Bearbull Portfolio: A new buy just for the Isa window

Last week, this column played host to a duel between two investment heavyweights. In the red corner, Jeremy Grantham’s GMO, which in atypical fashion had just stated its “excitement” at the opportunity set across equities, especially in the boxes marked value, small-cap, and non-US. To the oft-bearish asset manager, today’s conditions present the “best relative asset allocation” options since the collapse of the Soviet Union. Fundamentals? Back with a bang.

In the blue shorts, we had Jonathan Ruffer, pondering the end of the equity era and a sustained period of painful de-leveraging, corporate fire-fighting and disenchanting returns ahead. Ruffer’s long-held investing maxim – to not lose money, rather than maximise returns – echoed loudly. Those fundamentals? A second-order priority to a deteriorating macroeconomic backdrop.

With 5 April and the window on my use-it-or-lose-it individual savings account (Isa) allowance fast approaching, I was suddenly foggy with indecision. The goal of the Bearbull Income Portfolio, as I recall, has always been to use equities to simultaneously grow capital and draw on (an ideally also growing) stream of dividends as a modest prop to day-to-day expenditures. On one reading, this might be a bona fide moment to double down. On another, is a much grander rethink due?

The portfolio’s recent run has been fair. In the past two-and-a-bit months, accumulated dividends and capital growth has pushed up its total value by a handy 3.5 per cent. A few one-time deadweights (GSK (GSK), Anglo American (AAL), Johnson Matthey (JMAT)) are looking sprightlier, while the funds-led engine I built at the end of 2023 has been doing the job set for it.

Then again, given the likelihood of a trundling performance from the UK economy, we might need to temper any GMO-inspired hopes for domestic equities. In truth, however, what keeps me up at night as much if not more than the portfolio’s holdings are the prospective returns on fixed income. My internal debate is less to do with the dominant stocks-versus-bond narrative about relative value – given that this usually compares a pricey US equity market and high-yielding Treasuries – but a more humdrum British fretting around the various opportunities in gilts.

It is the thought of that sweet spot of modest income and capital growth (not winning exactly, but decidedly not losing money) that is so hard to ignore. More power to Ruffer.

Especially tempting are those five-year gilt issues, sold when interest rates were improbably low in 2020 and 2021, and still trading at a discount to par. Though their coupons are slight, this merely creates a cash flow timing issue, which is manageable; hold to maturity, and the eventual climb to redemption prices should offer a real return almost free of risk and entirely free of capital gains tax. I could be done with Isa fretting, and company monitoring, all in one go.

If I’m honest, becoming an amateur bond watcher would probably be my preference to investing with Ruffer. That’s not because I think I’d do a better job (though their fees would give me a head start). Rather – judging both by his comments and the rather flat performance of the Ruffer Total Return fund since a new market paradigm started to emerge three years ago – it’s not wholly clear whether the end-of-the-equities-era thesis makes obvious winners out of other asset classes. If inflation proves sticky, those real gilt returns might prove rather unreal.

So, I’m going to leave Ruffer’s warning semi-unheeded. Or rather, I’m going to take the middle way between his sticky inflation call and GMO’s rosy base-case return to lower interest rates.

A new position

Fortunately, there is a lot out there in UK share land that feels cheap, and not just for good reason. Of course, cheap, as long-time observers of my portfolio might recall, hasn’t always been cheerful. Most calls since the onset of the pandemic have been a bit of a damp squib, while almost three-quarters of holdings have failed to match the FTSE All-Share in price terms since they were acquired. While price appreciation shouldn’t be the first measure of an income investor’s track record, it is an important marker for long-term dividend assumptions.

Currently, the portfolio’s forward dividend yield is 4.9 per cent, on a weighted basis. I’m confident that several core holdings – such as the JPM income and growth trusts and the S&P 500 Dividend Aristocrats fund – should hit those estimates, as their diversification is designed to iron out individual corporate kinks. Nor is there reason to doubt, bar genuine calamity, the yield on my NatWest 9% preference shares, whose real issue is long-term capital erosion.

Others are dicier. As its forward yield of 10.3 per cent implies, the dividend cover ratio at Real Estate Credit Investments (RECI) looks fragile. Following the launch of a regulatory probe into value for money in the veterinary sector, a key pillar of Pets at Home’s (PETS) long-term growth story also now looks decidedly vulnerable.

The latter predicament serves as a reminder of the portfolio’s biggest long-term issue, namely its lack of dividend growth. With a few exceptions, distributions have largely gone sideways for the last decade, propped up by a few windfall takeovers.

With all this (as well as GMO’s trifecta of cheap, small(ish) and international) in mind, I’ve opened a position in retirement products specialist Just Group (JUST).

Full-year results, published a month ago, showed plenty of promise. A mix of favourable longevity assumption shifts, rising in-force profits, and a big step up in new business and sales meant adjusted pre-tax profits hit £520mn, two-thirds of which were squirrelled away for future profits. Capital ratios were stable, and the drag resulting from new business remained low.

Equally importantly, for anyone concerned by its exposure to big market movements or memories of a fateful historical over-reliance on equity release mortgages, Just looks well-hedged, thanks to a big step up in foreign currency, interest rate and inflation swaps. A reduction in property exposure means sensitivity to price swings is also now much less of a concern.

Just is enjoying the higher interest rate environment, which has driven demand from both pension trustees and individual savers keen to lock in guaranteed retirement incomes. However, despite operating in the business lines that have sustained valuation premia for larger peers Aviva (AV.) and Legal & General (LGEN), Just trades well below its liquidation value.

Though its market capitalisation is a 23 per cent premium to shareholder equity, this excludes the present value of £1.96bn in risk-adjusted future cash flows. As such, the discount to tangible net asset value is 54 per cent. Shares in Barclays (BARC), whose growth and returns look feeble by comparison, carry a discount of just 45 per cent.

Unsurprisingly, this has fomented a fair bit of chat around a possible takeover. While such speculation invariably glosses over the technical and regulatory obstacles facing a would-be buyer, the disconnect between audited and market valuations are likely to be compelling. Even at a 60 per cent premium to the current share price, a potential acquirer would get access to a well-managed asset pile for 25 per cent off. Should organic momentum in the defined benefit transfer start to wane in the coming years, consolidation might make sense.

While takeover speculation is rarely a hindrance to a stock, I’m more interested in the concrete moves management are making to correct the valuation gap. The good news, from an income investor’s point of view, is that this appears to have centred on the dividend. While still slim at 1.5p per share, the increase in the final payout brought the year-on-year rise to 20 per cent, and on the back of a 15 per cent hike in 2022. Maintain growth in line with a new return on equity target of 12 per cent, and the dividend could double by 2030. Handily, the latest distribution also goes ex-dividend on 11 April.

Naturally, Just’s ointment isn’t fly-free. The investment portfolio’s £176mn-worth of residential ground rent assets look vulnerable to a government consultation on leasehold reform, which explains a fresh £45mn provision. Longer-term product demand, though currently buoyant, is harder to call. Then there are general market and liquidity risks: as the 2022 gilt market crisis showed, some events are only foreseen until they very suddenly aren’t.

Having bought 14,500 shares at 104p, I’ve taken an average-sized position that reflects the potential for gremlins in an insurer’s balance sheet. It’s also either a slightly fudged answer to both Ruffer and GMO’s worldviews, or a free hit on UK value. If Just can’t catch a market bid, I’m not sure what it’s going to take to turn the tables for cheap domestic stocks.