over the global economy. But a recession is still not our central case, with lower oil prices, Chinese stimulus and central bankers are all helping to dispel some of the gloom. A recession is not our central case, but there are a few things on our watch list.

‘‘

Faster pay growth, robust labour markets and lower inflation are good news for consumers.

’’

Melanie Baker, Senior Economist

6 | LEADING EDGE | APRIL 2019

WHERE THE RISKS ARE IN 2019, AND HOW TO MANAGE THEM Risk assets have had a solid start to the year, following a volatile ending to 2018 when all major credit asset classes, other than leveraged loans, posted negative returns. A dovish turn from central banks and improving signs in trade talks between the US and China have allayed key investor concerns from 2018. Nevertheless, we remain cautious, seeing a multitude of potential headwinds for markets in 2019. Here we analyse three of the major risks that we have identified, and show how we are coping with them.

POLITICS Positioning for political risk has become incredibly difficult, suiting reactive moves better than proactive ones. This is in large part because the fundamental laws of economics have ceased to be of much value

in predicting market impact due to the unprecedented reactions of central banks. Investors might reasonably have taken a bearish view on Italy back in November, after its populist government defied the European Commission by implementing a budget that violated debt rules. Yet those investors would have been subsequently undermined by decisions from the European Central Bank (ECB) not only to keep interest rates unchanged in 2019, but also to roll over its bank lending programme; which encourages banks to borrow cheaply and buy high yielding Italian assets. From a credit market perspective, there is arguably no greater political threat in the current environment than the financing of budget deficits. The transition of central banks from quantitative easing (QE) to tightening (QT) is commonly noted. Less commented on is the impact of fiscal policy on QT. President Donald Trumpâ&#x20AC;&#x2122;s tax cuts have ensured that the net supply of assets net of central bank purchases

Quantitative easing to quantitative tightening Net supply of assets net of central bank purchases to reach post-GFC high of $3tn in 2019 in advanced economies,* $3tn 4

Net

Government

Non-

Rest

Central bank interventions

Financial bonds

3 2 1 0 -1 -2 -3

Source: Citi Research, Haver. *Data covers the US, eurozone, Japan and UK

will reach a post financial crisis high of $3 trillion in 2019 in advanced economies (US, eurozone, Japan and UK). This environment of heavy bond issuance, when investors are concerned about political risk, means that credit spreads will probably widen as the year unfolds. Yet it also gives us, as active managers, an opportunity to add tactical value in dealing with political risk. We think that by staying senior and shorter in capital structures, we can mitigate some of the volatility caused by political risks.

RECESSION Markets have become exceptionally pessimistic on global growth. There are currently expected to be no interest rate hikes by the ECB or Bank of England until the end of 2020, and a small amount of cutting by the Federal Reserve over the same period. Many investors imagine that the next recession is likely to originate in Europe, given its current state of growth, but it is notable that even US yield curves are pricing in a heavy recession risk; with the spread between two and ten year treasury yields close to zero. The core concern for credit investors with regard to recession risk is the possible impact on defaults in the market. The rate of defaults has been unprecedentedly muted since the global financial crisis. With the exception of 2016, when there was a crisis in the energy sector, the rate has hovered around the 1-2% mark. For comparison, in the 1990s the typical default rate was 4-5%. It is unlikely that the next recession will cause a spike up in the default rate to the same extent as in the previous two recessions. The proportion of leveraged buyouts (LBOs) in the market is markedly lower today than in 2006/07. Issuers have

APRIL 2019 | LEADING EDGE | 7

become increasingly savvy by issuing less debt while using trickier covenants and protections, instead of simply pumping their capital structures with low grade debt as used to happen. This has simultaneously reduced the default risk and at the same time increased the potential impact of defaults. The greater sophistication with which covenants are now crafted means that credit selection has become very important, giving active credit investors, like us, ample opportunities to add value.

CURRENCIES Deciding which markets to invest in was a relatively simple matter a few years ago, when central banks ubiquitously kept interest rates on hold. An investor would only need to judge the attractiveness of a bondâ&#x20AC;&#x2122;s yield and the outlook for its market. With central banks now at different stages in their tightening cycles, another confounding factor has been added to this decision process. Relative interest rate differentials are the main drivers of currencies, meaning that the differing pathways of US QT and Japanese QE have had pronounced currency hedging effects. US 10 year treasuries offer among the highest yields in the market today, at 2.60%, far higher than the 1.20% 10 year gilt yield. Sterling investors might therefore naturally be inclined to go overweight in US government bonds. Yet consideration of the currency hedging cost renders the sterling hedged equivalent yield of 10 year treasuries just 0.87%. By contrast, while the German 10 year bund has a yield of just 0.07%, when it is translated into sterling terms it rises to 1.39%. Perversely, a sterling investor seeking a pick-up in yield would be better served choosing a German bond with a 0.07% yield than a US bond with a 2.60% yield.

Azhar Hussain,

Craig Inches,

Head of Global High Yield

Head of Rates and Cash

As such, we are diversifying away from sterling into global index linked assets to both pick up yield and protect ourselves against a potential sterling appreciation should a deal be struck.

Leveraged buyouts LBOs pct of HY/ Loan Issuance

40 35 30 25 20 15 10 5 0

1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

2017

2019

Source: B of A Merrill Lynch Global Research

Currency considerations Hedge Cost

Domestic 10 Year Bond Yield

Germany

-1.32%

0.07%

Japan

United Kingdom

GBP Hedged Equivalent Yield

Yield Pick up

1.20% 1.39%

0.19%

-1.22%

-0.04%

1.18%

-0.02%

USA

1.73%

2.60%

0.87%

-0.33%

Canada

0.92%

1.75%

0.83%

-0.37%

Australia

1.06%

1.96%

0.90%

-0.30%

Sweden

-1.00%

0.45%

1.45%

0.25%

Source: RLAM, Bloomberg

8 | LEADING EDGE | APRIL 2019

ABS – ANALYSTS IN WONDERLAND ‘Wonderland’ probably isn’t the word most people would associate with asset backed securities (ABS). However, the reference is to Alice’s Adventures in Wonderland, in which a girl follows a white rabbit into a fantasy world populated by peculiar creatures. Logic is inverted and things are often not what they seem.

