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LEADING EDGE
Martin Cholwill on the merits of an agnostic approach to UK equity income investing.
Crude awakening Mike Fox considers the future of fossil fuels.
Debunked Martin Foden exposes eight of the biggest myths about the credit market.
Three hidden gems in Europe Neil Wilkinson and Andrea Williams explore some compelling European opportunities.
Avoiding the smart beta credit trap Shalin Shah considers the default risk posed by the quasi-passive strategies.
For professional investors only, not suitable for retail clients
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Beware the mega-cap trap
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RLAM’S REGULAR REVIEW OF INVESTMENT MARKETS • APRIL 2015
2 | TITLE OF MAG | APRIL 2015
Rob Williams
Head of Distribution
Welcome Welcome to the first edition of Leading Edge, our regular review of investment markets. Our aims with this e-zine are straightforward. First, we want to share our views on a range of issues currently facing investors. From the likely impact of rate rises to the opportunities and threats in the high yield bond market, our fund managers and investment specialists consider the forces presently at work within their respective asset classes and outline their expectations for the months ahead.
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: communications@rlam.co.uk Tel: 020 7506 6678 Fax: 020 7506 6796 Web: www.rlam.co.uk For professional investors and advisors only. This document may not be distributed to any unauthorised persons and is not suitable for retail clients. This document is for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Nor does it provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Past performance is not a guide to future performance. 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. Where this document references the trade marks ‘FTSE®’, ‘FT-SE’ and ‘Footsie’, these are owned by the London Stock Exchange Group companies and are used by FTSE under licence. The FTSE All Share index is calculated by FTSE. FTSE does not sponsor, endorse or promote the product referred to in this document and is not in any way connected to it and does not accept any liability in relation to its issue, operation and trading. All copyright and database rights in the index values and constituent list vest in FTSE. The views expressed are the authors’ own and do not constitute investment advice.
Second, we want to offer a perspective on the evolving needs of our clients. Whether a result of rapidly evolving pensions legislation, the need to hedge risk, or simply the fact that people are living longer, new challenges are constantly emerging and this e-zine seeks to address these problems and suggest potential solutions. Those of you who attended our inaugural investment conference in March will be familiar with some of these themes and indeed most of the articles contained within these pages have been written by the speakers at that event. We believe these are among the most pressing issues today and, as such, we hope you find these articles informative and helpful. Finally, with this e-zine we hope to offer some insight into the RLAM culture and approach. We do not set out to be all things to all people – we only manage money in those areas in which we believe we can excel. Nor do we have a single house style across our various teams. Instead, we have a commitment to think differently and a willingness to invest where others don’t or won’t. Through the articles in the following pages, we hope this approach and investment philosophy comes through. We’d love to hear your thoughts on the e-zine, so if you have any comments or feedback, please share them by emailing: leadingedge@rlam.co.uk I hope that you enjoy this issue. Rob Williams Head of Distribution
APRIL 2015 | LEADING EDGE | 3
Contents 4 Will a lack of supply support property prices in 2015?
Gareth Dickinson, Head of Property looks at the effect of limited supply on the UK commercial property market.
5 Why a strong US dollar could boost UK mid-caps this year The strong US dollar could benefit UK mid-caps, argues Derek Mitchell. He explores how with some stock examples.
10 Avoiding the smart beta credit trap
06
08
12
Crude awakening: why the winners over the next two decades will look very different
Debunked: Eight of the biggest myths about the credit market
Beware the megacap trap n agnostic approach to A UK equity income investing could be key to identifying sustainable dividends, says Martin Cholwill.
ike Fox, Head of M Sustainable Funds considers the future of fossil fuels and what this means for investors.
Martin Foden sets about exploding some of the myths that persist around the corporate bond market in particular.
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Three hidden gems in Europe
Armageddon or opportunity?
While the macro situation in Europe has dominated headlines, opportunities remain at a company level. Neil Wilkinson and Andrea Williams discuss some compelling examples.
zhar Hussain considers A whether fears for the high yield credit market could be unfounded.
UK rate rises will not wipe out bond fund performance
Quasi-passive smart beta strategies are growing in popularity. However, they may not be suited to current market conditions. Shalin Shah reflects on a Buy & Maintain approach as an alternative.
11 Do we face a bond bear market for the next decade? Paul Rayner offers his views on the possibility of a seismic shift in outlook for government bond markets globally.
20 Investment Conference Some thoughts and quotes from the investment conference.
ric Holt considers the future E of bond funds in the face of a rate rise.
4 | LEADING EDGE | APRIL 2015
Will a lack of supply support property returns in 2015?
