A Value View: Separating the Wheat from the Chaff

 

The Merchant’s Trust PLC

A Value View: Separating the Wheat from the Chaff

 

Transcript: Hello, and welcome to A Value View from The Merchants Trust. In each edition Simon Gurgle, Fund Manager at The Merchants Trust, offers his thoughts on developments affecting the UK market and what it means for investors.

Jon Cronin: Simon, it’s great to see you again, but it does feel like there’s a touch of deja vu about the circumstances. This time last year we had to record the podcast remotely because of the Covid lockdown, and the rapid spread of the new variant means we’re recording remotely again as we look forward to 2022. But it’s good to have the chance to speak to you, Simon, and reflect on the year that’s been for The Merchants Trust. So firstly, let’s just think about that year. How did markets behave in 2021?

 

‘We’ve had good returns from equities in the last year’

 

Simon Gurgle: Hi Jon, it’s great to speak to you again. It’s a really interesting way to paint the picture of the last year, because it was quite a volatile year in terms of the economy, and people have been getting used to lockdown and then releasing and getting back to activity again, and then further lockdowns again.

Despite all of that, really, the stock market’s been pretty strong. It had a very strong first quarter, and it’s been remarkably resilient through ups and downs of what’s been going on externally for the rest of the year, supported by low interest rates and government policy; the markets have been remarkably calm overall. Underneath, it’s been a bit like a duck swimming on water, the feet have been paddling furiously and there’s a lot of churn, but overall market levels have actually been quite resilient and strong; so we’ve had good returns from equities in the last year.

JC: And take me through some of those returns in terms of the Trust, Simon.

SG: That’s come initially from some of our investments in recovery shares, or shares that were quite depressed in terms of share prices last year, where the market got nervous about the impact of the pandemic and valuations were really beaten up in many of those companies. Many have recovered well and we’ve made good money out of them. We’ve had a number of companies taken over at significant premiums.

 

‘The income side of the Trust has recovered quite nicely as well’

 

And actually another thing that’s been quite pleasing: we’ve been able to reinvest that money from many of those shares into new ideas, which are quite interesting, and to move the portfolio into an area that might be better positioned for the future. We may come back to that. I think the other thing that’s been positive has been the income side.

So as I say, we’ve seen companies generally have coped with the pandemic, much better than you might have thought they would do – improved their balance sheet, improved their cash flow, strengthened their balance sheets – and that’s enabled companies to come back to paying dividends if they held them back, or indeed to grow their dividends at a faster rate than you might have thought. So the income side of the Trust has recovered quite nicely as well. Overall, it was a good year, and we’re very pleased with how it shaped up.

JC: There are some challenges, though, on the horizon; inflation rising, for instance; the Bank of England now moving to increase UK interest rates as a result. Is the portfolio positioned to withhold inflationary pressures do you think?

 

‘Many of the businesses in the portfolio can cope with higher inflation’

 

SG: Well, it’s a great question, and one of the good things about investing in shares, of course, rather than just cash in the bank, is that you do have businesses that generally can cope with inflation, can raise prices, and are real assets. Obviously if you have money in the bank or in bonds, they are nominal assets and can’t really cope with inflation.

An element of inflation, historically, has actually been quite positive for equity markets as long as it’s not too high. Yes, to answer your question more directly, there are areas of the market that we’re invested in that are able to pass inflation through quite quickly and quite easily. Some are regulated utilities, for example, where they can automatically pass through inflation because of the way their pricing mechanism works. Others, like energy clearly have benefited from higher commodity prices. But most companies that have been around a long time and earned decent returns are able to cope with a modest amount of inflation and pass it through.

They may not all pass it through immediately, there may be some lags, and we are seeing more individual company volatility, individual problems, as companies deal with inflation in their cost base before they can pass it through, and so on.  I think we are in for a more volatile period in individual companies, but generally, many of the businesses in the portfolio can cope with higher inflation and a modest amount of inflation is not really a concern.

JC: And, as you say, in the scheme of things the inflation rate is relatively modest compared to where it has been in the past; we’re perhaps just used to those figures being so low for rates and inflation as well. Is that part of the issue here, that really in the bigger picture, actually, we’re nowhere near as steep as we’ve perhaps been before?

SG: Well, interest rates are really low. Inflation has gone up quite a lot in the short term, and of course some of that feels like it’s transitory, some of it feels like it’s going to come off in terms of the year on year increasing commodity prices in energy costs; I don’t think we’re going to see big sustained increases of those types of assets on a year on year basis in the future.

Hopefully the inflation rate comes back a bit, but interest rates are still very, very low; we’re starting to go up, of course, but it’s very hard for the government or Bank of England to raise interest rates too high because there’s so much debt in the system. So the cost to most of the country of higher interest rates and to consumers of higher mortgage costs would be unbearable if interest rates moved up to where we saw them in the ‘80s and the ‘70s. So we are very sensitive to high rates, and therefore, we’re probably not going to see very high levels of interest rates in the short to medium term.

