Global Recovery Fund Q4 2020

Drivers of fund performance

The marked style rotation in the fourth quarter is reflected in the share price performance of the stocks held, with the fund significantly outperforming both the value indices and the broader equity market.

The portfolio's holdings in the financials sector performed strongly. UK listed banks NatWest, Barclays and Standard Chartered and Dutch listed ING were notable strong performers. The extraordinary share price moves of many of our favoured businesses were really a reflection of just how polarised markets became in 2020, rather than the result of a commensurate improvement in their operational performance.

At the request of their regulators, European banks are currently withholding dividend payments. We note that both the regulators and banks themselves have learned the lessons of 2008 and, as a result, the banks have built-up their capital reserves over the subsequent 12 years. This means there is not a liquidity crisis, and the withholding of dividends is simply to ensure banks can provide maximum support for households and businesses through the economic shock caused by covid-19.  While this support for the real economy means no dividends in the short term, any cash rolling-up within the businesses still belongs to shareholders and, if lent prudently, shareholders will benefit from banks having stronger clients, stronger relationships with their clients and through enhanced profitability. Banks are a significant position in portfolios because we continue to believe in the long-term attractiveness of the banks from both a valuation and, in the medium-term, from an income perspective.

Tapestry, owner of the Kate Spade and Coach luxury fashion brands, performed well over the quarter. We established a small position in Tapestry in March 2020, when a dramatic decline in the share price triggered by national lockdowns meant it looked very attractive in a recovery scenario, and while we thought there would be significant pressure on retailers of non-essential goods, Tapestry's balance sheet was in better shape than the vast majority of retailers, and we felt its high gross margins would help cushion the blow in terms of its cash burn vs. lower margin retailers. We added our position in May after it became clear the banks had waived their debt covenants for 18 months (which removed some of the near-term liquidity risk), and we felt confident it would have access to bank facilities to ride out the downturn. Since then, the shares have performed extremely well as the results have been surprisingly robust: the Asian business has quickly recovered towards prior levels of profitability and even in the US & Europe – where store closures have been a major drag –margins have held up well owing to strong growth online.

Two oil companies – Spain's Repsol and Italy's ENI – made a strong positive contribution to relative returns. The energy sector has been a laggard this year, with the pandemic and consequent lockdowns weighing on demand for oil. Repsol is refocusing its business towards renewables to achieve carbon neutrality in line with the Paris Agreement in 2050. Despite the renewable investments, free cash flow is strong, with a high single-digit free cash flow yield being generated. It also has significant exposure to refining, which makes it less exposed to the oil price than some of its peers. One of the things we are cautious about with the oil majors is their need to replenish a depleting asset base with new oil flows. Historically, this has led to poor cash conversion, which investors need to be very careful about. However, a period of capital expenditure (capex) discipline has taken hold at ENI.  It had spent a lot on capex when times were good, but with this complete, we now get the benefits of the capex spent through rising production, but importantly we also have an improved balance sheet and cash flow generation, which should be strong over the coming years.

Another top individual contributor was a French advertising agency Publicis. Advertising has come under pressure in the pandemic as companies seek to cut costs. The rise of digital advertising also poses a structural challenge for more traditional agencies. However, Publicis has been repositioning itself towards digital channels and e-commerce. Its Q3 organic revenue growth showed an improvement on Q2.

Miner Anglo American performed well. It has been a top contributor to the portfolio in recent years. Profits have grown, the balance sheet is repaired, it has grown the dividend, and management deserves significant credit for their restructuring and cost-cutting.

Royal Mail continued to perform well. It continues to face a number of challenges, but it has a strong balance sheet and has become favoured as a beneficiary of changes to consumer behaviour caused by the pandemic, with parcel volumes increasing as consumers move online.

While much has been made of the rotation from growth stocks to value stocks in the fourth quarter, we note that on the relative basis some of the largest detractors from relative returns were no owning Tesla, Alphabet and Disney, all of which performed well. Of the fund's holdings, Intel was the largest detractor from returns, although the shares were down by just 3% over the quarter. Intel has a significant upside to fair value, a rock-solid balance sheet and a leading market position.

Portfolio activity 4Q20

We bought a small position in Rolls-Royce ahead of the rights issues placing. On October 1st Rolls-Royce announced a rights issue alongside a comprehensive debt package to bolster liquidity, and an intention to make £2bn of disposals. There is no doubt the business faces acute pressure but ultimately, we believe the long term potential for the business is unchanged by this short-term dislocation. In 10 years' time, air travel very likely to be higher than it is today. Rolls-Royce have 60% market share in the long-distance air travel market, alongside attractive franchises in the defence and mobile power solutions markets. The question comes down to whether they have enough liquidity to see them through the short term? Following these actions announced in October, we think they can survive for two years with air travel at current levels.  Although this is a complex piece of analysis, we believe we have made prudent assumptions at all stages. All debt for the company remains totally covenant free, with reasonable maturities, which means we are not beholden to short-term profitability of the business. The only thing that matters is that the company survives and that the long-term franchise is intact. As long as that is the case, the upside from today's share price remains considerable.

We initiated a position in Vistra, the Texas-based energy company with a range of coal, gas, nuclear and solar electricity generation assets across the US. This is an example of a business where the last 10-years are not a good guide to the future. Vistra has three pools of assets. It's ongoing operational businesses, 'Sunset' assets (group of coal-fired power stations due to be retired, but generating some free cash flow until that point) and 'Asset Closure' assets (these that have been formally retired and in the decommissioning or remediation process, and generally consume cash). Among the areas for us to in our investment case are consider are the withdrawal from higher carbon activities and the associated costs, management's choices on how to allocate the cash that's thrown off from those assets, and how to value the capital expenditure invested renewables. Vistra is undergoing change but is very cash generative and with a management team and capital allocation approach that appears sensible. 20%-25% of the market cap will be returned to shareholders over the next 2 years, mostly by buy-backs of shares, and it trades on a double-digit free cash flow yield.

We added German pharmaceutical and life sciences firm Bayer to the fund. Its shares have come under pressure recently, largely due to still unresolved litigation issues in the US related to weed killer Round-Up. This has meant a significant rise in provisions. However, the underlying business is extremely cash generative. We see the group as an attractive recovery opportunity in the medium term.

We sold our positions in watchmaker Swatch Group, US department store chain Dillards and US tech giant Cisco, and luxury goods brand Tapestry (see performance section). All had performed strongly.