Gareth Dickinson Head of Property
Stephen Elliott Senior Property Fund Manager
UK property was one of the best performing asset classes in 2014, with late double-digit returns outstripping domestic equity and bond markets. This year presents new challenges for investors according to Gareth Dickinson, Head of Property and Stephen Elliott, Senior Property Fund Manager at RLAM. But yields on property remain very attractive compared to assets such as gilts, while a lack of available supply means they believe prices will continue to increase , even after impressive capital growth last year.
was the most “ Property popular sector for investors in February ”
“Property enjoyed a fairly monumental year in 2014 as the twin drivers of attractive yields and high demand combined to enable it to outperform the majority of other asset classes. After such a strong performance it is entirely right that investors consider what the sector can deliver this year, even with other asset classes such as equities and bonds priced for perfection. The IPD UK Monthly index is now sitting above the previous peak seen in 2007, having returned 19.3% in 2014 *. But should investors be scared-off by this fact? We think not, because the drivers of 2014’s returns remain in place this year. The downturn in construction activity in the aftermath of the credit crisis was so severe that it continues to impact the property market now, and should support prices once again this year. One of the principle results of this is that as occupational markets start to recover, rents, in certain sub-markets, are starting to move forward. This rental value growth and a tightening of available
properties for occupiers to move into will serve to underpin the positive yield movement. The early signs have been encouraging. According to the Investment Association, property was the most popular sector for investors in February, with inflows of £340m**. Appetite for exposure to the UK property investment market remains strong and diverse with domestic, overseas, institutional, sovereign funds and private individuals all wanting to increase their weightings to this sector. Yields remain attractive, with an Income Return of 0.5% delivered from the IPD index in both January and February, implying a full year yield of 6% could be maintained again this year***. This kind of attractive income return has already allowed property to outstrip both equities and bonds over the last five years in terms of income, and which should continue this year as rental value growth starts to support yield compression. ”
*Source: FE, total return, bid to bid as at 31.03.2015. **Source: Investment Association, net total sales as at 28.02.2015. 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. The views expressed are the authors own and do not constitute investment advice.
APRIL 2015 | LEADING EDGE | 5
Why a strong US dollar could boost UK mid-caps this year
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ome of the UK’s mid-cap stocks are set to enjoy a significant lift this year as the US dollar’s dramatic rise starts to feed through to businesses with overseas earnings, Derek Mitchell has said. The manager of the £321m Royal London UK Mid Cap Growth Fund* said currency moves which tend to be priced in to large-cap valuations rapidly are often overlooked in the mid-cap space. Given the dollar has risen sharply since last summer - the US Dollar Index, which tracks the greenback against a basket of other currencies, has gained 23% since its 52-week low** – Mitchell said many mid-cap stocks whose earnings are derived predominantly from overseas stand to benefit. “The strong dollar is key for mid-caps this year,” Mitchell said. “What you typically find is that, with the largest companies in the FTSE 100, a change in FX markets is quickly reflected in earnings forecasts.” “But that is not the case with mid-caps, where analysts are much slower to factor currency moves in. As such, the dollar’s recent show of strength has not fed through to forecasts, and when it does it could provide many companies with a real boost.”
Derek Mitchell Senior Fund Manager
The stronger dollar is already impacting US corporate profits negatively and is being cited as a potential threat to US valuations this year, but for those companies listed in the UK which operate in the US and elsewhere, it can be a tailwind which drives up revenues and profits.
“As people become marginally better off, it makes eating out or going to the cinema more affordable, and companies like The Restaurant Group – which owns chains including Chiquito’s and Frankie & Benny’s – benefit directly from this.”
Stocks in the Fund which are aimed at gaining from this ongoing trend include specialist healthcare company BTG, which generates a large portion of its earnings in the US where it sells innovative medical products.
While mid-caps outperformed larger peers in 2014, Mitchell still sees upside from a valuation perspective this year. Historically, mid-caps have traded on a significant premium to the FTSE 80 (which excludes the mega caps), but this valuation premium has fallen to just 6% currently****. Mitchell said this suggested there is still scope for midcap valuations to rise from here.
Allied Minds is another hidden gem which has performed well for the Fund so far. The company focuses on the US technology sector, investing in start-ups with a view to turning academic inventions in to commercial products. Both stocks feature in the Fund’s top 10 holdings. Elsewhere in the portfolio, Mitchell is tapping in to the theme of increased consumer discretionary spending through The Restaurant Group, as well as kitchen supplier Howden Joinery. “If you look at the Asda Income Tracker, consumers in the UK have not had this much disposable income since 2009***, with the sharp decline in oil prices in particular helping to put more money back into peoples’ pockets.”
The manager added that the mid-cap market also offers investors the chance to diversify their exposure to certain sectors. For example, oil and gas companies account for 14% of the FTSE 100, while they represent just 4% of the FTSE 250*****. “The largest company in the FTSE 250 accounts for just 1% of the index, versus the FTSE 100 where Royal Dutch Shell is worth 7.5%,*****” he said. “This lower concentration risk needs to be thought about carefully by investors and its outcome if markets were to turn.”
RL UK Mid-Cap Fund 5 year performance 150
Royal London UK Mid-Cap Growth Fund
Percentage change
120 90
IA UK All Companies Sector
60 30 0 -30 ' Mar 2010
' Mar 2011
' Mar 2012
' Mar 2013
' Mar 2014
' Mar 2015
Source: FE, total return, bid to bid net income reinvested as at 31.03.2015. Based on A Share Class. Past performance is not a guide to future returns.
* Source: RLAM as at 31.03.2015. ** Source: Wall Street Journal, April 2015. *** Source: Asda Income Tracker, February 2015. **** Liberium datastream, January 2015. ***** Source: FTSE as at 31.03.2015. 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. The views expressed are the author’s own and do not constitute investment advice.