However, should the company’s health deteriorate, banks are able to use their access to management to get security over assets, and get ahead of unsecured bondholders. This can lead to recovery rates of 30-40% – you ‘pay senior and get junior’. The answer can be to buy overcollateralised secured bonds coupled with protective covenants, which can enhance recoveries by providing early triggers to bondholder action.

So it can be with ABS. The sector has a render of complexity that dates back to the global financial crisis. The result is a labyrinthine, diverse and idiosyncratic area, which is now heavily regulated and often mispriced. The flipside is that these factors create a wonderland of possibilities – everything we dream of as active managers. But, like Alice, we have to be open-minded to discover these opportunities, while avoiding the traps.

COMPLEXITY BEGETS OPPORTUNITY

Traditional senior unsecured lending sees bondholders rank alongside banks as claimants on a company’s assets.

“Speak English!” said the Eaglet. “I don’t know the meaning of half those long words, and, what’s more, I don’t believe you do either!” From here, it’s not a giant leap to ABS, whether secured mortgage debentures or the more modern, and more complex, securitisation market. ABS are bonds whose income payments and value are derived from, and collateralised by, underlying assets. In some cases a pool of small and less liquid assets are combined. This pooling enables them to be sold as the risk of the underlying assets is diluted, with each asset only a fraction of the total collateral value. The hierarchy and detail of the different tranches of bonds is crucial – that is to say, who is entitled to the cashflow first and under what circumstances? Likewise, there can be very specific covenants, providing a plethora of different protections for lenders. In an uncertain world, this can inject welcome visibility and control into credit portfolios. For instance, the risk of leveraged takeovers by private equity firms that could otherwise destroy value for bondholders can be subverted, making typically negative events more positive, as the secured bond covenants oblige the acquirer to pay off the bondholders at a premium.

THE SUBORDINATION POTION It was all very well to say “Drink me,” but the wise little Alice was not going to do that in a hurry. “No, I’ll look first,” she said, “and see whether it’s marked ‘poison’ or not.” After the global financial crisis, the sector was shunned by many investors, but has recovered in recent times. This has led to a growing commoditisation of parts of the market, such as residential mortgage backed securities (RMBS) and auto loans, typified by low credit spreads at the senior level. As a result, some investors have ‘gone junior’, moving down the capital structure in subordinated tranches to increase returns. Indeed, some ABS funds have over half of their holdings in these assets. This is brave if we consider the nature of the risk that is being taken. A relatively small change in the financial assumptions can quickly wipe out the thin junior tranches, even if the day one rating on those bonds is investment grade (figure 1). The subordination potion – are you being paid to drink it? %

Total recovery

100

AAA AA A BBB

60 40 20 0

Total loss

Figure 1: Investing down the capital structure in ABS is high risk as these tranches can be wiped out by a small reduction in the financial performance of the asset. Source: RLAM

APRIL 2019 | LEADING EDGE | 9

OUR APPROACH TO ABS “Curiouser and curiouser!” cried Alice (she was so much surprised, that for the moment she quite forgot how to speak good English). These investors can lose sight of what makes some ABS attractive – control. By chasing returns, they end up with leverage without control, which is the worst of both worlds. We have various tenets for investing in ABS. We believe in diversifying to reduce the risk of any single holding failing; we use our analytical strength to research potential holdings in great depth; and, most importantly, we don’t compromise on capital structure. Over 90% of our ABS allocations are to senior ABS – stay senior and get your outperformance from embracing idiosyncrasy and the resultant market inefficiencies, not from increasing risk. Social housing highlights our approach: we like the sector for its social utility and government-style cashflows. It’s possible to buy conventional social housing ABS, with an established over-collateralisation of around £5 for every £100 lent. As inquisitive analysts we don’t have to look much further to find less conventional social housing offering a very different equation. In fact, it’s possible to root out

Matthew Franklin,

bonds that have over £100 of additional security. The real trick being that these less accessible bonds can be bought with higher yields despite their clear enhancements. Now that is curious!

A HAPPY ENDING? We like ABS because of the security provided by the collateral and the control and visibility provided by the covenants. However, what we really like is the opportunity to acquire these bond characteristics, in an increasingly uncertain world, without having to compromise portfolio yield. To this end, knocking down the barriers to ABS investment and analysis, whether perceived complexity, or disconnected regulatory or rating agency approaches, will continue to be a central component of our active management of credit portfolios. To find out more about our approach to ABS, please read our recent article ‘How active investors can benefit from inefficient markets’.

‘‘

It was all very well to say ‘Drink me,’ but the wise little Alice was not going to do that in a hurry. ‘No, I’ll look first,’ she said, ‘and see whether it’s marked “poison” or not.’ Lewis Carroll, Author

’’

Senior Credit Analyst

Martin Foden,

Head of Credit Research

10 | LEADING EDGE | APRIL 2019

WEATHERING VOLATILE MARKETS WITH MULTI ASSET STRATEGIES Investment textbooks tell you that if you want a higher return, you need to accept a higher level of risk. We aim to reduce unnecessary risk by diversifying our multi asset portfolios across a broad range of asset classes, by avoiding exotic or expensive investments and by adjusting exposures to ensure they are appropriate given the economic backdrop. Our new Multi Asset Strategies Fund (MAST) goes one step further, trimming exposure to equities during periods of heightened volatility with a view to limiting downside risk in bear markets. We have seen some large swings in stock markets over the last year and we think higher levels of volatility are here to stay. We are late in the business cycle and two years of US interest rate hikes are starting to take effect (chart 1). With geopolitical risk also rising, this is a good time to consider ways to limit portfolio volatility.

SELECTING AN APPROPRIATE RISK LEVEL The first way we control risk in multi asset funds is by diversifying across a broad range of asset classes. Different investors have different attitudes to risk and return. Our GMAP range (chart 2) spans the risk spectrum from a pure fixed income fund, through four progressively positioned multi asset funds to a fund fully invested in UK and global equity markets.

INVESTING IN A SENSIBLE ASSET CLASS UNIVERSE When building portfolios we include asset classes that make sense over the long run, each typically offering its best returns at a different stage of the business cycle. Assets like equities, property, commodities and bonds have been around for decades, even centuries, and have a proven track record. Unlike most of our peers, we avoid exotic, expensive and untested asset classes like aircraft leasing or peer to peer lending, some of which have never endured a recession.