JC: Now, Simon, we’ve talked many times about value investing on this podcast, but how far do you think there is left for value to run? Are there still quality value stocks out there to be found? I think I know what you’re going to answer, but I’m keen for your thoughts on this.

SG: It’s been interesting because we did see a bit of a rally in the value factor over the turn of last year from about November to the Spring, when we had the first positive vaccines news. But really value as a style has not been a great performer.

Last year was OK, but certainly for the two or three years before that it was quite a poor performer; lowly-priced shares were not on average performing that well. We’ve done quite well despite that headwind to our style, because we’ve been able to identify those lowly-priced companies that really are genuinely good businesses that were under-priced, rather than companies which have more structural problems, where you might say they were cheap for a reason.

 

‘We’ve been able to identify those lowly-priced companies that really are genuinely good businesses that were under-priced’

 

And I think that that still remains the case. There are still plenty of opportunities out there to buy really interesting companies; good businesses that are lowly rated. To answer your question directly, the anomalies within the market, the spread of valuations, is still remarkably wide. I would say at the extreme end it’s come in a bit: some of the cheapest, some of the lowest price companies from last year have now re-raced upwards, and some of the most expensive higher-growth companies have come down a bit in valuation. But there’s still enormous variation within the market, and one thing that I think has become more prevalent in the last six months or so has been earnings momentum.

So companies that are seeing upgrades to their earnings forecasts are generally performing very well in terms of share prices, and that can drive anomalies in the market as well, because clearly just because a company is seeing improvements in today’s earnings expectations doesn’t necessarily mean that the company’s worth a lot more in the long term, so if the market goes too far on some of those trends, that can create opportunities as well. So as a value investor, I find it a really exciting time to be looking at a market, there are plenty of opportunities to buy genuinely good companies that are wrongly priced, mispriced, because people have too high expectations about growth, or just simply because they are out of favour.

JC: Finally, Simon, just looking ahead, now – crystal ball time, here – is there anything that you think could surprise markets in 2022? What’s your outlook for the year ahead?

SG: It’s a great question, but of course almost impossible to answer, and also a critical one. I think the course of the pandemic will remain really important to markets. I think we mustn’t forget about geopolitical risks, which maybe have been bubbling beneath the surface between Russia and China and America. We’ve got inflationary pressures building up, interest rate policies; there’s lots of things that we need to keep an eye on and are potential risks for markets and for investors.

Having said that, there always are a lot of risks out there. We don’t spend most of our time thinking about these types of issues – we clearly are aware of them and they do come into our consideration, but where we spend most of our time is looking at individual businesses, individual companies, and trying to identify strong businesses that in the medium to long term can make good profits; can generate sensible, reasonable cash flows, resilient cash flows; and can pay attractive dividend yields to investors.

 

‘We can find plenty of opportunities to buy really strong businesses at fundamentally attractive valuations’

 

If we can find good businesses that are well positioned in most scenarios, to deliver strong returns in the long term and deliver cash flow and dividends to shareholders – and most importantly, if we can buy them at sensible prices – then I think that’s great. And at the moment when we look at markets, when we look at the UK equity market, we can find plenty of opportunities to buy really strong businesses at fundamentally attractive valuations where we believe we’re going to earn good returns for shareholders and a good income stream. And that’s what we’re trying to do – we’re not trying to be too clever.

And so I think a way to end this conversation really is to say, look, we’re pretty optimistic, when we look at the portfolio, about the type of companies we’re able to buy and the prices we’re able to buy them. And that should cope with most scenarios, but clearly, you know, when is it possible to know at the beginning of the year what’s going to happen?

JC: Well, Simon, I wish you best for the rest of this year, and as ever, it’s a pleasure speaking to you. Unfortunately, we’re out of time now, but thank you very much indeed.

 

Find out more about The Merchants Trust here > by going to merchantstrust.co.uk.

 

 

 

All sources Allianz Global Investors GmbH unless otherwise noted. This is no recommendation or solicitation to buy or sell any particular security. A security mentioned as example above will not necessarily be comprised in the portfolio by the time this document is disclosed or at any other subsequent date. Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors may not get back the full amount invested. Past performance is not a reliable indicator of future results. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer and/or its affiliated companies at the time of publication.

This is a marketing communication issued by Allianz Global Investors GmbH, an investment company with limited liability, incorporated in Germany, with its registered office at Bockenheimer Landstrasse 42-44, D 60323 Frankfurt/M, registered with the local court Frankfurt/M under HRB 9340, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht (www.bafin.de). Allianz Global Investors GmbH has established a branch in the United Kingdom, Allianz Global Investors GmbH, UK branch, 199 Bishopsgate, London, EC2M 3TY, www.allianzglobalinvestors.co.uk, deemed authorised and regulated by the Financial Conduct Authority. Details of the Temporary Permissions Regime, which allows EEA-based firms to operate in the UK for a limited period while seeking full authorisation, are available on the Financial Conduct Authority’s website (www.fca.org.uk). Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. The Merchants Trust PLC is incorporated in England and Wales. (Company registration no. 28276). Registered Office: 199 Bishopsgate, London, EC2M 3TY.

 

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