6 | LEADING EDGE | APRIL 2015
Crude awakening Why the winners over the next two decades will look very different
Mike Fox, Head of Sustainable Funds at RLAM, looks at how the changing global backdrop will power a number of different companies as economies around the globe evolve.
APRIL 2015 | LEADING EDGE | 7
“The world is in a constant state of change, with new innovations replacing old products in fields from medicine to computers as companies strive to constantly re-engineer how society or individuals function. From Apple and its revolutionary gadgets, to drug companies making breakthroughs to treat previously incurable diseases, innovation is all around us. While this is undoubtedly a good thing, for investors it can be a roller-coaster ride, and nowhere has this been displayed more dramatically in the last year than energy markets. Firstly, investors were hit by the tumbling crude oil price which halved in the space of six months as the US shale revolution pushed the country’s reserves up sharply. The price has remained depressed since and is increasingly plagued by volatility, with vicious intra-day swings becoming the norm.
Energy companies are, by their very nature, cyclical businesses which move in line with global growth, as well as with demand from major importers – chiefly China. As economies like China mature, the rampant need for commodities dissipates, and this is something we have witnessed in recent years across the commodities space. We are not making a call on whether this point in time represents a structural or cyclical correction for energy markets, because we do not need to. Rather, what it highlights is how even something as ingrained in society as oil can become less vital over time. Technology has made it possible to increase supply dramatically, so after years with the price above $100 a barrel, there is a major shift in forecasts and outlooks. Amid such a sea change, our job remains to find companies that can offer investors the chance to participate in the next two decades of growth, rather than the last two.
The price drops have led to an expected wave of consolidation which manifested itself recently in the shape of a proposed blockbuster takeover by Royal Dutch Shell, the UK’s largest energy company, which has offered a staggering £47bn deal for BG Group.
The next generation of winners
The crucial details of the deal reveal that Shell believes it is buying the company at a low point in the energy cycle, paying an implied price of $90 a barrel for its oil assets, more than a 50% premium to the current price of Brent crude*.
For us, at the moment, that means we have virtually no exposure to commodities companies, with the focus on healthcare, technology and communications companies instead.
Structural or cyclical?
What investors have to ask when something like an oil price collapse happens, is whether the change is structural or cyclical?
New drugs or communication breakthroughs are where we believe we will find the next decade’s winners, with a focus on companies with strong risk management. Healthcare at the moment is key for us, for example, because diseases like cancer and hepatitis C are now being treated more effectively than ever as a result of new advancements. It comes down to finding those areas with better growth prospects, and better investment returns, and which have a more tangible, positive impact on society. Legacy industries like oil may well thrive again at some point, but currently they have a more ambiguous future, and investors need to tread carefully, especially when there are so many other opportunities out there.”
Our investment process is about finding opportunities wherever they emerge, finding companies which screen as attractive in terms of their environmental, social and governance footprints.
This stance has clearly helped our suite of funds outperform mainstream peers in the last decade, with our flagship RL Sustainable Leaders Fund first quartile over one, three and five years*.
*Source: Bloomberg as at 31.03.2015. 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. The views expressed are the authors own and do not constitute investment advice.
job remains to find companies “ Othatur can offer investors the
chance to participate in the next two decades of growth
”
Mike Fox Head of Sustainable Funds
8 | LEADING EDGE | APRIL 2015
Debunked: Eight of the biggest myths about the credit market
T Martin Foden Head of Credit Research
he credit market is a fertile ground for the development of myths. As a relatively new asset class when compared to equities, yet often being more nuanced and complex, it has become a confusing place for investors. More positively, these misconceptions can cause material mis-allocations and mis-pricings that can be exploited for clients by experienced managers. The sector has undoubtedly enjoyed some impressive returns in recent years as yields moved lower amid a constant demand for income. But RLAM’s Head of Credit Research, Martin Foden, argues there are still some very attractive opportunities in the space. Below, Martin debunks eight of the biggest myths around credit to explain why investors should not overlook the value in this asset class.
1 Credit ratings are the best way to assess value
Ratings are said to be becoming increasingly important to investors in the financial sector once more as the level of regulation facing banks and insurers increases. But although they drive capital allocations in the financial sector, they do not show investors the whole picture, Foden argues. “Credit ratings give you a probability of default, but to assess risk or value using that metric alone means you miss out on a lot,” he said. “Other factors such as liquidity, rating migration, and volatility, and, most significantly, the money you would get back should a bond default, should take precedence over the credit rating when investing.”
2 Credit benchmarks are a good starting point to build a portfolio
Investors are very attached to benchmarks as the best way to compare the performance of credit portfolios. In equity markets, the highest weighting reflects investor confidence in the future growth and profitability of a company, but in credit markets, the highest weighting is the most indebted company in the market. Foden said as a result, investors needed to cast the net wider than benchmark investing in when it comes to fixed income. “We do not think a good starting point to build long-term portfolios is to use a credit benchmark,” he said. “Being straightjacketed by benchmarks doesn’t dampen credit risk but it does stifle opportunities and constrains you to investing in the debt of companies you might not want to hold at all.”
3 Bonds are safer than equities
Another long-standing myth about credit is that bonds are safer than equities. Whilst this may be true on a broad level, Foden pointed out that credit has an asymmetric return profile, with investors not only losing out if a company deteriorates but, if it improves, your return is capped because you lent to it at a fixed coupon. “unlike in equity markets, the things you get wrong aren’t offset by the things you get right,” Foden said. “When you buy a corporate bond its specific risk will be significantly higher than that of an equity, and the only way to mitigate that risk is to run a diversified portfolio.”