Chart 1: Volatility tends to rise 2 years after the Fed starts to hike US interest rates

US Federal Fund rate pushed to the right by 2 years

One year moving average of S&P Vix Volatility index (RH Scale)

50 40

Source: Thomson Reuters Datastream as at 21.03.19

20 20

0 20 15

20 10

20 05

20 00

19 95

19 90

APRIL 2019 | LEADING EDGE | 11

Trevor Greetham,

Head of Multi Asset

Chart 2: Global Multi Asset Funds spanning the risk spectrum Return

UK equities Overseas equities Property GM

Commodities

Expected Return in excess of inflation*

Global high yield bonds Investment grade corporate bonds

GP4

UK government bonds

Dynamic IA sector Global Equity

Index-linked gifts Cash and absolute return

GP5 Adventurous IA sector Mixed Inv. 40-85%

GP6

Growth

IA sector Mixed Inv. 40-85%

GP3 Balanced IA sector Mixed Inv. 20-60%

AF Defensive IA sector Mixed Inv. 0-35% Conservative IA sector £ Strategic Bond

Risk

Funds risk rated by:

Weightings may vary according to tactical asset allocation and the fund may invest outside of indicated asset classes as the manager sees fit.

EValue Q4 2018 Report. Risk Ratings (Scale 1-10) data generated by Fund Risk Assessor on a 10-year time horizon.

Figures in pie charts relate to equivalent Governed Portfolio.

The FinaMetrica Risk Tolerance Toolkit™ helps advisors and enterprises create lifetime relationships, through better advice that results in clients who refer more, invest more and remain suitably invested through market highs and lows. At Q4 2018.

The Dynamic Planner Risk Profile assessment of the fund is correct as at Q3 2018 and is reviewed independently by Dynamic Planner on an ongoing quarterly basis; and, if necessary, may change in future. Dynamic Planner is the brand name of the software system powered by Distribution Technology (DT). Copyright © Distribution Technology Ltd 2018 onwards.

Synaptic based on 1-10 scale, at Q4 2018.

12 | LEADING EDGE | APRIL 2019

WEATHERING VOLATILE MARKETS WITH MULTI ASSET STRATEGIES LIMITING DOWNSIDE WITH ACTIVE STRATEGIES

Chart 3: Investment Clock model INFLATION RISES

Industrial Metals

RECOVERY

OVERHEAT

▼

COMMODITIES

BONDS

CASH

TA P

REFLATION

▼

LES

, H E A LT H C

High Yield Bonds

CE N

UMER DIS ONS CR &C ET IO

STOCKS

FIN A

Government Bonds

▼

Softs

Y AR N

E AR

Energy

InflationLinked Bonds

GROWTH MOVES BELOW TREND

Corporate Bonds

IALS & ENE TER RG MA Y

GROWTH MOVES ABOVE TREND

LOGY & INDUSTR NO IAL CH S E T

MANAGING VOLATILITY With MAST we go one step further by reducing equity exposure during periods of market turbulence. Equity markets post their best returns when volatility is low and generate their greatest peak to trough losses when volatility is high (chart 4). Since 1973 the average peak to trough loss for US equities when volatility was below average was generally in the single digit percentage points. During periods of above average volatility the market experienced losses of 50% on more than one occasion.

STAGFLATION

Precious Metals

INFLATION FALLS

Source: RLAM

Chart 4: Peak to trough losses have been greater during periods of heightened volatility Periods of high volatility

10000

Periods of low volatility US equity market

MAST seeks to achieve a return of cash+4% p.a. gross of fees on a rolling five year basis while managing downside risk. The fund combines two types of strategy: risk premium strategies that seek to benefit from positive market trends, reducing risky

Source: RLAM Past performance is not a reliable indicator of future results.

20 17

20 13

20 09

20 05

20 01

19 97

19 93

19 89

19 85

19 81

19 77

19 73

We apply active tactical asset allocation positions with a view to generating additional return and reducing downside risk. Our Investment Clock model (chart 3) helps us tilt exposure towards assets that do best in prevailing economic conditions, and away from those more likely to generate losses. Analysis and experience suggests that our approach tends to add the most value going into and around recessions when downside risk is at its highest.

APRIL 2019 | LEADING EDGE | 13

A common criticism of volatility managed strategies is that they reduce exposure to stocks after a correction, leaving investors locked in cash when markets recover. Our approach allows us to take part in these rallies using a separate risk budget allocated to tactical positions. Our model-based framework for tactical asset allocation allows us to simulate positions we would have taken in MAST since the early 1990s. The simulation shows that MAST would have returned an annual average of 5.3% in excess of cash since 1995 with peak to trough losses of less than 10%. Our analysis suggests that, during this period, MAST would have captured about half of the upside from stocks over calendar quarters when they rose. At the same time, a combination of downside risk control and positive tactical asset allocation would have meant that on average MAST would have moved sideways over calendar quarters when stocks fell (table 1). We are late in the business cycle and volatility is likely to remain high for the next few years. A disciplined approach, considerate of downside risk at every stage of the investment process, will be more important than ever.

Chart 5: A Simulation of the Multi Asset Strategies Fund since 1995 FTSE all world (£)

Balanced (60/40)

RLAM MAST

Cumulative return

8.7%

8.1%

9.5%

Return excess of cash

4.5%

4.1%

5.3%

15%

6% 1.6%

Volatility Return/volatility

0.6%

.9%

Max drawdown

-48%

-27%

-7%

6.7 years

4.9 years

1.1 years

Return to HWM* 800 600 400

RLAM MAST Balanced 60/40 FTSE all world £ Cash + 4% CPI

200 0

19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 20 14 20 15 20 16 20 17 20 18

asset exposure when volatility is high, and tactical asset allocation strategies that take advantage of opportunities irrespective of market direction.

Peak to trough losses (drawdown) % 0 -20 -40

Source: RLAM, for illustrative purposes only.

