Stocks are volatile, yet to generate long-term returns investors must ignore the market furore and abide by their investment discipline, according to Chris Murphy and James Balfour.
While the IA UK Equity Income sector returned 78.5% over the past ten years1, the decade has been marred by politics making it difficult for investors to ignore market noise and shun herd-like behaviour. In the UK, Brexit led to ongoing uncertainty over the health of the UK economy, and the global pandemic has resulted in significant share price volatility across global markets as a whole.
Markets have always been inefficient in that fear or greed end up driving a lot of investment decisions
“Markets have always been inefficient in that fear or greed end up driving a lot of investment decisions,” says Chris Murphy, manager of the £1bn Aviva Investors UK Listed Equity Income Fund. “When investors do not know the outcome of a major macro event it creates a sell-off in stock markets. On the other hand, we see periods of share price escalation as styles of companies become overvalued and bubbles form very quickly. Those movements are all related to fear and greed. Why would you want to get sucked into that cycle of fear and greed?”
Over the past decade Murphy has made a name for himself as a manager who has been able to ignore such short-term noise and, to an extent, systematic biases. Instead, he focuses on the long-term potential of companies over multiple investment cycles. His approach, he notes, means he tries as much as possible to invest in what he describes as “dull, boring businesses”.
Yet despite this rather sober label, the fund has returned 107.1% over ten years to May 31, 2020, ahead of the FTSE All Share benchmark which returned 80.2%.2
The fund has earned notable external recognition, including topping the most recent Sanlam White List half-yearly Income Study in January 2020, being A rated by Square Mile, and is on Hargreaves Lansdown’s Wealth 50. Murphy manages the fund alongside his co-manager, James Balfour who joined Aviva Investors in 2012.
Markets are driven by short-term news flow, earnings upgrades and downgrades
“Markets are driven by short-term news flow, earnings upgrades and downgrades. And a lot of investors have a tendency to value businesses when they are doing really well with high returns. All that means is that they value them inappropriately. What is needed is discipline to understand company behaviour based on facts.”
Murphy and Balfour invest in stocks on the basis that any business, no matter how successful it appears to be today, will become “average or worse over time”. Their approach therefore aims to pick stocks based on businesses’ cash flow and their ability to invest that cash over the long term.
“We want to base our decisions primarily on if the cash they hold can pay the bills, fund capital expenditure and ultimately pay dividends,” explains Murphy. “To understand how companies do that we split the lifecycle of a company and its cash flows intro three broad silos of: future cash flow, cash compounding businesses, and those in the recovery process.”
Future cash flow businesses tend to focus on companies that have clarity on returns and are able to generate capital growth. These are typically more ‘balanced’ businesses and will thus generate higher yields in the future.
Cash compounding businesses are what make up the bulk of the portfolio and are comprised of strong, reliable businesses with stable cash flows. This includes stocks such as Compass Group which aims to reinvest or return cash to investors each year.
The third silo focuses on recovery or out of favour stocks, either for macro or company-specific reasons. However, companies in this bucket must have a clear path to recovery and the opportunity to turn strategic value into future cash flow. Murphy and Balfour refer to this as ‘cheating fade’, whereby a business can reinvest or develop a new product to enable growth again.
By fading a company’s returns and prospects will look poor and the valuation will fall
“Companies can do what we call ‘fade’, whether that is because of a shock in the market or mismanagement of the business itself. By fading a company’s returns and prospects will look poor and the valuation will fall. Yet there can also be a proper business model that just needs to get back on track.”
“If you can invest in the right business, with something unique about them, then the ‘fade’ rate is much less so we call it ‘cheating fade’. The company will either reinvest in the business to help it recover or is a strong brand that is able to bounce back with the right management in place. While investors might ignore it because typically it would not represent ‘high’ growth, not ‘fading’ is a valuable tool that retains the terminal value of the business.”
Though the focus on cash flow may mean the portfolio is perceived to be a little dull in terms of its stock selection, this is not an issue for the managers. Indeed, Balfour notes that this shouldn’t be seen as a negative.
“Typically, the stocks in our portfolio are better-established businesses, mature even and can have slightly higher valuations too. But they do also have the potential for a decent amount of compounding growth which means they often deliver ahead of the market. And because they are more established, they can pay out a slightly higher yield and return cash to investors rather than consuming it.”
We invest in businesses for their potential to generate cash over a number of years
In addition, by honing in on company fundamentals and not the macro outlook, the focus remains on the long-term prospects of the stock: “We don’t chase stocks. We don’t want to or need to. We invest in businesses for their potential to generate cash over a number of years, therefore the entry price and trying to tie into that doesn’t matter as much. It also means we don’t need to turn over our stock in the portfolio as often; because we are not trying to time the stock to go up a certain amount before selling. It really is about conviction of ideas rather than valuations, and the consistency of our portfolio returns shows that.”
Faith and discipline in such an investment philosophy is particularly important in periods of stress or extremes such as those being seen today. While at the start of the year the world economy was beginning to take off again in a conventional boom-bust cycle, the arrival of COVID-19 saw stock markets plunge as fears of a slump in global economies became increased. Though central bank and government stimulus measures have been announced, the long-term impact of the pandemic is unknown and it remains to be seen how deeply the UK economy will be impacted.
Governments and health organisations are trying to flatten out the peak of COVID-19 infections and that will create a period of dislocation in economies
“It is very easy to get sucked into market movements and forget your own beliefs at the moment,” says Murphy. “I have a lot of different charts on my screen showing the impact of COVID-19, and it is an unknown that is not going to suddenly go away. Governments and health organisations are trying to flatten out the peak of infections and that will create a period of dislocation in economies. It makes it difficult to predict when investors will gain confidence again.”
“We don’t believe we can call when it will end. What we do have is a portfolio of quality stocks with strong business models, and we will investigate if we need to make small changes to those holdings. What we are looking at now are stocks that might miss a year of profitability. The question of course is at what point can they survive through that and still generate cash, and we do not know this yet.”
The team will not, however, be calling the bottom of the market and taking on risk in new stocks, says Balfour. “For us this is a binary event that is causing a lot of volatility. If we get the call wrong, it will heavily impact returns.”
The fundamentals of an income fund remain, despite all market dips. Income funds generally, and more so Murphy and Balfour’s style of focusing on cash flow is not just for people that want to take out an income. In fact, net income reinvested can provide much more consistent and less volatile long-term returns.
How businesses change and adapt to ongoing wider challenges is important
“The macro outlook will always move up and down,” says Balfour. “But how businesses change and adapt to ongoing wider challenges is also important. Being at the forefront of new opportunities and changing trends is actually what will help companies reduce their cost of capital and prosper for longer.”
The Fund View from Square Mile Investment Consulting and Research
Chris Murphy operates under the philosophy that many investors are habitually driven by fear and greed and therefore tend to overpay for what they perceive to be exciting growth opportunities. He believes that a more mundane approach to investment is appropriate and that steady, simple businesses that have the ability to compound returns over time are the types of companies that investors should seek.
The fund benefits from the lengthy experience of Mr Murphy alongside the challenge and views of James Balfour, who has made a very promising start to his investment career. The pair seem to enjoy a collaborative working relationship and despite favouring what could be described as dull companies, have the courage to match their conviction. Therefore, at times, they will construct a portfolio which, at a sector level, can look markedly different from the UK market.
“We think this is a solid offering within the UK equity income space and one that benefits from a well-defined investment process and a complementary pair of fund managers, blending youth with experience”.