4 Senior is senior
Senior unsecured bonds are supposed to offer the holders an element of protection in the event of a
APRIL 2015 | LEADING EDGE | 9
is very much a supplementary “ Trading driver of returns ”
borrower defaulting, but sometimes they can offer less security than expected. If you lend to a company which then starts to struggle and you do not have the right type of covenants in place, because of the unsecured nature of your bond a bank lender can move above you in the capital structure to ensure it gets paid first.
the composition of the UK corporate bond market, you notice less than 40% is domiciled in the UK, while 60% is made up of issuers outside the UK**. “Buying in the UK actually gives you worldwide exposure, so you don’t need a global credit fund to get truly global diversification,” Foden said.
“While senior might suggest more protection, and despite having to pay up for the seniority, at the exact moment you need it, it can be taken away from you,” Foden said. “We prefer to buy senior secured bonds, which give the lender a prior claim over a company’s assets, shielding them in case of default.”
“Just like equity markets, most of the returns come from internationally diversified companies.”
5 Bond investors can be traders not lenders
In principle, it should be easy to be a trader in the credit markets - over the last 20 years, the amount of outstanding corporates has grown nine-fold, which should be an ideal environment of easy liquidity*. But the reality is credit markets are at the mercy of the investment banks to provide that liquidity, and since the financial crisis they have been less willing to take risk. As a result, there has been a squeeze on liquidity which has made it far more risky for short-term investors. “Trading is very much a supplementary driver of returns,” said Foden, adding there is “no substitute” for hard fundamentals.
6 C redit funds need to be global to be globally diversified
Sterling corporate bonds look straightforward, as if you are simply buying UK plc. But if you dig deeper into
7 Event risk is bad for bonds
What keeps credit analysts awake at night? Event risk is top of the list, according to Foden, as it is hard to predict and can be very damaging to bondholders. Clearly random events, such as the oil price fall, will always be a threat, but far from being a one-way story, investors can turn it to their advantage. “We try and build in pre-emptive control over the company to which we are lending. Then we can turn that negative event risk into something positive,” he said.
8 Big is best
The theory among some investment houses is that the more analysts you have, the better the coverage of the market should be. However, he argues that while this path to broad coverage may seem ideal, there is a risk a team becomes diluted and fragmented and misses out on the right level of interaction. Foden said: “Big is not necessarily better. You can get more effective credit market coverage by using a more focused approach, with fewer voices clamouring to take a fund in a certain direction.”
*Source: Bloomberg as at March 2015. **RLAM as at 31.01.2015. 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. Unlike the income from a single fixed income security, the level of income (yield) from a fund is not fixed and may go up and down. The views expressed are the managers’ own and do not constitute investment advice.
10 | LEADING EDGE | APRIL 2015
Shalin Shah Fund Manager
Avoiding the smart beta credit trap
I
nvesting in credit markets using a smart beta strategy could prove to be a big mistake at this stage in the cycle, exposing bondholders to much higher default risk, according to Shalin Shah, manager of RLAM’s ‘Buy & Maintain’ credit strategy. He is clear that this strategy should not be confused with passive or quasi-passive investment approaches (including smart beta funds) which can leave investors over-exposed to cyclical, riskier areas of the credit market. As we’ve touched on, credit benchmarks differ from equity indices in the sense that it is the most indebted companies, rather than the most highly valued, which make up a larger proportion of the benchmark. Some smart beta strategies try to circumvent this issue by setting their own arbitrary rules to select new stock and sector weightings within a benchmark to give them, for example, 25% in each sector and 0.5% in each bond. “In our view, that is the worst possible scenario,” said Shah. “There is a reason why defensive bonds are a larger part of the credit
benchmark - they are better quality companies with more robust cashflows, and that is why investors are more prepared to lend to them. “If you split a benchmark into four parts, for instance, you would end up with a higher proportion in cyclicals such as oil and gas, and industrials. The result of this would be exposing yourself to higher risk in terms of the impact of default, while limiting your upside.” Shah said it is important to differentiate between passive investing and a buy and hold investment approach which, with a long-term time horizon, keeps transaction costs lower and returns higher. He noted that buy and hold strategies tend to have turnover rates between a quarter and a third lower than a pure active portfolio. “We are lenders not traders,” Shah said, adding that flows into this type of strategy have been increasing as spreads as a proportion of risk free yield levels remain attractive when compared to longer-term history. Shah favours an approach which is not
‘straitjacketed’ by benchmarks and allows him to focus on the areas of the market in which he sees value. At present this is in secured bonds. A typical RLAM Buy & Maintain strategy would have around 55% in secured and senior secured bonds, compared to around 15% in the wider sterling investment grade index*. The strategies also typically have a high level of diversification through a portfolio of around 150 securities, favouring blue chip names, for example BT and BBC, but with additional protection by way of security over assets and including exposure to a range of sectors and maturities. RLAM manages assets of more than £2.5bn in its Buy & Maintain credit strategy*. *Source: RLAM as at 31.03.2015. 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. Unlike the income from a single fixed income security, the level of income (yield) from a fund is not fixed and may go up and down. The views expressed are the managers’ own and do not constitute investment advice.
