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Key questions for 2021: the professionals’ view

11 fund managers set out their views on some of the key issues in their areas of expertise
Key questions for 2021: the professionals’ view
  • There is a large group of companies for which the impact of Covid-19 on profitability has been more modest
  • Despite the ugly politics and a long period of outperformance, the US should form the largest part of our portfolio

How can equity income investors select companies that look better placed to maintain or grow dividends?

Dan Roberts, Fidelity

We can assess the outlook for returns by looking at three key building blocks. Firstly, whether the dividend yield is attractive at around 3 per cent in comparison to 2 per cent for MSCI AC World Index. Secondly, whether we expect dividend growth in mid-single digits, in keeping with the long-term growth rates for the strategy. Thirdly, any change in valuation for the portfolio and the market. 

We look for companies with resilient cash flows and strong balance sheets, and seek to buy them at attractive valuations. The quality of the businesses we own, the defensive tilt to our positioning and the significant valuation discount in our holdings should underpin an attractive long-term total return. This should also give some protection if current expectations for a sharp recovery in 2021 prove overly optimistic.

We aim to produce resilient and growing income streams, so it’s important that the companies we invest in have sustainable operating models. Only then can we have confidence in the sustainability of dividend distributions. Companies that fail to effectively manage environmental or social risks are more likely to experience negative surprises, which can cause significant declines in equity value and place dividends at risk.

There is a large group of companies for which the impact of Covid-19 on profitability has been more modest. We have built a portfolio of companies whose success is not determined by one or another vision of a post-Covid-19 world. Given significant uncertainty around what this world will look like when it arrives, we prefer to remain focused on individual stock analysis, seeking out companies that can thrive in a range of economic scenarios.

A key holding is Taiwan Semiconductor Manufacturing (TAI:2330). Semiconductor manufacturing is extremely capital intensive, and demands continuous research and development. This gives Taiwan Semiconductor a deep competitive ‘moat’ around its franchise and means it should be able to reinvest capital at high rates of return well into the future. 

The US market has risen a great deal, so is it still worth allocating to this market and why? How can you still find companies in the US market that are worth the price?

 

James Thomson, Rathbone

In a world with scant mega bailouts and where sustainable growth continues to wither, it all points to a market where the strong get stronger. That’s why I’ve increased my US weighting to close to its highest level in [the fund’s] history – 65 per cent.  

Despite the ugly politics and a long period of outperformance, the US should form the largest part of our portfolio, because that’s where the growth is. Since 2005, US companies have consistently grown profits more than four times faster than the rest of the developed world. Part of that growth is due to a permanent competitive advantage as that is where the FAAMGs – Facebook (US:FB)Amazon (US:AMZN)Apple (US:AAPL)Microsoft (US:MSFT), and Google owner Alphabet (US:GOOGL) [are listed], as well as tech hardware companies that the rest of the world simply doesn’t have. 

In the weeks preceding the presidential election, many investors had positioned themselves for a Democrat landslide, which I thought would happen too. Many strategists advised a switch out of growth stocks into value – something I won’t do – which would benefit from a stimulus-driven reflation bounce. They advocated selling growth and tech stocks ahead of a big increase in capital gains, corporate and personal income taxes. A Democrat landslide was also expected to bring guaranteed regulation and a break-up of big tech. 

But now we appear to have a Democrat president-elect, a split Congress and electorate, and a gridlock that will stop any maverick political agenda played out on Twitter. So investors now believe that gridlock is a good thing.

While the impact of politics can be overplayed when putting together a portfolio, if you are looking for a political justification to get bullish, then equity markets usually thrive under these conditions. 

 

Which parts of Asia look well placed to recover when Covid-19 is under control?

Richard Sennitt, Schroder

The roll-out of a vaccine next year combined with easy monetary and fiscal policy globally is likely to see global growth rebound through the second half of next year. Asia will benefit as a manufacturer to the world. With domestic growth in many Asian countries already reviving, we should see an earnings recovery that broadens out beyond many of the lockdown winners – both from a company and a country perspective.