Simulated data is not a guide to past or future performance. The above charts contain simulated performance data. Balanced (60/40) refers to 60% FTSE All World Equities in £ and 40% FTSE Actuaries All Stocks for bonds. The simulation assumes fixed weight allocations to Risk Premium Strategies, with volatility management and constant risk budget for tactical

asset allocation. The simulation for MAST is calculated using historical positions generated by RLAM’s inhouse tactical asset allocation models and signals from our volatility management process. Gross of fees and transaction costs. The data presented in this chart does not represent the actual performance of any past or present fund/strategy.

Table 1: Capturing upside with limited downside Quarters when Stocks Fell

Quarters when Stocks Rose

FTSE all world (£)

-7.6%

5.9%

2.1%

Risk premium strategies

-1.0%

2.4%

1.5%

Tactical asset allocation

1.1%

0.7%

0.8%

RLAM MAST

0.0%

3.1%

2.3%

% Time

27%

73%

100%

1995 Q2 to 2018 Q1

Source: RLAM. For illustrative purposes only.

Average Quarter

14 | LEADING EDGE | APRIL 2019

DIVIDEND DISCIPLINE AND CONTRARIAN INVESTING Every week we receive a barrage of phone calls from brokers operating under the premise that, as income investors, we only need to hear about a company’s high dividend yield to become immediately interested in it. Dividend yield is a crude valuation tool. It can be indicative of an outstanding income investment opportunity, but equally it may reflect a value trap in which a dividend will be imminently cut. The following chart, which displays UK dividend growth by yield group since 1990, shows that the higher a company’s dividend yield on average, the lower its dividend growth over the following 12 months. There are good psychological explanations for why dividend yields often reach unsustainable levels. Dividends are generally viewed as expressions of confidence in a company’s future. As such, CEOs will typically be highly reluctant to cut them. Companies frequently overdistribute for many years before having to make dramatic cuts; often only after a change of CEO, a new company strategy or a rescue rights issue.

This does not mean that we simply ignore high yielders, since the rewards for those investors capable of sifting through them to discover those companies able to sustain and grow their dividends are substantial. In such cases the compounding dividend will combine with a market willingness to apply a higher valuation (lower yield) to the stock.

SO HOW DO YOU SPOT THE DIVIDEND CUTS COMING? An important starting point is to avoid relying on generalisations. The classic way to assess dividend sustainability is to look at the dividend cover ratio. As a rule of thumb, it is thought that a dividend is safe if a company is able to cover it twice with its earnings. Yet looking at those companies that recently cut their dividends, it is striking how many of them would have comfortably passed this test. A better strategy is to assess the underlying fundamentals of the company and how they are changing over time. Everybody focuses on earnings, but cashflows are what determine the

UK dividend growth by yield vs dividend group since 1990 Dividend growth over following 12 months (%) 25.0

Working capital

This is the company’s ongoing cash relationship with both its suppliers and its customers. An ideal situation is where a company is paid by its customers before it has to pay its suppliers. One of the many issues suffered by Interserve was that most of its growth came from the Middle East, where payments from customers were slow to non-existent. Despite the company booking strong profits in its accounts, it was left short of cash, leading to rising debt levels. It ended up not only having to cut its dividend, but also required a rescue rights issue. Capex

This is the money that a business must invest in order to fund growth. Inmarsat looks like a fantastic business placed in a growth industry. It builds next generation satellites and has EBITDA margins in excess of 70%. However, its business model is capex intensive; involving building and launching satellites. The level of investment required to grow the business resulted in high debt levels rendering its dividend unsustainable. Exceptional items

20.0 15.0 10.0 5.0 0.0 -5.0 -10.0 -15.0 -20.0 -25.0

sustainability of a dividend. There are three key factors that determine a company’s ability to convert earnings into cashflows: working capital, capital expenditure (capex) and exceptional items.

0-1.0

1.5-2

2-2.5

2.5-3

3-3.5

3.5-4

4-5.0

5.5-6

Starting dividend yield (%)

Source: SG Cross Asset Research/Equity Quant, FactSet 1990-2016.

6.5-7

7.5-8

These come in many forms, but are problematic in nearly all companies that cut their dividends. A struggling business will naturally take assertive actions to rectify problems. It may shut down a factory or lay off staff. Since such actions are one-off in nature they are classified as exceptional items and do not impact adjusted earnings. A more subtle form of exceptional item are ‘provisions’. Outsourcing firm Capita was incredibly acquisitive, and whenever it would buy a new company it would make one-off

APRIL 2019 | LEADING EDGE | 15

provisions against all of its loss-making contracts. This meant that as these losses materialised, profits were not impacted due to the offsetting provision, yet the cashflow was significantly lower and a deterioration in its balance sheet ensued.

WHAT ABOUT DEBT? It is often assumed that companies that are heavily indebted will have to cut their dividends. We think the reality is more subtle than that, and that there is a strong dynamic between the defensiveness of a company’s earnings and the amount of debt it should have. Cyclical businesses ought to have lower amounts of leverage to prevent situations in which managements would be forced to sell quality assets at the bottom of the cycle, to shore up capital. On the other hand, low risk businesses with dependable cashflows can afford to have higher levels of debt. A great example of this is water utility Pennon Group which despite having a net debt to EBITDA ratio of 5.8X, has been able to consistently grow its dividend for a decade due to the reliability of its cashflows.

CONTRARIAN INVESTING We truly differentiate ourselves with our contrarian, long-term approach. Share prices are considerably more volatile than the fundamentals of companies, driven by a common obsession with short-term earnings forecasts. By focusing instead on the long-term ability of a company to generate cashflows, investors can find attractive entry points and achieve consistent, long term, market beating returns. As evidence, look no further than our RL UK Equity Income Fund, which has performed ahead of its peer group for 9 of the last 10 years, and our RL UK Dividend Growth Fund, which is top quartile after three years.

Richard Marwood,

Senior Fund Manager

‘‘

Niko de Walden,

Fund Manager

... avoid relying on generalisations.

