UK equities recorded modest gains in what was a mixed quarter for global stock markets. US/China trade tensions continued to weigh on investor sentiment as they exacerbated ongoing concerns around the global growth outlook. On the positive side, global central banks loosened monetary policy as expected, led by the US Federal Reserve (Fed), which cut base rates twice. The European Central Bank (ECB) cut once and announced it was restarting quantitative easing.
The latest GDP data for the world’s major economies confirmed that growth had decelerated in Q2 versus Q1, with both the UK and German economies contracting. Meanwhile, forward-looking indicators pointed to a further softening in the outlook for the world economy and inflation, with the prognosis for manufacturing particularly weak. Part of the reason for the global slowdown in manufacturing has been the continued moderation in global trade, so a further escalation of the US/China trade war in the period was particularly damaging for sentiment.
As a consequence of these developments, investors favoured assets perceived to have defensive qualities. These included bonds and so called ‘quality growth’ stocks, which are characterised by their superior and defensible earnings growth. Defensive areas helped the UK stock market record positive gains while merger and acquisition activity was also supportive – trade and private equity buyers capitalised on the relative valuation opportunity of UK equities, sterling weakness and readily-available cheap debt financing.
However, many of the economically sensitive areas of the market performed poorly, including the heavyweight financial and commodity sectors. These trends reversed somewhat towards the period end. This occurred as expectations rose that policymakers might switch from monetary to fiscal measures to stimulate economic activity and inflation. Brexit and domestic political uncertainty remained elevated as Boris Johnson took over as the UK’s new prime minister. However, legal developments increased expectations that a ‘no deal’ outcome on 31 October would be averted.
An increasingly uncertain backdrop
As we have often discussed, the global nature of UK equities has resulted in international developments setting the tone for the market, and this continued to be the case in the third quarter of 2019. Global economic data increasingly points to deteriorating fundamentals with many forward-looking indicators pointing to a softening in the outlook for growth and inflation. This has caused central banks to once again loosen monetary policy in order to try and keep economies stable.
Market distortions resulting from loose monetary policy
One particular equity market distortion resulting from the loose monetary policy of the last decade has been the outperformance of growth companies versus value stocks. Growth has become an increasingly sought after commodity and these companies have been valued off the back of these very low bond yields which is a dangerous yardstick to use.
Large dispersion between most expensive and cheapest valuations
As bottom up stockpickers, our job is to calculate the fundamental value of a business in order to identify mis-priced opportunities and dividend opportunities that will help the portfolio deliver attractive levels of income that grow in real terms. However, given the valuation distortions described above, while we admire many of the aspects of the business models of some of the highly valued ‘quality growth’ stocks, in many instances we cannot justify buying the shares at the current extended valuations. Accordingly our portfolios have a slight bias towards more lowly-valued stocks at the moment, where we can still find companies that are not priced for perfection.
Opportunity in UK domestic shares
In addition to the global trends influencing UK assets, Brexit continues to dominate sentiment and is creating considerable uncertainty for the UK economy and political environment. As a result, we are being presented with a compelling opportunity in some good quality, soundly-financed domestic companies taking a long-term perspective. This is reflected in our holdings in stocks such as Crest Nicholson, Hollywood Bowl, Legal & General, Lloyds Bank, Pets at Home, Tesco and Whitbread. We continue to be very selective in the types of business model and financial characteristics that we choose to invest in. We are wary of companies whose business models are particularly susceptible to disruption, such as areas of general retail. In addition, we place a large emphasis on balance sheets and accounting, as a weak balance sheet can hamper the ability of a company to invest in its operations or respond to changing market conditions.
Performance in the third quarter of 2019 was positive in absolute but lagged the FTSE All-Share Index.
The key stock detractor over the period was software group Micro Focus International, whose shares fell sharply after the company lowered its forecast for full-year revenue, explaining that weak sales had been compounded by a deteriorating macro environment leading to increased conservatism and longer decision-making cycles among their customers. The shares fell significantly more than the modest reduction in earnings expectations resulting in the stock being very lowly valued. The dividend remains covered on earnings and cashflow. The market appears concerned that the forthcoming strategic review (Jan 2020) may lead to increased investment. We believe any increased investment would likely address concerns over revenue and ultimately be beneficial to the share price.
Performance was also notably impacted by the portfolio’s lack of exposure to outperforming Vodafone and London Stock Exchange (LSE), neither of which are owned by the Fund. The former bounced on news that it would spin off its European mobile mast business. The latter performed very strongly, first on its bid for data and analytics company, Refinitiv, and second after the LSE itself received a takeover approach from Hong Kong Exchange and Clearing.
The Fund’s holding in Pearson detracted from performance as the stock issued a profit warning driven by weaker trading in its US university textbook business.
On the positive side, BAE Systems moved up from depressed levels with the market viewing its lowly valuation as anomalous given its ongoing ability to secure attractive long-term contracts.
Shares in luxury fashion brand Burberry were boosted after the company revealed better-than-expected Q1 like-for-like sales, attributing the increase to their customers’ response to some of its new product lines. This positive quarter underscores the progress made under CEO Marco Gobbetti’s turnaround and the commercial impact of new creative chief Riccardo Tisci.
GlaxoSmithKline performed well on increased market confidence in management’s sharpening of the group’s focus, both strategically and operationally.
Lastly, it was a good quarter for shares in bookmaker William Hill, which, as mentioned in previous updates, had been negatively impacted by the profit headwinds caused by tighter regulation in the UK and investor concerns about the investment required for the company’s expansion into the US. Shares have bounced after the market responded positively to first half results that were in line with expectations, proving that the affect of tighter regulation hasn’t been worse than many imagined, while the US remains an exciting opportunity for growth.
|Q2/2018 - Q2/2019||Q2/2017 - Q2/2018||Q2/2016 - Q2/2017||Q2/2015 - Q2/2016||Q2/2014 - Q2/2015|
|Net Asset Value||-0.5||7.9||19.5||0.0||8.7|
|FTSE All Share Total Return||0.6||9.0||18.1||2.2||2.6|
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