Bill Mott is one of the UK’s longest serving and most experienced equity income fund managers. For many years he ran income funds for Credit Suisse and after taking a break for a few years is now doing the same job at the boutique firm of PSigma Investment Management. In this Q and A he describes how he is positioning his holdings for the future.
How are you positioning your fund now?
There are a number of different themes in the portfolio today.
1. Search for Yield
Interest rates will remain very low because the eventual removal of Quantitative Easing and the inevitable heavy tax increases will be sufficient to slow the UK economy. Those UK companies which have maintained or increased their dividends during the last two years are very unlikely to cut them now that the recovery has begun. We believe that a key theme for at least the next 12 months is that investors will become ‘yield hungry’. There are a number of larger UK companies which currently yield significantly more than 10 year gilts and we believe that these companies will undergo positive re-ratings. Their yields will gradually fall as share price appreciation delivers capital growth. Our favourites here are the integrated oils (BP, Royal Dutch Shell ‘B’), pharmaceuticals (AstraZeneca, GlaxoSmithKline), telecoms (Vodafone, Cable & Wireless) and utilities which all appear attractive on this basis, as do a number of companies from a variety of sectors such as RSA Group, Standard Life, British American Tobacco and British Aerospace.
2. Sterling Weakness and Overseas Stocks
Our view on sterling is that it is likely to be a weak currency for a sustained period of time. As well as having a very overseas -orientated UK portfolio, we have in addition allocated around 9% of the portfolio to overseas companies in sectors that are internationally priced and where there is a restricted number of UK companies that fulfil our requirements. This is a tactical rather than long-term strategic move. Our positive view on telecoms, pharmaceuticals and utilities has resulted in us adding to the portfolio some European stocks – KPN (yield 5.3%), Telefonica (yield 5.1%), Deutsche Telekom (yield 7.7%), Sanofi–Aventis (yield 3.9%), E.ON (yield 5.2%) and GDF Suez (7.25%) and the US Pharmaceutical Pfizer (yield 4.3%).
3. The ‘Nifty Fifty’
Assuming a very low growth environment in the UK and an anaemic recovery elsewhere, those UK companies which can deliver growth considerably in excess of the average will be re-rated in a return to the ‘Nifty-Fifty’ style of the 1960s and 1970s when the top 50 most popular large cap stocks led the market and rewarded a ‘buy and hold’ strategy. These companies will be able to deliver this superior growth because of their high geographic exposure to faster growing areas of the world, or because of the industry in which they are operating, or because of their superior technology, or management ability. We are balancing our high-yield portfolio with a number of companies which we believe will deliver superior growth. Companies in this category include Tesco, Wm Morrison, Reckitt Benckiser, Inmarsat, Healthcare Locums, Serco, Xchanging, Compass and Arm Holdings.
4. Consumer Staples
A particular sector we like globally as they benefit from a fast-growing global population. Their ‘global footprint’ makes them ideally placed to exploit the growing middle classes and their aspirations in emerging markets. In general they have underperformed the market rally as they are perceived as defensive. We believe they will be able to grow much faster than the corporate average in the future and will be in the forefront of the new ‘Nifty Fifty’. In the UK, we hold Unilever, Reckitt Benckiser, Diageo, British American Tobacco and Imperial Tobacco, whilst overseas we own Nestle, Johnson & Johnson, Procter & Gamble, Colgate Palmolive and Coca Cola.
What are your views on the global economy?
Unprecedented fiscal and monetary stimulus has allowed the world to recover from the financial crisis. The big question now is what happens when the stimulus is withdrawn. All the major deficit countries, such as the US and the UK, will have to reduce their budget deficits to retain the support of bond investors. However, with the private sector still de-leveraging, it is neither likely nor desirable that the recovery will be supported by increased private sector consumption. This would increase leverage and be a negative.