’’

16 | LEADING EDGE | APRIL 2019

THE ATTRACTION OF INCOME FROM CORPORATE BONDS 2018 was a difficult year for credit investing. Only five funds in the IA sterling strategic bond sector made positive returns: three of those were RLAM funds. Paola Binns, manager of the Short Duration Credit Fund, and Rachid Semaoune, who manages the Global Bond Opportunities Fund, outline how they dealt with the challenges and are approaching 2019. Brexit; President Trump and tariffs; US interest rates and quantitative tightening; the eurozone slowdown; and credit market concerns and the GE downgrade – there are always threats that investors must consider, but 2018 was quite a year. To make matters worse, many of these factors reached a peak in the fourth quarter, causing financial markets to fall sharply. Brexit uncertainty had an interesting effect: sterling fell from nearly $1.42 in January to below $1.25 in December, yet the 10-year gilt yield was unchanged as investors prized the safety of government bonds. This ‘risk off ’ thinking was reflected in higher investment grade credit spreads, which widened from around 90 basis points to nearly 150bps. This had a significant impact on borrowing costs for UK issuers: for example, the cost of financial BBB increased by around 1.0-1.5%. Not all of this was Brexit related as spreads also rose in the euro and dollar credit markets. Nonetheless, UK country-specific risk in the iBoxx corporate bond index is around 50% by size and 25% by revenue. Further afield, escalating trade tensions between the US and China led investors to fear a shock to the global economy from the imposition of tariffs. Unsurprisingly,

Twitter diplomacy didn’t reassure increasingly nervous markets. Alongside these tensions, the Federal Reserve (Fed) increased interest rates five times from December 2017 and more hawkish central bank rhetoric caused investors to worry about the US economy overheating. The tipping point came when the Fed implied that rates could rise faster and further than previously expected. The yield on US 10-year treasuries rose above 3.0% and capital flooded out of credit into treasuries, attracted by the higher yield and reducing exposure to corporate debt as investors feared that higher interest rates and quantitative tightening could tip the US economy into recession. The eurozone completed the downbeat economic picture as Germany, France and Italy all struggled, albeit for quite different reasons. Whether caused by trouble passing the government budget, civil unrest or problems with the auto sector, the sharp and unexpected falls towards recession in the region’s leading economies was unwelcome.

This rang alarm bells for credit investors. Recessions are rarely pleasant, but commentators started to worry that credit market quality had deteriorated. The US BBB corporate bond sector had grown to $3.2 trillion, representing 50% of the investment grade credit markets compared to 44% in 2012. Did this represent a systemic risk? It seemed so when General Electric melted down in the autumn. Writedowns, excessive debt and lack of clarity from management about strategy resulted in its debt being downgraded two notches by all three ratings agencies, pushing its spread from 150bps over gilts to 450bps. Its price fell 30% (figure 1), creating a negative spiral in the wider market. If the embodiment of American capitalism could fall, then others would surely follow – there’s no smoke without fire. Quite a set of challenges. And 2019 looks similar – political and economic risks remain elevated and it would be complacent to think the bad news has passed. Yet we’re more positive than

General Electric (GE) bonds £ 150 140 130 A 120 30% fall in price

110 100 90

Dec 2017

BBB Mar 2018

Jun 2018

Sept 2018

Dec 2018

Figure 1 Ratings agency downgrades saw a collapse in General Electric’s bonds, raising fears of a wider meltdown in credit markets. Source: Bloomberg

APRIL 2019 | LEADING EDGE | 17

Paola Binns,

Examples include income contingent student loans and ML33 (private Norwegian property company): both

are asset-backed with strong protection and covenants, and attractive yields. Yet they are off-benchmark and, in the case of ML33, unrated. While these are just two holdings in highly diversified funds, they illustrate our investment approach perfectly. While other fund managers rule out such bonds or don’t have the research capabilities to invest in such opportunities, this is how we gain our edge. To find out more about our approach to ABS, please read our recent article ‘How active investors can benefit from inefficient markets’.

Investment process CHMARK BEN

• SECURITY • • COVENANTS • • INCOME •

T RA

Instead, we seek out investments that offer security to bondholders, including strong covenants and good income: an example would be ‘coupon steps’ between investment grade and high yield. Income is at the heart of our investment process (figure 2). We not only want to be paid for the risks of investing, we also want to know that the income is as secure and protected as possible.

Senior Fund Manager

Our investment approach is always gloomy – it has to be because bond investors risk losing all of their capital for a small coupon. We eschew the industry preference for the apparent safety of indices and benchmarks, credit ratings and liquidity. None will afford much protection when markets are falling.

Rachid Semaoune,

Default rates in high yield are expected to be lower than in 2018 as are downgrades. Even GE has recovered: by slashing its dividend and selling business units, it has narrowed its spread over gilts from 450bps to 250bps. Despite this more optimistic tone, credit valuations remain attractive. With a spread over gilts of 150bps, the implied default rate is 12.1% – yet the fiveyear average default rate is only 0.5%. Our long-term estimate of the premium needed to compensate for the risk of default is around 40bps – there’s a lot of money on the table for disciplined credit investors.

Senior Fund Manager

might be expected: Brexit is reaching an endgame, albeit temporarily before talks start about a permanent trade deal; US-China trade tensions may be easing (after all, there’s a re-election campaign to run in 2020); and, while a global downturn is possible, central banks have become much more dovish and are even applying stimulus packages.

Figure 2 Income is at the heart of our investment process. We seek out bonds that offer security to bondholders, including strong covenants and good income.

18 | LEADING EDGE | APRIL 2019

BEST OF BOTH WORLDS: MIXED ASSET SUSTAINABLE INVESTING Sustainable investing has seemingly reached a tipping point. Just three years ago, there was little interest in presentations and roadshows on Environmental, Social and Governance (ESG) factors, yet today it’s all the rage with articles everywhere. For RLAM, this is welcome, albeit slightly bittersweet. We’ve been fully integrating ESG factors into our investment processes since 2003, and run credit portfolios and multi-asset funds on this basis since 2009 and 2013, respectively. We’re naturally delighted that sustainable investing has finally moved into the mainstream, yet a little frustrated that the bandwagon effect is generating some questionable marketing claims.

THE SUSTAINABLE LANDSCAPE Before outlining our approach to sustainable equity, credit and mixedasset investing, it may help to clarify terminology. Ethical investing, which began meaningfully in equities in the 1990s, was based on negative screening i.e. screening out ‘bad’ stocks on criteria such as environmental impact (e.g. oil companies) and social harm (tobacco companies, arms manufacturers).

