228. There’s always rain in the desert for stock-pickers

Published 8 December 2022 (pre-recorded 1 December 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRO]

Darius McDermott (DM):

I’m Darius McDermott from FundCalibre, and this is the Investing on the Go podcast. Today I’m delighted to be joined by Chris Kinder, who is the manager of the CT UK Extended Alpha fund. Chris, good morning.

Chris Kinder (CK):

Good morning.

DM: Maybe I’ll just say one word of introduction on this fund for our listeners. This fund does have the ability to go … have a long book, but also a short book as well. It’s not a market neutral or a hedge fund or anything like that, but it does have the ability to take some positions in companies that they like, and maybe to have a small, short book of companies that they don’t like.

[INTERVIEW]

DM: So, Chris, let’s get into this then. So, for the past few years we’ve seen central bank intervention, propping up markets, you know, all tides rising, maybe not so helpful for your investment style. Now that has stopped – yet to properly reverse – but, in short, do you think we’re in a better market condition for your style of investing?

CK: I do, at the margin, yeah, I do. I definitely feel that reflecting on the last … basically, the sort of the post-covid period of excess liquidity, and the way that that drove valuations in relatively narrow sub-sectors of the market to, [what] I think what will be considered – when we look back on it – as excessive levels, that was quite challenging I think, for people just to get their head round just the extreme nature of the moves that often were not supported by historical financial performance or prospective financial performance. And so, yeah, that was quite challenging, and I do feel quite encouraged that that wave of liquidity and that excessive, what you might call speculation, is being removed from the market. So, it is the one positive side effect of what’s been going on with interest rates. It is crushing speculation, which is positive.

DM: So, as I mentioned in [the] introduction, in this fund, you do have the ability to be short of sectors [and] stocks, that you think are out a favour. I noticed that you’re short industrials, real estate and financials, what is it about those three sectors – again, without picking on individual stocks that you’re short on – that [have] the characteristics that you think are unfavourable in the current market climate?

CK: Yeah, just for context really, just so people understand; we do shorting on a bottom-up basis. So, in and of itself we don’t sort of sit here and go, we have a view on industrials that is cautious, therefore we have these short positions. For us, it’s very much about identifying idiosyncratic mispricings within various sectors. So, we actually have plenty of exposure on the long side in all of those sectors and exposure on the short side as well. I mean, particularly within industrials, we believe there are still a cohort of shares that still – even though they have derated relatively sharply over the last 18 months or so – still have a fair degree of downside risk to the multiples. And of course, you know, it doesn’t take a genius to work out industrials, with the economies where they are, there will be volatility and earnings that often downside risk certainly isn’t priced into a number of these shares. So, we tend to do things much more on a bottom-up basis. And it’s not particularly taking big sectoral views.

DM: Yeah, you talked about earnings and I’m very lucky in my job to see lots of different fund managers and, you know, [it] looks like we’re going into one of the biggest telegraphed recessions ever. I’m not hearing that earnings are getting absolutely smashed yet, that doesn’t appear to be a factor. Do you think that’s coming?

CK: Honestly, I would agree. It’s not a given. I think that’s my sort of central case really, that what I’m very confident about is that the derating we have seen, has protected prospective returns against future downside to earnings to a degree: ie. any earnings downgrades that may or may not be coming, has – to a significant degree – been captured in the multiples and indeed the expectations already.

So, when one looks across portfolios, there are a number of companies where earnings next year are already forecast to be below this year, which might make sense in certain scenarios, and the multiples on those lower numbers are also very low. So, selectively, you can make a very powerful case, [that] expectations have already been crushed and multiples on those are very low, implying there is no recovery thereafter. So, even if there is a recession, history tells you there is generally a recovery as well. So, there’s an argument that we’re seeing sort of both of those things being in the price.

Yeah, and you know, it depends where you are, doesn’t it? It depends … in my view on all these things is there will always be certain pockets of growth and performance. You know, there’s always rain in the desert, for want of a better phrase. So, I think it’s our job as stock pickers that even if there is a very difficult world next year, we should be able to find things that do relatively better. That is our job.

DM: And where maybe then, and I want to touch on a few stocks in a minute, [in] which sort of areas are you seeing those pockets of growth?

CK: Thematic investing, as I said, it is not really our thing, we’re much more stock-pickers. But if you…  I mean the dreadful phrase, energy transition, <laugh>, there is going to be a huge amount of money spent in this area over the next decade. It is incumbent upon us I think, to look into that sort of area and find beneficiaries of that.

The theme of onshoring or reshoring or moving production back into [the] developed world, particularly the USA; that is going to be a very rich vein of spending for many, many years to come. So, are there ways of benefiting from that?

The UK’s not a great luxury market, [but] you know, is luxury spending going to sort of continue? So, there will always be interesting things. At the moment we’ve got this quite unusual situation where businesses that have historically quite resilient growth rates in the staples space, these things have all lost a ton of value as well. So, the growth rate of something like Diageo, for example, may slow – we’ve seen how Diageo performs in previous cycles – [but] it does tend to come through quite well. So, there’ll always be something we can invest [in], I could go on <laugh>.

