Benjamin Graham, the Anglo-American investor rightly dubbed the founding father of investment analysis, ran his portfolios by numerical rules. One such rule told him to sell any holding if it had done nothing after two years; Graham rarely kept holdings for all that long anyway.
True, Graham, whose active investment years spanned the middle decades of the previous century, was operating in simpler times. Not that simpler necessarily meant easier; after all, in those days mandatory disclosure of company information was minimal compared with today’s overload, so a determined investor had to do a lot of digging. But at least it meant there was always another barely-researched stock to move onto if the likes of Cleveland Gramophone & Radio didn’t deliver.
What, therefore, would Graham make of the holding in Real Estate Credit Investments (RECI) in the Bearbull Income Portfolio? It is now in its 11th year in the portfolio, during which time the price has done nothing much at all. The holding was bought for 109.5p in January 2013 and its mid price is now 125p.
Then again, RECI was bought for more than just share price appreciation. The dividend yield, which stood at 6.5 per cent based on 2012-13’s distribution, was especially important, too. Still, that just prompts a supplementary question: when is a dividend cut not a dividend cut? Answer – obviously – when it’s RECI’s dividend. In that respect, the chart tells the whole story. It is now six years since RECI’s directors last raised the payout and, in that period, the 12p dividend has lost 38 per cent of its purchasing power as measured by the rise in the UK’s consumer price index.
Sure, a maintained dividend is better than one cut or axed, and plenty of financial sector players have hacked their distributions since 2017. And RECI is constrained by operating in a niche exposed to all the difficulties confronting the real estate sector when the cost of money rises. The Guernsey-based closed-end fund plays a value investment game that Graham well understood. Basically, it buys bank debt secured against real estate below face value and runs it to maturity, picking up interest payments and eventual repayment of principal. Currently, its £406mn book has 45 investments, 60 per cent of which, by value, is in the UK with most of the rest in France and Spain.
RECI’s chief risk is that it could make bad calls and, naturally, the game gets tougher as interest rates rise. Property values drop, collateral gets stretched, higher discount rates depress the present-value guesstimates of future cash flows. Perhaps worst, leverage – the process of using fixed costs to gear up returns to equity – goes into reverse. Happily, RECI’s leverage – restricted to 40 per cent of shareholders’ funds – is falling. Gross financial liabilities of £100mn in March 2022 had dropped to £80mn this March and were £59mn by July for a leverage ratio of just 17 per cent of net assets. That said, there may be non-quantified leverage in some special-purpose subsidiaries that are not consolidated.
Naturally, the hope is that the market is overreacting, as the market does. There is history. Less than three years after RECI’s 2006 flotation, its share price dropped 96 per cent to 12p at the pit of the global financial crisis. A further two years on and the price was a 10-bagger, standing at 123p. Another helter-skelter spell in the wake of Covid’s appearance meant the price fell 40 per cent in the first half of 2020, since when its recovery has been unconvincing.
The major worry is that the dividend will be cut. Since RECI’s dividend yield supplies all the total return and more, that would be a blow. The current cost of the payout – £27.5mn – has had a mixed relationship with free cash flow over the past five years; on average, cash flow hasn’t quite been sufficient. Yet the track record of the fund’s long-term manager brings some reassurance and it is mildly encouraging that three of RECI’s four directors (all non-executive) were buying smallish amounts of shares in July.
So the Bearbull portfolio will stick with its holding, but – as it were – the grip is getting looser, especially as the income portfolio has more exposure to the UK’s deeply unpopular property sector via Primary Health Properties (PHP), a holding whose performance is currently the worst in the portfolio. In one sense, that’s illogical since the security of income offered by the GPs’ surgeries that occupy PHP’s properties – latest occupancy rate 99.6 per cent – could hardly be bettered.
The snag is that management has used the near-certainty of income to lever up shareholders’ returns via debt. That was fine when interest rates were low and stable; not so smart when they are high and maybe still rising. And PHP runs on a lot of debt – £1.3bn compared with £1.2bn of equity. It matters little to fretful investors that 75 per cent of the debt is fixed-rate, that its average cost is 3.2 per cent compared with a net rental yield of 4.9 per cent or that 85 per cent of the variable-rate stuff is hedged, since the rate caps will need to be renewed at some stage. The moral is that when a company’s basic business model is out of favour there is little for investors to do but ride it out, or take a deep breath and sell out. I may yet do the latter.
Yet there is also the question of what to do with the portfolio’s second-worst performer, shares in metals processor Johnson Matthey (JMAT), whose price – at £15.83 – has just hit its stop-loss level. Matthey is much as it was a year ago when the holding was bought – a group in transition; a recovery stock with an accompanying 4.9 per cent yield (as that figure is now). One problem is that the group’s clean-energy future, using platinum to help process so-called ‘green hydrogen’, remains unclear. Sure, much money and effort is being poured into Matthey’s Hydrogen Technologies division. Construction is on track to expand its UK plant from 2 Gigawatt capacity to 4GW and management targets £240mn of revenue from the division by 2024-25. Yet the brutal truth is it’s still uncertain whether hydrogen will become a feasible primary source of clean energy to rival electricity, especially as it needs its own dedicated infrastructure.
Of more immediate concern, the price of platinum group metals (PGM), of which Matthey is the world’s biggest recycler, has faded. Thus underlying group operating profit in 2022-23 was 21 per cent lower at £465mn, and almost half the £124mn drop was due to lower PGM prices. Nor is management talking up prospects for 2023-24. Newish chief executive Liam Condon says that if PGM prices stay at their end-May level, another £50mn would be chopped off operating profit compared with 2022-23.
Predictably, therefore, City analysts expect earnings to fall this year, but – ever the optimists – to rise in the following two years and be back to their 2021-22 level of 213p by 2025-26. Simultaneously, they also expect the dividend to creep upwards and be 85p by 2025-26. Given that Johnson Matthey offers something different to the Bearbull portfolio, I’ll stick with it for the time being, though more in hope than expectation.
bearbull@ft.com