2 Social and environmental improvement – we believe companies that address social issues through innovation will succeed over time. This is not an open chequebook for start-ups, but we are more open-minded towards companies that are trying to address long-term social or environmental challenges. 3 Engagement – this is a key issue for sustainable investing. Rather than exclude or sell out of ‘transgressors’, we prefer to engage with them and make the case for higher standards or a different approach. Not only does this help to make society better, it can improve financial returns by avoiding problems. We have been applying these sustainable investing criteria since 2003. The 10-yearplus head start we have over many of our competitors means that we’ve had time to develop a differentiated investment process based not just on data-driven models as ESG data standards are poor. We’ve also learned to be flexible and understand the differences between equity and debt when considering sustainable criteria: what works for one isn’t always relevant or important for the other.

SUSTAINABLE INVESTMENT PROCESS

Sustainable investing, although having its origins in ethical, is a more modern, inclusive manifestation of the principle of embedding values in investing. The main difference compared to ethical is that the screening is positive – it’s about using capital to have a positive impact. For us, sustainable investing has three core principles:

Our process has four elements: two fixed sustainable considerations and two financial ones that vary according to whether we’re looking at equity or credit:

1 Alpha generation – generating returns is the point of investing and we believe this is entirely complementary to the other two factors. Essentially, we believe that well-managed companies by ESG metrics are likely to be financially well run – sustainable investing does not mean foregoing returns.

2 ESG leadership –companies that encourage good corporate behaviour.

1 Products and services – we seek out companies that are aiming to create a cleaner, healthier, safer, more inclusive society.

For equities, the two key financial criteria are (see figure 1): 3 Value creation – we look for returns that exceed the cost of capital.

4 Valuation – we are committed to paying a fair price. Positive ESG can attract an unwarranted valuation premium – we will pay up for quality, but not overpay. The equity investment process has three stages. Through screening, we populate a chart that compares a stock’s sustainable score against its financial one. As we’ve said, however, data on ESG is quite poor and inconsistent. To mitigate this, we apply our proprietary qualitative analysis to consider a company’s real ESG qualities. This can sharply move the company’s position on the chart, pushing stocks into or away from our investment universe. Finally, we construct portfolios from those companies that score well on our differentiated analysis. Financial and sustainable factors are treated equally in our investment process. As an example, Google has attractive financial qualities, but its dual share class structure is a governance black mark. On initial screening, it is therefore out of our investment universe. However, when we consider its sustainable credentials on more specific factors, such as remuneration, board structure, environmental impact, social impact, and products and services, its sustainable score increases significantly, making it investable for our funds. This more granular, qualitative analysis is our alpha – that is to say, how we generate stock-specific returns.

CREDIT – SIMILAR, BUT DIFFERENT The sustainable considerations for credit are the same as for equities, but the financial ones are necessarily different. Unlike equities, credit risks are asymmetric: upside returns are capped, however the company performs, yet a deterioration can lead to negative returns, through default, forced sale because of fund restrictions or mark-to-market losses.

APRIL 2019 | LEADING EDGE | 19

Mike Fox,

Therefore, alongside the two fixed sustainable considerations, our credit financial criteria are (figure 1): 3 Bondholder protection – we focus on bonds with good structures, and strong security and covenants. We particularly like secured bonds and certain highquality asset-backed securities, where there is in-built protection. This requires diligent credit research.

An example is the First Hydro Finance 9% 2021, which is an unrated, offbenchmark bond issued by a subsidiary of French company, Engie. As an electricity generator, the parent company has a poor sustainability score, but First Hydro generates hydro-electric power in Snowdonia and has a far better sustainable assessment. Furthermore, the bonds are secured, with strong covenants and ring-fenced assets and cashflows. A bond that fails on traditional ESG credit screening becomes investable under our more nuanced integrated credit and ESG analysis. Again, this is our investment edge. Applying sustainable criteria with different financial considerations for equities and credit unlocks opportunities in these very

Richard Nelson,

Senior Fund Manager

Sustainable investment process – core principles

Sustainable

4 Diversification – we seek to reduce stock-specific risk by investing across a range of bonds As well as reducing risk, we also seek out investment opportunities that are particularly complex or off the beaten track as they’re not included in mainstream indices or benchmarks and/or unrated by credit ratings agencies. There are attractive opportunities in ring-fenced bonds issued by operating company subsidiaries of holding companies, which can be below the radar for many fund managers. This is true for all credit investment, but a good sustainable investment process can highlight such opportunities.

Head of Sustainable Investment

different asset classes (figure 2). This illustrates how the intelligent application of sustainable factors can increase the returns we achieve for investors across our five mixed asset sustainable funds.

Products and services Cleaner, healthier, safer, more inclusive society ESG leadership Encouraging good corporate behaviour

Financial – equities

Financial – credit

Value creation

Bondholder protection

Returns ahead of cost of capital

Focus portfolios on security, covenants and structure.

Valuation Paying a fair price

Reduce stock-specific risk Diversification

Figure 1 Sustainable factors are fully integrated in our investment process, but we apply different financial considerations to equities and credit.

Best of both worlds

Sustainable

Credit

Equities

Cleaner, healthier, safer, more inclusive society

Social housing

Healthcare

ESG leadership Lowering investment risks

Utilities

Technology

Infrastructure

Engineering

Financials

Chemistry

Figure 2 Different sectors respond well to sustainable criteria in equities and credit.

20 | LEADING EDGE | APRIL 2019

HOW TO INVEST IN A WORLD THAT ISN’T SHORT OF ANYTHING is chasing returns in lots of places, such as coffee shops and online foam mattress retailers. Even the technology sector is finding it tough to grow as indicated by the lower-than-expected demand for new iPhones.

The world is awash with excess capacity and the normal dynamics of supply and demand don’t seem to apply. Since the global financial crisis, central banks have pumped capital into a global economy in which there was already plenty of capacity. In addition, technology has made it possible to buy goods cheaper and faster than ever before, bringing down returns.