APRIL 2015 | LEADING EDGE | 11
Do we face a bond bear market for the next decade?
B
onds could face a decade-long bear market caused by an upcoming switch in central bank policy, with the current period of plunging yields now drawing to a close, believes Paul Rayner, Head of Government Bonds at RLAM. Rayner, who is also co-manager of the Royal London Absolute Return Government Bond Fund, said the multi-decade fixed income bull market which has driven yields on core government bonds down from 6-7% is set to be replaced with a new era of tightening, causing a rebound in yields. The manager expects this next decade to be dominated by an increase in volatility across the fixed income universe as central bank intervention is unwound. “The first 30 years of my career have been spent in a bond bull market, but for the remainder of my career I expect that to switch to a bear market,” he said. “As central banks, led by the US Federal Reserve (Fed), start to tighten monetary
policy it is likely we will see volatility climb much higher, but this is not just a short-term event. We have had unprecedented stimulus around the world and that has driven yields down because you have had fixed buyers in the market. But as that ceases we expect bond markets to normalise and yields to move out.” An ongoing search for yield has made more risky parts of the fixed income market popular with investors, with many expanding into corporate, high yield and emerging market debt. The high demand for yield has also helped dampen liquidity over the last three years, with plenty of capital available from buyers offsetting any selling pressure. However, if the US central bank does start raising rates this year as expected, Rayner said volatility in fixed income markets will increase. “The Fed has not raised rates since 2006, but that looks set to change this year if the US economy continues to perform well,” he said.
Paul Rayner Head of Government Bonds
“That shift in direction, coupled with a lack of liquidity in bond markets caused by banks reducing the amount of risk they are able to hold, is a very dangerous combination, and therefore we think volatility will be much higher than investors expect.” Whether volatility climbs back to levels seen at the peak of the financial crisis remains to be seen, but Rayner said it was a key risk now facing investors who are sitting on double-digit returns after last year’s stellar performance. “We are in a bond bubble, with many securities priced for perfection, but it will not last as rates start to normalise,” he said. “The stakes are so much higher now when you consider the starting point for yields in 2015, the increasing likelihood of Fed action, and the lack of liquidity in markets. Therefore an allocation to a solution which can protect investors and make incremental returns from a broad spread of trades makes more and more sense.”
We expect “ bond markets to normalise and yields to move out
”
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. Unlike the income from a single fixed income security, the level of income (yield) from a fund is not fixed and may go up and down. The views expressed are the managers’ own and do not constitute investment advice.
12 | LEADING EDGE | APRIL 2015
Beware the mega-cap trap Why the largest companies are not always the safest when it comes to dividends
Investors have traditionally relied on the largest companies in the UK to provide them with an ongoing income stream, yet there are many more opportunities spread across the wider FTSE All-Share index. Here, Martin Cholwill, manager of the £1.8bn Royal London UK Equity Income Fund*, explains why focusing solely on the biggest names could put your income at risk over the long term.
“For many investors the biggest companies in the UK represent the pinnacle of innovation and success. With brand recognition that is typically second to none, the 20 largest companies in the UK – including household names like Shell, BP and Tesco – enjoy a profile that puts them at the forefront of investors’ minds. But when it comes to prospects for future income, this fixation with the largest companies makes little sense. Indeed, by sticking slavishly to recognisable mega-cap names – most of which have been growing payouts at a far slower rate than smaller businesses – investors could be overlooking some of the best dividend opportunities in the UK. Large cap vs the rest
A number of special dividends from the biggest companies – in particular Vodafone – helped FTSE 100 firms deliver a 22.8% increase in dividends in 2014, versus just 8% for FTSE 250 companies**. Yet that headline number is deceptive. Underlying growth, which excludes the impact of these one-off bumper payouts, was just 0.7% for FTSE 100 companies, compared to underlying growth that was 10 times greater from FTSE 250 firms.
Martin Cholwill Senior Fund Manager
This is far from unique. If you look at annual growth per quarter for dividends since 2013, FTSE 250 names come out well ahead of their larger peers.
Therefore, by typically clustering around the same handful of larger companies, investors are not only limiting returns, but also exposing themselves to potential shocks. In the last year alone, energy utilities – which I do not currently own – have been plagued by political interference, which can be arbitrary and unpredictable. That is why we take a multi-cap approach rather than focus on the ‘stalwarts’ of the income sector which tend to make up a large part of our peers’ portfolios. For example, we own neither National Grid nor Centrica, both of which are owned by more than 50% of funds in the IA UK Equity Income sector.***” Dividend growth the key
Focusing on headline yields is, in our view, too common a mistake. The top 20 dividend payers in the UK account for around 60% of the income all UK companies produce, so it is understandable that investors are drawn to them**. But you have to ask where those dividends are going. Look back to the 1920s and you will see dividend growth has been one of the key drivers of overall returns, alongside the dividend itself. Since the credit crunch some of the biggest companies have struggled to grow and have resorted to cutting costs to boost their bottom lines. Rather than focus on these names, we prefer to spread risk and typically invest over 40% outside of the FTSE 100, giving us a diversity of income that is ultimately more durable.