The [performance differential between the] ‘haves’ and ‘have-nots’ of the past year is stark. And while in aggregate valuations across Asia are modestly above their longer-term averages, this masks a significant divergence across stocks. Against this backdrop of wide valuation spreads and broadening earnings revisions, we continue to look for attractively valued names that have a reason to re-rate, rather than value for value’s sake, given the long-term structural challenges faced by many companies from ongoing disruption. Examples of these include selected property companies.

North Asia has suppressed Covid-19 incredibly well, whereas life has been much tougher for India and many Association of Southeast Asian Nations (Asean) countries whose markets have lagged. This has reflected their difficulty in managing the virus and also a lack of lockdown beneficiaries in public markets. Going forward, a vaccine and return to normal should benefit these countries disproportionately more than North Asia. Thailand, for instance, is set to benefit hugely from any resumption in global tourism. And countries such as India and Indonesia have announced a number of structural reforms that should aid long-term growth rates.

With geopolitics likely to remain a headwind to further globalisation, Asian domestic growth will become increasingly important, aided by rising intra-regional trade. The recent signing of an economic partnership by 15 Asian countries [which account for] roughly 30 per cent of global gross domestic product (GDP) highlights this potential. It should benefit Korea and Japan in the longer term by reducing tariffs with China. And companies looking to restructure their supply chains should benefit Asean countries, including Vietnam.

 

In which areas do you have the highest conviction? Which themes, sectors or regions offer opportunities or risks in a post Covid-19 world?

Dale Nicolls, Fidelity

Our focus continues to be on the underlying value of companies according to their growth prospects, underlying competitive strengths and quality of management teams. This has led to a bias to smaller caps. As long as these companies can execute and deliver on their strategies and earnings over the mid term, this should be reflected in stock prices over time. 

We continue to focus on ‘New’ China – sectors we know have good growth prospects over the mid term, such as consumption-related, technology and healthcare sectors. Many consumer goods in China are underpenetrated versus other countries, and the trend towards upgrading and premiumisation is strong.

Another area in which we are finding opportunities is materials. Several sectors are still very fragmented, but with signs of consolidation under way we are focused on the leaders coming out of this process. 

We are less interested in pure commodity-related plays and more in companies with growing pricing power, for example in areas such as paint and floor tiles. 

Among financials, we are particularly interested in insurers given the low penetration in protection-type life insurance areas, as demand here will rise with higher incomes. The insurance sector could also, over time, see renewed demand coming out of Covid-19 as people focus more on protection in areas such as health insurance, even though right now companies may not be seeing the immediate change. 

 Given the strong run in markets since March, notably in the technology, healthcare and staples sectors, it has been harder to find value. However, there are pockets of opportunity, especially in the small-cap space. For example, many Hong Kong-listed small-caps are trading at single-digit price/earnings (PE) ratios, even when their businesses are viable with healthy cash flows.

 

How well placed are companies in emerging markets to maintain or increase their dividends in 2021?

Omar Negyal, JP Morgan

2020 has been pretty challenging for dividends in emerging markets. These markets are payout-ratio-driven; so dividends follow earnings, there is cyclicality and unsurprisingly the absolute numbers are down this year. 

But, in general, emerging markets have continued to pay dividends. And in 2021 we could begin to see some recovery, although we need to be careful about what the pace of that is. Some 2021 dividends will be paid on earnings from 2020, so we could see a lag effect. 

But longer term, looking a bit past next year, the prospects appear more positive because the underlying economies in emerging markets and the companies should be able to deliver. 

We are positioned towards three areas for dividends and growth in emerging markets: technology, consumer and financials. The companies that we own share the stock characteristics that are really important to us: high levels of profitability, high free cash flow to pay dividends and positive dividend policies. But those three sectors have quite different drivers.

Technology is an area where there are continuing positive, structural trends underpinning demand, whether semi-conductors in Taiwan or IT services in India.

Financials represent more of a recovery play considering what’s happening this year with Covid, and the economic links to banks in particular and insurers.

And consumer staples depend on which specific markets the companies are located in. So, for example, Mexico would represent more of a recovery area whereas China’s already relatively well positioned in terms of its economy – it’s an area where 400m millennials are looking for more choice with brand awareness. So there we just want to find strong companies that can deliver dividends off the back of that. 

