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Recognising the UK's strengths

John Baron has been adding to his portfolios' equity positions during the market's recent volatility over the EU referendum
July 8, 2016

In my column last month ('Ignore the noise over Brexit', 10 June 2016), I suggested investors should ignore 'Project Fear', which was always overstated, and focus instead on the bigger issues. Brexit was nothing more than a dog barking from the sidelines as the elephants quietly walked by. The market would move on whatever the result. Accordingly, I took advantage of market volatility and added to the portfolios' equity exposure - particularly UK smaller companies. Although the UK market has since had a good run, I will continue with the strategy should volatility return.

The UK was always in a stronger position than Project Fear had us believe. Putting aside predictions of war and plague, the size of our trade deficit meant it was in the EU's interest for trade to continue should we leave. On exit, the Lisbon treaty's two-year negotiating window - once triggered by the UK - would ensure little changed in the short term while a trade deal was discussed.

If access to the single market is unreasonably withheld, then the UK can fall back on the World Trade Organisation's rules used by many countries that trade with the EU. The WTO's 'most favoured nation' tariffs ensure punitive tariffs cannot be imposed - the US's average being around 3 per cent. And recent comments by the head of Germany's CBI confirm business there is not keen on them - for tariffs make little sense to a net exporter.

Meanwhile, the size of the UK's competitive cost advantage (much lower corporation taxes, more flexible labour market policies), its language, the quality of its higher education and research base, its skilled labour force, and its open market will ensure international business continues to find the country attractive - tariffs or not - as confirmed by a string of recent statements by various companies.

A depreciating currency will help exporters in the short term, while our new-found ability to negotiate our own trade deals, free of the tortuous EU process, will help longer-term growth rates - the governments of Australia, New Zealand, India and Canada have already expressed interest. In addition, smaller companies in particular will gradually benefit from being freed from the shackles of EU business regulation.

In short, many positives will flow from freeing ourselves of the EU's drive towards monetary, fiscal and political union - including the new-found ability to introduce a fairer immigration policy, which does not discriminate against the rest of the world and so better attracts its talent. Time will both silence the pessimist and armchair critic, and reward the doer and canny investor.

In recent columns, I have extolled the virtues of smaller companies both listed and unlisted, and in last month's column promised to explain the attractions of two recent additions to both my IC and website portfolios - Small Companies Dividend Trust (SDV) and F&C Private Equity (FPEO).

 

Small Companies Dividend Trust

As the name suggests, Small Companies Dividend Trust (SDV) focuses on smaller companies producing a decent income. Its current yield of 5 per cent is supported by revenue reserves exceeding one year, and it has generated an impressive dividend growth rate over the years. Meanwhile, it has a good long-term track record of growing NAV - averaging nearly 14 per cent annualised returns over the past three years, which compares well with both its peer group and the wider market.

SDV has a disciplined approach to stock selection. It will not buy shares unless there is a 4 per cent prospective yield on offer, and will automatically sell if the yield falls below 2 per cent. No individual stock will represent more than 5 per cent of the portfolio's NAV or 5 per cent of the portfolio's income. No sector will represent more than 20 per cent of the NAV. Such an approach reduces the risk of negative 'outliers' disproportionately harming performance.

The portfolio is comprised entirely of ordinary shares in Aim and fully listed companies - there are no bonds or preference shares to help with the income stream. Investors should be aware that SDV is a simple split-capital trust consisting of 8.5m zeros and 16.55m ordinary shares. Such gearing can result in volatility in uncertain times, but can also reward the patient investor - as has been the case here. Investors should also recognise that SDV has a market capitalisation of only £30m.

However, a good track record, a healthy and progressive dividend, the well-respected management team of David Horner and David Taylor, and a sector with strong fundamentals, particularly attractive to those looking to diversify their income stream, all suggest SDV should be tucked away for the longer term.

 

 

F&C Private Equity

The many attractions of private equity have been covered in recent columns (including 'Seeking value via private equity', 8 April 2016). But F&C Private Equity (FPEO) offers an additional attraction - a decent yield, currently running at 4.5 per cent, funded by its excellent track record of realisations. Furthermore, FPEO has committed to ensuring the dividend does not drop below that of the combined previous four quarters - a promise supported by five years' worth of revenue reserves.

FPEO focuses on the mid-market sector on a pan-European basis. Partly because it invests throughout the cycle, FPEO had a buoyant 2015, realising £80m of investments, which represented around 40 per cent of its portfolio. It currently has more than 60 per cent of its portfolio offering a maturity of at least three years, which is attractive. This should help FPEO defend its enviable record of producing a 10 per cent a year return over the equity market in recent times.

According to managers Hamish Mair and Neil Sneddon, FPEO believes the sector remains attractive over the longer term. Private equity managers will continue to seek 10-12 per cent annual returns in absolute terms regardless of the wider environment, but this is particularly attractive in the current low-growth environment.

Add in FPEO's attractive discount, the fact that realisations can often result in a NAV uplift of around 25 per cent, which is not unusual in the sector, and FPEO's gradually increasing exposure to co-investments, which it believes offers the best of all worlds, and this is an attractive investment, particularly to those seeking income.

 

 

Portfolio changes

During a volatile week over the 23 June referendum, within the Growth portfolio Small Companies Dividend Trust (SDV), City Natural Resources (CYN), Standard Life Equity Income (SLET) and finally Henderson Smaller Companies (HSL) were all topped up.

Likewise, the Income portfolio's holdings of JPMorgan Mid Cap (JMF) and Utilico Emerging Markets (UEM) were also added to. The buying in both portfolios was focused on the UK's mid-cap and small company sectors, given the market's overreaction during the emotion and 'noise'.

 

ABOUT THE AUTHOR:

John Baron waives his fee for this column in lieu of donations by Investors Chronicle to charities of his choice. As these are live portfolios, he has interests in all of the investments mentioned. For more portfolios and commentary please visit John's website at: johnbaronportfolios.co.uk