What’s the solution? As investors, how do we sift through this capital excess to identify the stocks that will outperform? The first thing to note is that stock selection really matters. Looking at MSCI World Stock Returns between 2014 and 2019, the worst performing 80.2% of stocks performed behind the benchmark, with a third losing value, whereas the best performing 19.8% of stocks represented 99% of the excess return (figure 1).

As a result, investing capital profitably has become much harder. It’s estimated that the companies in the S&P500 have as much as $2 trillion of excess capital on their balance sheets. Even the most celebrated investor of the last 50 years, Warren Buffett, is struggling: his investment company Berkshire Hathaway is sitting on over $120 billion of capital and he recently accepted that his investment in Kraft Heinz had been a mistake.

Our investment universe comprises around 6,000 stocks. We are fundamental, bottom-up investors, so we need a way to understand the world and categorise companies that isn’t rooted in top-down macroeconomics. The broad economic environment will have an effect, of course, but we believe that good companies

Against this, many new businesses are capital light, often using technology to use existing capital more intensively – think Airbnb and Uber. Instead, capital

100 …best performing 19.8% stocks represented 99% of total return

Worst performing 80.2% of stocks collectively had total return of 0%, and 33% of stocks lost value...

40 20 0

200

401

602

803

1,000

1,201

1,400

1,600

1,800

2,000

-20 Number of stocks

Figure 1 The importance of stock selection: the best performing 19.8% of stocks represented 99% of total return (MSCI World Stock Returns 2014-19) Source: RLAM and MSCI as at 28 February 2019

Through a proprietary algorithm, our Corporate Life Cycle model categorises companies according to their stage of development. Quantitative analysis helps us to identify potential opportunities by scoring stocks across a range detailed financial factors. We then apply our scoring system to rank characteristics to identify which companies to conduct further fundamental research into for possible inclusion in the portfolio. As figure 2 shows, the Corporate Life Cycle plots economic returns against required returns (that is to say, cost of capital) and describes a typical corporate journey. It describes five distinct phases: Accelerating, Compounding, Slowing & Maturing, Mature and Turnaround. These help us to understand where companies are in their journey and how to analyse them to pick the real winners – and, perhaps more importantly, avoid the potential losers. After 10 years of excess capacity and cheap money that followed the global financial crisis, there is too much capital chasing investment returns. Given the returns data referenced earlier, we believe passionately that active investment is the best way to achieve excess returns. The proof is in the pudding. Our disciplined bottom-up investment process gives us an edge as shown by our performance record: we have outperformed our benchmark in 15 of the last 17 years.

The importance of stock selection

perform well across the economic cycle. What matters more is how the company is using its capital.

APRIL 2019 | LEADING EDGE | 21

Will Kenney, Senior Fund Manager

Understanding the corporate life cycle Accelerating

Compounding

Slowing & maturing

Mature

Turnaround

Economic return on productive capital

Figure 2 Making sense of our investment universe – our proprietary Corporate Life Cycle model. Source: RLAM

Three stocks at different stages of the Corporate Life Cycle (figure 2) Accelerating

Slowing & maturing

Turnaround

Old Dominion Freight Line (US): trucking company that fills the space between FedEx/UPS and full truck payloads. Has lower than industry average driver turnover and has grown at an average of 15% per annum for the last two years – five times the rate of GDP growth. Deploying incremental capital into buying additional trucks and building more depots to in-fill its existing nationwide network.

Safran (France): short-haul aircraft engine manufacturer. The quant picture is distorted by an acquisition, but hub-to-hub flying is an essential service and revenue passenger kilometres growth has averaged 5% per annum since 1989, even allowing for 9/11 and the global financial crisis. There is only one competitor (Pratt & Whitney) after Rolls-Royce the shorthaul engine market as its extremely difficult to deliver reliability against cost and fuel efficiency.

Maeda Road (Japan): road resurfacing. Stocks in the turnaround category offer hidden value and there are big rewards if they can turn round. Japan is an earthquake zone, so roads frequently need to be resurfaced. Road mending may not be exciting, but this company is in the top 10% of value opportunities globally. Furthermore, 50% of its market capitalisation is accounted for by its surplus cash – this has higher returns than at first glance due to the excess capital on the balance sheet.

22 | LEADING EDGE | APRIL 2019

DEALING WITH ABSOLUTES Uncertainty and volatility came back in full force in 2018. Nearly all major asset classes generated negative returns as monetary policy tightening, global trade concerns and weak economic data weighed on market sentiment. While the start to 2019 has been more positive, the upcoming headwinds loom large, threatening increased bouts of volatility and heightened gap risk. How can investors capitalise on this situation to generate positive absolute returns in a difficult environment? In this article we shall suggest two strategies, employed respectively by our RL Multi Asset Credit Fund (MAC) and our RL Duration Hedged Credit Fund (DHC). Both funds embody RLAM’s investment philosophy of individual stock selection and exploitation of market inefficiencies. They differ in that MAC is a global strategy while DHC has a sterling bias (albeit with geographical diversification). MAC has a significant degree of flexibility to best balance risk, return, volatility and liquidity. DHC, on the other hand, is biased towards secured and investment grade debt while managing duration towards a range around zero years.

MAC The guiding principle of the MAC fund is ‘know what you own’. We apply it to three areas, which form the pillars with which we are able to navigate challenging markets and deliver absolute returns. 1 Business – who owns and manages it? What is the fundamental outlook? What is its value?

Structure

2 Structure – security, jurisdiction, protections, placement in the capital structure 3 Liquidity and Volatility – size of investment, currency, asset class, rating, ability to sell To demonstrate this process, we can apply it to a previous investment of ours: a term loan in international sandwich shop Pret a Manger.

Business The company had solid fundamentals, with stable trends in its niche focus area and a proven track record of deleveraging and generating strong cashflows. The company was exceptionally well run, having learned from the operational excellence of early investor McDonald’s. Management were prudent in their expansion plans, sticking to their core competencies in busy city centre locations. Capital expenditure was low.

Pret A Manger When offence is the best defence

The structure was reasonably simple, in a lender friendly jurisdiction. It was a senior secured term loan with a few other facilities, but all with similar or lower rank. It included a revolving credit line, maintenance covenants, negative covenants and other protections relative to other loans. Leverage was maintained at a reasonable level relative to the value of the company.