The traumas of the last three years were caused by global imbalances which allowed western consumers, particularly in the US and the UK, to become over-indebted. Global financial rebalancing is needed to sustain a durable recovery. Without this rebalancing, there will either be a prolonged global recession, a renewed bout of borrowing by an already over-indebted private sector, or ultimately unsustainable fiscal deficits. The big question is: how can this global re-balancing be achieved?
Given the impotency of the large deficit countries, attention will move to the high surplus nations such as China and other emerging and developing countries. These countries (particularly China) need to change their economic models, and they will need to change from targeting output to targeting growth. This can be done by focusing on growth in domestic demand rather than targeting growth in domestic supply. However, this change cannot occur whilst exchange rates in emerging economies are pegged at unrealistic levels to the US dollar.
If currency adjustments are not made, the results will be inflationary excess demand in surplus countries and deficit demand in deficit countries. These exchange rate changes are becoming essential to facilitate the global re-adjustment and ensure a durable global recovery. One consequence of this is that China will have to accept huge losses on its dollar asset portfolio. Even assuming that these currency adjustments are made, the global recovery still needs to be anaemic so that the adjustment is gradual and not disruptive.
Where does this leave the UK economy and stock market?
The UK is uniquely poorly positioned in the evolving economic landscape. Over the last 15 years, Britain has become disproportionately dependent on financial services, property speculation and consumer spending to fuel its £1.3 trillion economy. The UK will thus have a much bigger hangover from the credit boom than most other nations. Although the UK manufacturing sector is benefitting from the weakness of sterling and attracting orders from overseas markets, it comprises too small a share of the economy to pull the UK’s economy out of its slump on its own. What is more, as we have already pointed out, emerging economies need to change their economic model towards consumption and therefore traditional UK manufacturers may not benefit as much as expected.
Major policy errors by government and Bank of England have added to the UK’s problems. In essence, government and Bank of England inflation-targeting in the years leading up to the Credit Crunch allowed interest rates to remain too low for too long. The globalisation of the world economy with cheap products flooding in from emerging markets should have led to a major decline in inflation, but inflation-targeting allowed the Bank of England to achieve its inflation goal when every other economic indicator (house prices, consumption etc) was flashing red. This was the environment which fostered irresponsible behaviour by bankers, consumers and the government.
As Derek Scott, former economic adviser to Tony Blair, recently pointed out: “In an inappropriately low interest rate environment, investment spending is brought forward by households and businesses from tomorrow to today, so that when tomorrow arrives, budget constraints reduce spending at precisely the time when yesterday’s investment comes on stream, adding to supply.” The only way to keep things going is even lower interest rates, more Quantitative Easing, and even more government spending which, of course, brings forward even more ‘jam’ from tomorrow to today. So far, all the various fiscal and monetary measures have delivered stability and gentle recovery by bringing forward spending from tomorrow to today.
So you are not optimistic about the prospects for the UK?
The bond market in the UK will force the government to adopt a more prudent approach following the next election which is in May at the latest. It is time to face up to the fact that policy makers will have to tolerate a long period of very slow growth and high unemployment whilst the excesses of the past are worked out of the system in terms of both private and government consumption. In our view, Quantitative Easing should now be withdrawn. It has facilitated some re-financing of bank debt by large corporations, but only at the expense of an unnecessary rise in asset prices which increases the risk of inappropriate consumption by the private sector.
Cuts in the budget deficit need to be draconian both in terms of public spending and tax rises in order to persuade international investors to own sterling assets. The removal of Quantitative Easing and draconian fiscal action (huge tax rises) will be enough to keep growth at well below previous growth rates to allow for the long-term re-balancing that the economy needs. This will allow interest rates to stay at current very low levels for some time before eventually normalising as the anaemic recovery begins to build over the next few years. All the economic dynamics point to sterling being a weak currency for the foreseeable future. However, it is to be hoped that, if policy is appropriate then the downward adjustment of sterling can take place in an orderly fashion over a long period of time and not through a one-off precipitous fall of the pound against other major currencies.
Jonathan Davis 