Emerging markets are not known for ethical standards or good governance. How can you apply an environmental, social and governance (ESG) strategy to this area and find investments that meet the requirements?

 

Elena Tedesco, Federated Hermes

Various studies highlight that emerging markets lag developed ones in many respects, including on ESG issues. Developing nations have a long way to go in terms of emissions, labour standards, human rights, governance and disclosure, but responsible owners can contribute to their evolution over time and reap the benefits of the progress. That said, we draw a clear line in the sand to indicate where we will not own unsustainable businesses that are at risk of causing harm to communities and shareholders, destroying market value and reputations.

We look for attractive business models and management teams that demonstrate the motivation and capacity to confront sustainability challenges as part of their responsibility to generate value for shareholders. We look for clear evidence of ESG awareness and forward thinking on issues such as global warming, employee wellbeing and financial inclusion. We avoid companies that turn a blind eye to sustainability issues, and fail to translate slogans into concrete actions. We also commit to keeping our portfolios’ carbon footprint below the level of the benchmark, as we aim to create and manage portfolios of future-proof companies that can stand the test of time.

We engage with our holdings and regulators in emerging countries, because stewardship and advocacy are a powerful way to foster change. Engagement helps us gain a deeper insight into companies and can contribute to unlocking value and/or limiting downside risk. It is also a means for investors to help generate a positive impact through their portfolios.

Given the economic headwinds facing the UK, are investors best focusing on large-cap global multinationals? Which types of UK stocks are best placed to deliver growth? 

 

Richard Hallett, Marlborough

There are UK companies that are strongly positioned for growth, despite the economic headwinds, and they can be found across the market cap spectrum. Growth potential isn’t necessarily about size, it’s about the strengths of a company and the market in which it’s trading.

We look for companies that are leaders in their chosen business area, have a sustainable competitive advantage over rivals and operate in a sector that benefits from at least one long-term structural growth trend.

One company we like is Rentokil Initial (RTO), a global leader in the growth areas of pest control and hygiene services. The company regularly acquires smaller rivals, and its scale and global reach are important selling points with multinational businesses. It is benefiting from a number of long-term global trends. Climate change is increasing pest numbers and regulation is growing around the world. Emerging economies are introducing new food safety and hygiene legislation. And Covid-19 has resulted in a far greater focus on hygiene and increased demand for products such as hand sanitiser dispensers and specialist disinfection.

Intertek (ITRK), a major global leader in the testing of companies’ products and services, is also strongly positioned and regularly acquires smaller competitors. Quality assurance was already a growth area and now Intertek is benefiting from increased scrutiny of ESG responsibilities. Its services include auditing and certifying the health, safety and sustainability of companies’ operations. The pandemic has created additional demand for its services, from testing and certifying personal protective equipment to helping companies increase the resilience of their supply chains.

 

How well placed are companies listed on European stock exchanges to deliver growth, and what areas and types of companies look promising?

Giles Rothbarth, BlackRock

Investors buy securities for one of two reasons: they believe that the market is wrong about the future earnings expectations of a company, or wrongly assess the valuation ascribed to those earnings. We believe that for many European sectors and companies the market may be wrong on both.

Take travel: the International Air Transport Association (IATA) estimates that passenger traffic in 2021 will still be less than half of 2019 and won’t recover to previous levels until 2024. Better testing capabilities, a successful vaccine roll-out and a resilient global consumer are just three reasons why we think this assumption is eminently beatable.

We have exposure to travel primarily through aerospace engine manufacturers. These are companies with strong market positions due to large installed bases of engines that can generate significant cash flow. However, airlines need to buy new engines too. These engines can provide a cost advantage with better fuel efficiency and are cleaner technologies that airlines require to meet their carbon reduction goals. This is likely to lead to demand growth irrespective of precise passenger growth rates.

The climate agenda, more broadly, provides multi-year growth tailwinds for many European companies. We tend to find the best opportunities in businesses we think of as ‘giants in niches’, for example renewable fuel manufacturers, wind farm operators, speciality chemicals distributors and semi-conductor businesses. These are in sectors that are growing structurally, where our work suggests that expectations for earnings are wrong and/or the valuation of those earnings is wrong.