APRIL 2015 | LEADING EDGE | 13
RL UK Equity Income Fund 5 year performance 100 Royal London UK Equity Income Fund
Percentage change
80 60
IA UK Equity Income Sector
40 20 0 -20 ' Mar 2010
' Mar 2011
' Mar 2012
' Mar 2013
' Mar 2014
' Mar 2015
Source: FE, Total Return, bid to bid, net income reinvested as at 31.03.2015. Based on A Share Class. Past performance is not a guide to future performance.
Safety in numbers
Most companies endure tough spells. Diversifying our portfolio means we can shelter investors more effectively when the inevitable occurs. In the last year alone Tesco, besieged by both discount retailers and high-end chains, was forced to scrap its final dividend. From a sector perspective, mining companies – which make up a sizeable chunk of the large-cap index – cut payouts by 8%. Banks continue to face regulatory headwinds, and while they are returning to the dividend register they remain under balance sheet pressure. Possibly the most famous example of the dangers of dividend risk was the Deepwater Horizon disaster in 2010. The catastrophe
resulted in BP’s share price halving and its dividends being scrapped for the remainder of that year as it cut costs to pay astronomical damages. While it has recovered to some extent, the oil majors now collectively face a major headwind in the form of an oil price that has almost halved since last June. Not too many experts were predicting that last year. By running ever-larger positions in fewer names, investors leave themselves at the mercy of these unlikely or unforeseeable events. Nothing is sacrosanct in investment, and even though investors may feel they ‘know’ a company well, the reality is often very different. Rather than be a hostage to fortune, I prefer to diversify across mid and small-cap companies which can supplement income from the large caps.”
e take a multi-cap approach “ W rather than focus on the ‘stalwarts’ of the income sector ” *Source: RLAM as at 31.03.2015. **Source: Capita UK Dividend Monitor, January 2015. ***Source: Lipper as at 31.01.2015. 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. The views expressed are the author’s own and do not constitute investment advice.
14 | LEADING EDGE | APRIL 2015
Three hidden gems in Europe E
urope’s economic woes and challenging political backdrop have been occupying the minds of investors for a number of years. While the outlook remains clouded, the region’s equity markets have confounded doubters by soaring so far this year, with a 9% gain for the FTSE Eurofirst index amid the European Central Bank’s (ECB’s) move to introduce quantitative easing*. European equity Fund Managers Andrea Williams and Neil Wilkinson believe there are still some compelling opportunities on key stocks in Europe which are yet to feel the full effect of either quantitative easing (QE) or a shift out of fixed income markets where yields have turned negative. Below, the managers, who jointly run the £654m Royal London European Growth Fund and £292m Royal London European Opportunities Fund**, highlight three hidden gems which they believe can deliver further gains in 2015.
1
inding value in the pharmaceutical F sector: Bayer
“We first purchased Bayer, the German chemical giant that makes aspirin among other products, in 2010 as it showed good earnings growth and looked cheap against both the market and the sector.
was very meaningful as the business had an overall healthcare sales base of €10bn***. “The business screened well on valuations, cashflow and earnings, yet it traded on a discount to the sector. It really accelerated in 2014 when it announced the IPO of its plastics business and today it remains a transformational story which continues to offer good value.”
2
eing greedy when others are B fearful: KBC
“Like others we have been concerned about the capital and litigation risks facing European banks and their exposure to struggling economies like Spain. But we noticed there was value accruing relative to both the sector’s history and the market, and we saw with interest that our peers were very underweight. This led us to ask whether there was value in banks. “On a price to book versus return on equity basis we decided to consider three banks: Deutsche Bank, Danske Bank and KBC. Deutsche Bank was rejected on the grounds that it was short of capital and, more broadly, because we didn’t like the volatility of investment banks. Nor did we invest in Danske Bank, due to our concerns about its exposure to Ireland and the overall health of the Danish economy.
“Bayer underperformed in 2011 due to its exposure to chemicals and market concerns about GDP growth. But, having met the management a number of times, we were aware the company was looking to deemphasise the chemicals business so we added to our position.
“That left KBC, a Belgian bank operating in the Benelux region where five banks account for more than 80% of the market, giving them a degree of price control. Economic conditions have been improving in Belgium and Holland and KBC has focused on growing its capital in contrast to some of the Spanish banks, for example.
“Through 2011 and 2012 Bayer had five drugs that were in phase three, the final stage before the drug comes to market. Those drugs had estimated peak sales of €5.5bn, which
“The bank’s share price has doubled since we bought it, while during the last few years it has also paid back the money it borrowed from the authorities during the financial
crisis. It also now pays cash dividends, with a sustainable expected return (over a 50% pay-out) from 2016. In a world where many peers remain indebted to governments and hamstrung by politics, KBC stands out as a clear winner to us, which also has the potential to expand its operations faster than rivals.”
