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Time to reassess and be contrarian

John Baron reminds readers of the importance of portfolio rebalancing and highlights some contrarian calls
November 12, 2020

Sound investment requires a combination of qualities – some of which are symbiotic. Humility, a much underestimated quality, helps us to understand it is better to remain invested than to try to time the markets because few can accurately predict the future, while it also allows us to better recognise when we have been wrong and to move on. Yet conviction is also required to commit to an overarching investment policy, otherwise portfolios can be unduly buffeted and influenced by prevailing winds, and to support contrarian opportunities when sentiment trails the fundamentals.

 

Long-term focus

While the nine real investment trust portfolios managed in real time on the website www.johnbaronportfolios.co.uk, including the two covered in this column, pursue a wide range of investment remits and income objectives, their underlying investment policy is to invest in entrepreneurial companies that have the potential to grow faster than the market over time. For the reasons most recently highlighted in the column ‘Remaining focused on the long-term’ (7 August 2020), the portfolios continue to favour ‘growth’ over ‘value’ and tend to be overweight smaller companies both at home and abroad.

This has served them well over the years – the performance tables in this column and on the website illustrate the extent of outperformance. The portfolios will remain committed to this approach. When referring to Professor Bessembinder’s research on 7 August, it could have been added that, when looking at global equities between 1990 and 2018, he showed 61 per cent destroyed value, 38 per cent then make up for that value destruction and just 1.33 per cent accounted for the $45tn of net value created. In other words, the excess return over equities was accounted for by a small number of stocks.

The portfolios will continue to seek and, where found, hold that small number of stocks over the long term. However, the importance of portfolio rebalancing is also recognised. Occasionally, because these companies have performed so well and positions have become outsized, portfolios have reduced weightings while remaining overweight the theme generally. This rebalancing is an understated investment discipline. It is also one that allows monies to be channelled into the contrarian opportunities that at times invariably accompany an investment journey.

 

Contrarian opportunities

The portfolios have long benefited from a questioning of the consensus when it comes to some of the many sectors, themes and regions that make up the markets. It is important to challenge the accepted view. For benchmarks can only be beaten by deviating from them. As Sir John Templeton once said: “It is impossible to produce superior performance unless you do something different from the majority.”

Putting aside whether ‘growth’ itself is such a call given the numerous voices believing ‘value’ will ‘revert to mean’ after a prolonged period of underperformance, the portfolios have been maintaining or increasing their exposure to a number of contrarian positions. Examples include commodities, smaller companies and commercial property. After the extent of the UK market’s recent fall, larger companies are now also looking attractive on a range of valuation metrics. 

As the money-printing presses start up again, it is perhaps worth taking stock and revisiting some of these contrarian opportunities. As highlighted in a recent column, commodities should benefit from a combination of demand and supply factors, while producing record free cash flow after a difficult decade of restructuring. Company valuations are another reason to be positive. The sector usually trades at a market discount – the average having been around 25-30 per cent relative to the S&P 500. Recently, the discount touched nearly 80 per cent.

The market has little faith in the sector after a poor decade of performance. This should change over time, particularly as sentiment comes to better appreciate the attractive and growing dividends on offer when compared with the wider market. Examples of companies held within the portfolios include BlackRock World Mining (BRWM) and CQS Natural Resources Growth & Income (CYN) – both continue to stand at attractive discounts while offering tempting yields, the latter particularly so.

While unfashionable, we continue to favour smaller companies that possess strong finances, entrepreneurial leadership and innovative products. These are companies that tend to be less dependent on the wider economy than most. Sector valuations relative to prospects and their larger brethren remain attractive. As we have suggested at times previously, for a host of reasons, the future is small. Examples held include Montanaro UK Smaller Companies (MTU), Standard Life UK Smaller Companies (SLS) and Oryx International Growth (OIG).

The market has yet to catch up with MTU in particular. Its track record under Charles Montanaro, investment remit and dividend policy equating to 4 per cent of net asset value (NAV) are all attractive characteristics. But sentiment continues to trail fundamentals by way of discount because the market has yet to fully recognise the quality of the portfolio’s investments – something that is becoming increasingly evident as economies struggle. Strangely, the market does recognise this characteristic when it comes to Montanaro European Smaller Companies (MTE).