 

To what extent can you get decent growth from listed companies, and how important is it to have an allocation to unquoted companies to achieve this? What are the main reasons for an allocation to unquoted companies?

Stewart Heggie, Scottish Mortgage

We are determined to own the most transformational growth companies in the world. The majority of these are public companies, but we did not initially buy all of these when they were public. This is because the nature of capital markets has changed and our search for exceptional companies has moved with it.

Access to online distribution has grown the addressable market for breakthrough businesses by an order of magnitude. The ability to harness third-party infrastructure has drastically reduced the capital intensity of growth. And this has made new companies less dependent on external financing, so companies are remaining private for longer.

To maintain our opportunity set we invest in these private companies. This has little impact on our investment process, but allows us to lengthen the period of ownership and unlock the returns prior to initial public offerings (IPO) for our shareholders. For example, Alibaba (HK:9988), Spotify Technology (US:SPOT) and Meituan Dianping (HKG:3690) are three large public companies that we first bought when they were still private. And these companies had tripled in value by the time of their IPOs.

This is becoming a well-trodden path for us. Over the past two years, we have purchased 23 new companies, but only six of these were publicly listed at the time of investment. Meanwhile, a flow of companies have listed on public markets recently, including CureVac (GER:CVAC)Snowflake (US:SNOW) and Palantir Technologies (US:PLTR).

 

How can you get a decent total return and income from bonds for a reasonable level of risk? 

John Pattullo, Janus Henderson

We invest in sensible income and our job is to generate sustainable income for our shareholders without permanently impairing capital throughout the cycle. Our style of quality credit investing means we rule out approximately 45 per cent of the high-yield market because it’s too low quality, and about a third of the investment-grade market. We avoid fashion retail, energy, airlines and autos, which tend to have high operational and financial leverage.

We like the ‘sweet spot’ of credit, which is often the bottom end of investment-grade and top end of high yield. It may seem dull but it works in most economic cycles. We look to buy businesses that have a moderate amount of leverage, but not too much. We also avoid cyclicals and opt for larger-cap companies.

In previous recessions credit was the villain, but it’s come out of the Covid-19 crisis looking like one of the best income asset classes you could be in. Covid-19 [resulted in] a liquidity crisis rather than a solvency crisis for the credit market. We always felt the default rate would be much lower than it was in 2008-09.

Broadly speaking, high yield is where we are seeing opportunities. But we still think that the longer-term challenges of living in a low-growth and low-inflation world, with a secular stagnating economy, remain.

 

What are the biggest risks to bond investors at the moment and how do you invest/manage a portfolio of bonds to mitigate these and generate an attractive level of income? 

Mark Holman, TwentyFour Asset Mgmt

At present, the biggest risk to bond investors is scarcity of income. Although swift government and central bank intervention has been necessary to combat the economic impact of the Covid-19 pandemic, it has made cash and government bonds unviable asset classes. Investors have largely disengaged from risk-free markets such as US Treasuries this year, probably because their yields are so low that they no longer look like they will provide the downside protection they once did. 

Demand for income has helped drive a rapid recovery in credit spreads but also pushed investors further down the credit spectrum in search of yield. Although it is an opportune time to embrace risk, it’s still too early to be fishing in the more speculative credits and sectors where the default rate is likely to be highest. 

A handful of sectors in particular face both structural and cyclical issues. These include bricks-and-mortar retail, automotive, commercial property and travel which are going through big structural changes so may be worth avoiding.

To generate an attractive level of income, we need to embrace pro-cyclicality in our bond portfolios while avoiding these pitfalls. Our top pick for 2021 is the banking sector, and in particular additional tier-1 bonds, or cocos. Banks needed to prove their resilience through the economic cycle for investors to regain a greater degree of confidence in them after what happened in 2008, and they are now doing this. 

We expect high yield bonds to perform well in 2021 though will remain pretty selective in this area. High-yield bond default rates have been markedly lower than even the most bullish of forecasts earlier this year, and are expected to peak by the end of the first quarter. 

Corporate hybrids should also prove to be a lower risk credit compression play in 2021.