Don’t stand so close to me

Read this article to understand:

• Why investors should stick to their principles and long-term views
• Why better opportunities can be found in mid-cap UK stocks
• Key investment themes for investors

Size mattered for UK equity investors last year, with an unusually big disparity in the performance of large-cap shares and the rest of the market. The presence of some of the world’s largest energy, mining and minerals companies, as well as financials – all historically consistent dividend payers – on the FTSE 100 was also beneficial for some income investors. Stripping out one-off payments, UK dividends rose 16.5 per cent to almost £85 billion in 2022, according to Link Group.¹

But with interest rates and inflation remaining elevated, and the fear of recession still present, it has been a stop-start first half to the year for UK equities. By the middle of June, both the large-cap FTSE 100 and small and mid-cap FTSE 250 indices were flat year-to-date. That is also reflected in the outlook for dividends, which are expected to see a modest improvement in 2023. 

Far from obsessing over short-term movements, Chris Murphy (CM) and James Balfour (JB), portfolio managers on the Aviva Investors UK Equity Income strategy, believe investors should have the courage of their convictions and hunt for companies offering the best long-term potential, including smaller names, and not simply hug the benchmark.

Oil and gas stocks have had an undue influence on UK equity market returns over the past 18 months. How have you responded to this challenge?

CM: There is a tendency across the fund management industry to own big index constituents just because it manages risk in terms of tracking error. The problem is this ignores long-term risk. We try to ignore the structure of the market. We don't own stocks just because they are big index constituents. We do not believe fundamentally that is the right way to think about portfolio construction.

JB: While prospective returns at the oil majors can look superficially high, they have a history of writing down assets, often made via acquisitions, thereby destroying capital. Shell bought BG in 2016 for $52 billion, but in 2020 wrote off $22 billion, much of which was the result of the acquisition.

Relative to our peers, we tend to focus more on opportunities in mid-cap stocks. We are trying to deliver reliable outcomes for our clients over the medium to long term. We believe this comes down to picking companies with strong fundamentals.

Performance was hindered in 2022 due to our relative lack of exposure to large-cap oil and gas stocks. If we do not think they are great companies, we do not think we should own them just because oil is a big sector. Hence why we have a bias to mid-cap stocks.

That can lead to big skews in performance relative to the market, which is what happened last year. But we are prepared to tolerate this kind of risk if it means not holding companies we would rather not own. Even if you don’t have a view on oil companies, by being neutral on BP in 2010, the Deepwater Horizon oil spill would have cost you 300 basis points of performance.

Is there any reason why do you tend not to like oil and gas stocks?

CM: You want to hold companies with a differentiated product as that enables them to control pricing. Listed oil companies are price takers. And though they may be very large, they are relatively small players on the global stage. The big ones tend to be owned by governments.

We do not see this as a great business model. It is not rocket science, but we prefer to own businesses that can differentiate their product, control their market and are able to deliver income and capital growth more reliably. It just so happens that BP and Shell are a big part of the UK index, so distorted the overall market return last year.

ESG considerations are also crucial. It is undeniable that if we use continue to use hydrocarbons in the same way and quantum, we will destroy the planet. We are trying to find ways to make money in a positive way that will help address the climate crisis. We have owned windfarm operators for nine years and are supporters of the grid to help deliver the electrification the country needs.

JB: Oil companies say they are investing in renewables, but they are late to the game. Shell’s balance sheet contains c$435 billion of property, plants and equipment, yet in 2022 the company made capital expenditure of just $2.6 billion in its renewable and energy solutions arm. Even if its entire annual capital expenditure budget of around $25 billion was fully spent on renewables, it would take decades to replace its current hydrocarbon assets.

Some firms have used the events of the past 18 months to increase oil and gas production. They have reneged on some of their own targets, and claimed it is because of the war in Ukraine. But let’s not forget that at $70, the oil price is not that high.

Banks have been the focus of investor attention this year. What are your thoughts on the sector?

CM: Regulation has continued to tighten, which is a barrier to the kind of returns seen before the global financial crisis. HSBC and Standard Chartered have spent the last decade trying to get their return on tangible equity back above ten per cent but continued to encounter setbacks.