3
inding overlooked value: F Ferrovial
“In the second quarter of 2012, prior to Mario Draghi’s ‘whatever it takes’ speech, the Spanish stock exchange fell around 25%. There was a huge correlation across stocks and everything was treated harshly by investors regardless of a company’s individual merits. “Ferrovial screened extremely well in the industrial sector both on a cashflow basis and in terms of valuation. As an infrastructure business, it has two main assets: a stake in Heathrow Airport, and a ring road in Toronto. Those assets have a number of things in common. First, they have very predictable cashflows. Second, they have inflation linked management contracts. Finally, and most important, both are non-euro assets, so the Heathrow cashflow comes back in sterling and the ring road cashflow comes back in Canadian dollars. “When we invested in June 2012, we estimated that over 90% of the group’s assets by value were non-Spanish domiciled and yet it was being treated as severely as other more domestically-exposed Spanish names. “We continue to hold the position even after a spectacular run over the last three years, as we still get a 4% yield. Moreover, we remain confident that, given the assets it holds and its preference for reinvesting excess cash into new businesses – it has a new toll road in Texas, for example – we believe Ferrovial will grow the dividend in future.”
APRIL 2015 | LEADING EDGE | 15
Neil Wilkinson Senior Fund Manager
Andrea Williams Senior Fund Manager
today remains “ Bayer a transformational story, of a stock that offers value in an unloved sector
�
*Source: FE as at 31.03.2015. **Source: RLAM as at 31.03.2015. ***Source: Thomson Reuters Datastream as at 20 March 2015. 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. The views expressed are the authors own and do not constitute investment advice.
16 | LEADING EDGE | APRIL 2015
Armageddon or opportunity? Why the four biggest fears for high yield are unfounded
Investors often grow wary of an asset class after a strong run, and the high yield credit market is no exception. Fears volatility in the bond market may climb, coupled with an environment of rising rates, are combining to increase nervousness around the outlook for the asset class. However, how much of this is realistic as we remain in a cycle of low rates and low growth? Azhar Hussain, Head of Global High Yield and manager of the £240m Royal London Global High Yield Bond Fund*, explains why many fears are unfounded, and why he believes the asset class can continue to deliver this year.
“The high yield credit market is booming in an environment of conservative bank lending. Some of the most well-known household brands use it to raise capital, with Tesco and Heinz both constituents of the sector. The latest wave of issuance has helped the market grow substantially to $2trn in size, with over 3,000 issuers**. So far this year issuance has continued to come thick and fast, despite a rise in defaults late in 2014 in the energy space following the plunge in the oil price to a multi-year low. Last year’s sell-off did send yields back out above 6%, where they currently remain, presenting investors with an enticing reason to revisit the asset class, but some remain dubious fearing another spike in defaults or an interest rate hike are just around the corner. So what are the biggest fears for the sector, and have they been overblown?” Is volatility about to pick up? To answer this first concern, we would refer to historic data from Bloomberg and Merrill Lynch comparing the performance of global high yield with global equities. Between 1998 and 2015, global high yield outperformed global shares to deliver 6.4% annually (versus 5.9% from equities), with less than half the
volatility***. So while there may be bouts of increased volatility, price swings have been lower than those seen in equity markets.” Are defaults about to spike? To tackle this, investors need to look at lending standards. One obvious measure of weakening standards is the type of issuance coming to market. In times of easy lending such as the ‘90s, zero coupon and payment-in-kind bonds, when the coupon is deferred, were on the rise. These days we are not seeing high levels of this kind of lending, which can be a precursor to default. So, on this measure at least, lending discipline looks better, helping to alleviate some of the fears around default rates. Another way to assess the health of the market is to look at CCC-rated bonds as a proportion of the total high yield market. Before the sell-offs of 2002 and 2008, we saw a sharp spike in the amount of CCC debt being issued, but this trend has declined in the last couple of years.” Does high yield look overvalued after such strong returns last year? There is always a risk of a sector moving in to bubble territory, but we believe high yield is nowhere near that stage. In fact, we believe it is cheap, because spreads are still overcompensating you for the credit risk you are taking. If you look at credit risk throughout
APRIL 2015 | LEADING EDGE | 17
here is a risk of a sector moving into “ Tbubble territory, but we believe high yield is nowhere near that stage ” most of history, the typical excess spread above government bonds was 270 basis points - almost 3%. But what about today? The spread between US high yield and government bonds at the end of February was 446 basis points which, even when you factor in predicted default rates, gives you 291 basis points of excess spread**.” What happens when interest rates rise? The ‘Taper Tantrum’ of 2013 when interest rate rises were first put back on the table as an option had quite a muted impact on high yield, which
still returned 5.7% that year despite a dramatic 100 basis points move in five year treasury yields**. Certainly interest rates look more of a risk than in previous years, but we estimate global high yield could still deliver 3.4% p.a. if we saw a 50 basis point rise in interest rates. Another factor working in its favour is that the high yield asset class is insulated from any swings in treasury prices by its considerable spread cushion, which is large enough to help it withstand bouts of volatility from rising rates.”
*Source: RLAM as at 31.03.2015. **Source: Source: Bank of America Merrill Lynch Global Research as at 28th February 2015 ***Source: Bloomberg. Global High Yield represented by Bank of America Merrill Lynch Global BB-B Global Non-Financial High Yield Constrained Index (2%) and global equities by the MSCI World Index including emerging markets. (1998 to Feb 2015). 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. Unlike the income from a single fixed income security, the level of income (yield) from a fund is not fixed and may go up and down. Sub-investment grade bonds have characteristics which may result in a higher probability of default than investment grade bonds and therefore a higher risk. The views expressed are the managers’ own and do not constitute investment advice.