Liquidity and Volatility Being a sterling denominated loan, size was an important consideration. It was approximately £450m and gave investors around 400 basis points over LIBOR of compensation for the risk. Although loans can be less liquid, its reasonable tranche size, favourable credit rating and multiple exit options for the business owner meant that it could form a core holding, such that reducing exposure and managing volatility would be possible if the investment rationale did not materialise as expected.

Feb 18 New Look downgraded to CCC Mar 18 Coffer Peach business tracker – 5% Lfl May 18 JAB Holding buys Pret a Manger for £1.5bn Jul 18

102

House of Fraser ratings downgrade

Sep 18 Debt refinanced

101

100

Jul 17

Aug 17

Sep 17

Oct 17

Nov 17

Dec 17

Jan 18

Feb 18

Mar 18

Apr 18

May 18

Jun 18

Jul 18

Aug 18

Business

Structure

Liquidity

Ownership Value Fundamentals

Secured Guarantees Protections

Size & FX Rating Asset class

Source: Bloomberg

Sep 18

Oct 18

APRIL 2019 | LEADING EDGE | 23

Khuram Sharih,

Conclusion

• Rating agency rigidity – credit ratings typically only tell you about likelihood of default while missing a crucial aspect: loss given default. We exploit this limitation while maintaining attractive yields within portfolios.

The loan generated a positive total return of c.2.5% over the period with very little volatility. The company was positioned in an extremely challenging sector, with several notable downgrades as the broader UK retail high yield bond segment experienced significant losses. Nevertheless, our fundamental analysis revealed an excellent business that offered solid protections, reasonable liquidity and stable returns in an uncertain market.

• Undervalued security and covenants – security and covenants are typically underrated by the market, possibly the result of a long period of benign markets. Our strong emphasis on security and covenants allows us to remain disciplined and avoid complacency without sacrificing quality or returns.

DHC One of our key ambitions is to exploit market inefficiencies, a few of which we will now mention:

There are four key strands to our success:

• Dumb money (passive/ETF) – the rise in thoughtless capital allocation continues, with investors favouring benchmark based strategies. This creates opportunities for those willing to invest across a wider set of attractive opportunities, such as unrated debt, secured sub-investment grade debt and smaller sized issues while controlling risk. Passive strategies remain flawed in that they have an inherent bias towards the most indebted companies.

1 Building in attractive yields 2 Landmine protection 3 Looking beyond ratings and benchmarks 4 Effective diversification

Build in attractive yields The chart below juxtaposes the credit spreads available in the market with historical default data going back to 1920. Across all rating bands, it shows that credit

Build in attractive yields

Credit spread Default risk

250 200 150

139

100 50 0

220

207

Aaa

4 Aa

Baa

Shalin Shah,

Senior Fund manager

investors are significantly overcompensated for historical default risk. It assumes a 40% recovery rate on unsecured debt, with a higher recovery for DHC due to its higher levels of senior secured debt relative to typical credit indices. This has enabled DHC to pick up market-beating yields in a risk-controlled fashion.

Landmine protection No matter how deep our analysis of an investment is, the potential for black swan events will always exist. We seek to mitigate the risks by biasing exposures towards strong balance sheets with stable cashflows. Beyond this, a thorough analysis of the covenants is a cornerstone of our approach. Protections in the form of security or income step ups for downgrades help to reduce the risk of rating transitions into lower buckets.

Looking beyond ratings and benchmarks A persistent myth exists that a bond’s rating is an assurance of its quality, yet the majority of rated benchmark bonds offer little covenant protection. By insisting on secured cashflows with strong covenant packages, we find bonds with protections that punch above their nominal ratings and are consequently able to generate higher yield compensation for the same risk as higher rated bonds.

Effective diversification

136

Fund manager

21 Investment grade

20 DHC

Source: Moody’s, RLAM based on historical default data 1920 – 2017 and credit spreads as at 27 February 2019. Assumes 40% recovery on unsecured debt. Higher recoveries assumed on Duration Hedged Credit Fund, reflecting higher level of secured debt within the fund than typical credit indices.

The upside is very limited in fixed income relative to equities, whereas the downside is potentially the same. While equity investors can afford to be conviction-driven and more concentrated, it is essential that fixed income investors diversify widely to contain their risks. Diversification within BBB rated debt and targeted allocations towards areas with low rating transition risk can lead to better risk-adjusted returns.

RLAM Investment Conference 2019: a recap of our views We have pulled together a range of videos and webinars to bring you the thinking from our investment conference. Richard Marwood and Niko de Walden

Dividend discipline and disciplined contrarian investing

Mike Fox and Richard Nelson

Best of Both Worlds

Rachid Semaoune and Paola Binns

The attractions of income from corporate bonds

Will Kenney

How to invest in a world that isnâ&#x20AC;&#x2122;t short of anything

Khuram Sharih and Shalin Shah

Dealing with absolutes

Trevor Greetham

Weathering Volatile Markets with Multi Asset Strategies

INVESTMENT CONFERENCE 2019

All information is correct at April 2019 unless otherwise stated. Issued by Royal London Asset Management Limited, Firm Registration Number: 141665, registered in England and Wales number 2244297; Royal London Unit Trust Managers Limited, Firm Registration Number: 144037, registered in England and Wales number 2372439; RLUM Limited, Firm Registration Number: 144032, registered in England and Wales number 2369965. All of these companies are authorised and regulated by the Financial Conduct Authority. Royal London Asset Management Bond Funds Plc, an umbrella company with segregated liability between subfunds, authorised and regulated by the Central Bank of Ireland, registered in Ireland number 364259. Registered office: 70 Sir John Rogersonâ&#x20AC;&#x2122;s Quay, Dublin 2, Ireland. All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number 99064. Registered Office: 55 Gracechurch Street, London EC3V 0RL. The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The Royal London Mutual Insurance Society Limited is on the Financial Services Register, registration number 117672. Registered in England and Wales number 99064. Ref: N RLAM W 0009

Contact us For more information about the funds or RLAMâ&#x20AC;&#x2122;s range of products and services, please contact us. Royal London Asset Management 55 Gracechurch Street London EC3V 0RL 020 7506 6500 communications@rlam.co.uk www.rlam.co.uk

55483 04 2019