We again tend to prefer mid-cap financial companies. Part of the reason people get excited about banks is they make a bit more margin when interest rates go up. But we are not trying to take binary bets of where we think the world is going to be and what rates are going to be.

Although this has not been a big driver of performance, we feel there are more interesting structural stories within financial stocks, whether that is in platforms like St. James's Place, Intermediate Capital, which is effectively a fund management business, and Phoenix. Given the big moves in inflation and interest rates, the latter looks well placed to benefit from increased demand from managers of pension schemes for buy-outs and buy-ins.

There has been quite a swing back towards growth and away from value this year as markets sense a peak in US rates. How has this affected your portfolios?

JB: We are mindful of style factors as an output of stock selection and portfolio construction, but it is not a starting point for our idea generation. We invest with a long-term view based on cash-generative company fundamentals, which can be viewed through a lens of where a company is in its cashflow generation lifecycle.

Figure 1: Cashflow generation lifecycle

Source: Aviva Investors, June 2023

• Future cashflow: Under-appreciated investment opportunities, driven by structural reasons and not a momentum or upgrade story. Businesses must be able to cover their cost of capital.
• Cash compounders: Companies with seemingly unique value, such as stocks that hold a leading position in their industry, have high barriers to entry or have secure cashflows, which can be re-invested or returned to shareholders.
• Cashflow recovery: Companies that offer strategic value, where cashflows may be depleted for company specific or macroeconomic reasons but where there are visible catalysts for change and a clear path for cashflow regeneration.

We often find clients correspondingly like to view these buckets through the style factors of growth, quality and value. Our approach gives us a flexible opportunity set across all style factors – driven initially by a fundamental, bottom-up approach.

We do not tactically trade with a short-term lens so, not having made big changes to the portfolio, we have not been massively impacted by these swings. We are not trying to second guess whether the market wants to buy growth or not. Within technology, one of our holdings is in Sage, which sells accountancy software and we believe offers us a recurring and growing revenue stream backed by structural demand. It may not be glamorous, but it has performed well.

Rising rates have led to cracks appearing in some areas of the equity market. Have you been paying extra close attention to companies’ balance sheets, their debt profile and ability to refinance?

CM: It is something we do all the time. We have never liked highly levered businesses. It is not a story for just now but over the next few years. If you are highly levered, your interest expense ratio is likely to rise considerably. But while there must be companies that have been kept afloat by low rates, I do not think there are many in our universe. What we have seen in terms of US regional banks is the tail end of a bubble, but the UK market is not highly levered.

You do not want a strategy predicated purely on economic growth and the bull market continuing. Good businesses will survive regardless of the environment. If you panic too much, you forget the world is still close to full employment. People are not being laid off en masse. Having said that, in a world of high inflation and rising rates, it will be tough for the consumer.

Are there any underlying themes you are looking to take advantage of?

CM: Defence is an interesting area. Names in the sector had been languishing as they were out of favour, partly owing to ESG concerns. But everybody is aware of the worsening geopolitical climate. Even before Russia's invasion of Ukraine, we were moving into a structural need for increased defence spending. Europe has underspent, Australia is investing and so is Japan, which is a big fundamental shift considering its attitude to having an army post the Second World War.

If the Ukraine war ended tomorrow, defence companies would likely roll off for a period. But when you see what the likes of Australia and Japan are doing, it's a structural long-term thematic.

JB: The other big theme is the climate transition. That informs some of our exposure to the mining sector because we need metals to make electric vehicles and build out infrastructure.

The outlook for the Chinese economy can massively influence mining shares, but the sector is interesting because we are going to need a lot more metals, and reserves have been depleted.

Furthermore, if we’re going to transition away from fossil fuels to more renewable forms of energy provision, with the critical need for infrastructure to implement and achieve the electrification of the UK economy, we believe companies such as National Grid, SSE and Greencoat Wind are well placed to benefit.

There have been concerns raised about a spate of companies opting to list in New York over London. Does this worry you?

CM It’s been blown out of proportion. The US has always been more highly rated than the UK and the rest of the world. When you have a lot of businesses either being sold out of private equity or family businesses listing, their motivation will largely be driven by where they can secure the highest price. That is often through a US listing.

We think London does have to look at how it attracts the right companies, and it has clearly not been helped by last autumn’s mini-budget fiasco and Brexit. But it is unclear there is some great exodus happening.