Azhar Hussain Head of Global High Yield
18 | LEADING EDGE | APRIL 2015
UK rate rises will not wipe out bond fund performance
Eric Holt, the manager of the £1bn Royal London Sterling Extra Yield Bond Fund*, says any move by the Bank of England to raise rates this year or next will not wipe out bond fund performance as some ‘experts’ are predicting.
“The last six years have been something of an extraordinary environment for bond fund managers. From the unforgettable experience of the credit crisis and its immediate aftermath when liquidity vanished, to the introduction of untested QE programmes, fixed income has been anything but slow and steady. Alongside QE, record low interest rates since 2009 across the developed world have helped economies to heal and rescued many borrowers who were over-indebted. They have also helped fixed income funds achieve some truly stunning - and above normal - returns, with annual double-digit gains becoming commonplace. Is all this under threat now from our very own Bank of England? Some certainly believe so, predicting an imminent change in the interest
rate cycle over the next year which will wipe out fixed income fund performance and leave them nursing losses. The maths is unquestionable. If rates were to rise by 0.5%, for example, a fund with duration of five years would lose 2.5%. But to look at it in this way is far too simplistic. Firstly, there is no guarantee rates will go up this year. Expectations for the first rate rise have been pushed back so many times they have lost credibility, and managers who strategically shorted fixed income have suffered more than most. Perhaps a more important point to consider is that any rate rise, when it finally comes, is almost certainly going to be marginal and more of a token gesture than a reversal of the accommodative stance central banks have been forced to adopt for the last six years.
APRIL 2015 | LEADING EDGE | 19
here is no guarantee rates will go up this year. “ TExpectations for the first rate rise have been pushed back so many times they have lost credibility. ” With that in mind, funds which still pay out a high yield look well placed to continue delivering inflation-beating returns. The Royal London Sterling Extra Yield Bond Fund returned around 9% in 2014, 7% of which was from income and just 2% of which was from capital growth**. Where do the sceptics think this income is going? Simply put, they have disregarded it, but they do so at their peril because funds which have high yields can use them to offset any capital losses if rates do rise. Some funds also invest in floating rate notes which should actually do well in a rising rate environment, further countering any notion of a sell-off. In short, such a small rise in the base rate would not prevent us having a positive year.
A greater threat to funds like ours, which are primarily invested in sub-investment grade debt, would be a decline in the economic outlook and a turn in sentiment. But given central banks appear supportive of growth and are willing to ‘kick the can down the road’ in terms of future inflation problems, we feel the recovery looks reasonably entrenched.
Eric Holt Head of Credit
Of course prices are now higher than they were, but it does not mean they are unattractive, given the lack of inflation pressure. While there will undoubtedly be volatility as markets try to predict the first base rate hike, it presents active managers with the chance to exploit price moves. It may be a challenging year, but while markets try and price in a hike they cannot time, we will keep looking for the best opportunities for our investors.”
RL Sterling Extra Yield Bond Fund 5 year performance 80 70
Percentage change
60
Royal London Sterling Extra Yield Bond Fund IA Sterling Strategic Bond Sector
50 40 30 20 10 0 -10 ' Mar 2010
' Mar 2011
' Mar 2012
' Mar 2013
' Mar 2014
' Mar 2015
Source: FE, Total Return, bid to bid, net income reinvested as at 31.03.2015. Based on A Share Class. Past performance is not a guide to future performance.
*Source: RLAM as at 31.03.2015. **Source: FE and RLAM as at 31.12.2014. Mid to mid, net of fees and taxes, net income reinvested unless otherwise stated. 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. The views expressed are the author’s own and do not constitute investment advice.
RLAM Inaugural Investment Conference On 25 March, we held our inaugural investment conference at Lord’s Cricket Ground. In the year that Lord’s celebrates 200 years as the ‘home of cricket’, we reflected on our own long history and how current uncertain market conditions present something of a new challenge to investors. Our fund managers presented on how they intend to respond to some of these macro trends within their respective markets, as we’ve explored in our first issue of ‘Leading Edge’. We’d like to thank those of you that attended, and share some of the memorable images and thoughts from the day. If you would like to share any further thoughts on themes covered during the day or in this issue, please use #leadingedge or email leadingedge@rlam.co.uk
“ Eric Holt and Martin Cholwill team up to discuss income opportunities in bonds and equities. ”
“ Ian Kernohan @RLAM_ UK takes to the stage to discuss three economic scenarios. ”
“ The excellent Paul Craven speaks to a full house on behavioural economics to finish off. ”
“ Greatly looking forward to speaking at the @RLAM_UK conference at the @ HomeOfCricket today. A place full of happy memories and future fun. ” “ At Lords for the first RLAM Investment Conference. Presenting Singles; Not Boundaries - RLAM’s approach to Absolute Return. ”
Income activists With income increasingly sought after by investors, our income activists are dedicated to identifying sustainable sources of income and uncovering value in often overlooked areas. To find out how visit www.incomeactivists.co.uk our online resource for wealth managers and advisers.
This document is for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Nor does it provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Past performance is not a guide to future performance. 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. Issued by Royal London Asset Management Limited, 55 Gracechurch Street, London, EC3V 0RL Registration Number 141665 which is authorised and regulated by the Financial Conduct Authority.