OIG has been another holding where the market is only slowly according the rating it deserves given its long term track record under its manager, Christopher Mills. A conviction approach focused on undervalued companies that can benefit from wise counsel and long-term commitment is slightly ‘outside the box’ and not something the market fully appreciates, but therein lies the opportunity. The same can be said for Herald (HRI) given its excellent track record and commitment as an investor to fast-growing smaller companies under its respected manager, Katie Potts.

Commercial property is another sector the portfolios remain committed to. The ‘generalist’ companies in particular have had a torrid time. Rent collections have fallen, NAVs have been under pressure and many companies have seen their discounts widen considerably as the sector contemplates an unprecedented economic shock and what the ‘new normal’ may involve. Dividends have been cut to reflect both the reduction in rent received and the heightened uncertainty. Sentiment remains poor. Holdings include Standard Life Property Income (SLI) and Regional REIT (RGL).

SLI in particular is a case in point. The company has an enviable track record born of good strategic and effective asset management of its portfolio as overseen by Jason Baggelly, its respected lead manager. A 10-year net asset value total return of nearly 140 per cent testifies to the team’s success. A focus on quality assets has assisted. The company retains one of the more attractive sub-sector allocations within its peer group, with around half the portfolio committed to industrial, a third to offices, 10 per cent to retail warehouses and 2 per cent to retail.

In response to the economic effects of the crisis, the company has been cautious in cutting its dividend by 40 per cent. And yet rents received have come in better than expected. Second and third-quarter collection rates were 87 per cent and 84 per cent compared with last year, while fourth quarter rates were forecast to be 83 per cent as at the end of October. The majority of those in arrears have agreed to a schedule of repayment, mostly in 2021, with a few agreeing to an extension of lease. 

Furthermore, although the company’s void rate is low at less than 6 per cent, the general trend to convert unused assets, such as offices, into other uses, such as residential, continues at a reasonable pace. Investors also need to remember that real-estate investment trust (Reits) are obliged to distribute at least 90 per cent of their qualifying income to access certain tax advantages. There is potential for dividend upgrades. Meanwhile, the company yields over 5 per cent on its rebased dividend while standing at a 30 per cent discount to NAV. 

 

Looking forward

There is a contrarian opportunity emerging regarding larger UK companies. The outlook for dividends remains cautious. As highlighted in previous columns, various metrics suggest they may not recover to 2019 levels for some years to come. And with the number of Covid-19 cases now increasing again and further restrictions introduced, questions remain regarding the strength of the economic recovery. This helps to explain the portfolios’ earlier reduction in exposure to mainstream equity-income trusts and, by way of compensation regarding the lost income, increase in exposure to commodities.

However, while accepting dividend cover in the UK is towards the lower end of the scale, the extent of the market’s discount to others suggests other factors are at play. There is little doubt that the prospect of a no-deal outcome to the current negotiations with the EU is weighing on sentiment. For a host of reasons this is misplaced. The comparative advantage of lower corporation tax, more flexible labour markets, an entrepreneurial and skilled workforce, top universities, language and time zone are just some of the factors which, in combination, are more important than average WTO tariffs of 3-5 per cent should there be no deal.

Britain will remain an attractive place to do business. If proof were needed, the economy has been doing better than most despite all the predictions of gloom from the Bank of England and Treasury, among others, should the country vote to leave the EU. The figures relating to inward investment have been especially encouraging – recent years seeing twice the level of that of France and Germany combined. And this in the full knowledge that a no-deal outcome was and remains a real possibility.

In increasing exposure to this unloved sector of the market, due regard will need to be given to those investment trusts that possess strong revenue reserves, proud dividend records, determined boards and a flexibility in approach, including drawing on capital reserves as necessary, to see through the dividend drought. If successful, the rewards could be great for both company and shareholder alike.

 

Portfolio performance (1 January 2009 – 31 October 2020)
 Growth (%) Income (%)
Portfolio322.1220.8
Benchmark*155.4121.2
Yield 2.93.5
* The MSCI PIMFA Growth and Income benchmarks are cited (total return)