DM: Okay. Look, so you’ve made your point and I think it’s absolutely well made about you’re a bottom-up stock picker so, let’s get into a few stocks then. One of your top holdings is London Stock Exchange. I believe that actually it’s just lost its position as the premium stock exchange or the number one stock exchange to the French. Does that impact your investment or does that give you a thesis on your view on UK stocks or.. tell us why it’s still a top 10 position?

CK: Yeah, no, there’s a couple of things in that. And I think that the major problem is the name of the company and they actually call themselves LSEG <laugh> – which is the London Stock Exchange Group – which is interesting for many reasons, but, when one looks into it, the London Stock Exchange is in fact about 3% of the company’s revenues; the business has diversified itself over, you know, we’ve been long term holders in this. And the theme of LSEG group, for want of a better phrase, has been diversification over a 10-year period. So, they have systematically built-up positions beyond what was just the London Stock Exchange many years ago. So, they have businesses in clearing, they have derivatives trading, they have bought – in the last two years – a very, very significant financial data business. So, it is incredibly well diversified, and I would say this is a classic sort of business that you would expect it to be able to grow pretty much regardless of the macro-economic conditions that prevail.

I mean the really interesting question underlying that – thanks for bringing it up – is just how sort of insignificant the UK stock market would appear to be becoming on a global stage. I believe that at some point, Apple – maybe still is – Apple is greater than the entire market cap of the FTSE 100 or even the FTSE All-Share, who knows. So yeah,…

DM: It certainly was in covid times as they had that massive rally.

CK: … Yeah, it did. So, of course, what you’re alluding to, is the systematic disposal of UK-listed stocks by traditional owners. These are the big things that we in the industry are wrestling with at the moment. So, what I think we are seeing is a generational ownership shift from the traditional owners of UK companies, to a whole new cohort. There is a reason that the UK market is, I guess, I don’t know the word, is it suffering from? or benefiting from? or is it experiencing? a wall of M&A. You’ve got this systemic selling matched by systemic buying from new non-traditional owners; from wealth funds, high net worth individuals, other corporates, global corporates looking to pick up their competitors and rivals in the UK or adjacent businesses. Then of course private equity, which is obviously in abeyance at the moment. But you know, these have been very quiet over the last couple of years. These have been quite powerful themes, which is leading to an ever-smaller UK stock market. But that, but it is part of this ownership change, which I think is really interesting.

DM: And has this fund been a beneficiary of M&A in the last 12 months? [Have] you had any takeouts?

CK: We have had one; surprisingly, only one, actually. And yeah, we were shareholders in Aveva [AVEVA Group plc], the industrial software company. And that has been taken over by its largest shareholder, and I think that is absolutely symptomatic of what we’re seeing – that the share price fell very sharply on … this is the point about a derating of quality companies. We didn’t actually own it. We’d been wanting to own it for many, many years. Always felt it was a little bit overvalued for us. [The] share price fell down, we were able to invest in it, to make a targeted return, and that return obviously came much quicker than we were expecting because of the intervention of Schneider [Schneider Electric SE]. So yeah, so, that was one. But you know, over the years we’ve had a long and illustrious track record of our companies being taken over. Which I mean, yeah, one is always too minded about it because one hates to lose a business such as Aveva, but if you can recycle the money into similar opportunities or opportunities that offer a comparable risk reward, then of course we’ll do it.

DM: Okay. So, another name that I think has gone into the portfolio recently is SSE [SSE plc]. Would you tell us a little bit about what you like about that?

CK: Yeah, SSE: again, [a] really interesting sort of case study for us, really. I think quite a good example of what we try and do in that we’ve been watching [SSE], probably for about 18 months you know, sort of observing basically the opportunity that this business has to deploy capital in quite interesting areas. You know, when whenever we look at it, we test and probe their ability to make a return from this capex [capital expenditure] program that they’re about to embark on, which is going to be massive. We’ve made ourselves comfortable that they probably can and that there is going to be long-term demand for the products and services they provide. And for us, therefore, it was just about waiting to invest in it at the good price.

And of course, with the chaos that we saw over the last quarter or with fears around windfall taxes or price caps or whatever these regulatory mechanisms might be, coupled with the big selloff in, in UK domestics assets and particularly utilities with the rise bond yields, this created what we felt was a pretty decent entry point to invest in a very interesting business, at a very attractive price. And that’s exactly what we did. So, you know, we think it offers a really nice balance of resilience, growth, and of course sensitivity to inflation, which you know, is quite hard to get in a high-quality way. So, it ticks a lot of boxes for us, SSE, and we were able to buy it at a really good price when everyone else was selling it. So yeah, really pleased with that. And so far, so good.

Since then, of course we’ve had this – [and this] is part of our thesis – this idea that they have a certain set of assets in their portfolio that to third parties are hugely valuable. So, they sold part of their distribution or transmission businesses for, I think it’s 1.9 times the regulated asset value to again, to, I think it was a Canadian pension fund. So, you know, this idea that the UK doesn’t have interesting assets, is very unusual. And of course, if you applied that valuation to the rest of the group, you’d get a much higher share price. So yeah, it ticks a lot of boxes actually, SSE.

DM: So, maybe the Canadian Pension Fund will do that for you and that would be a nice result. So,

CK: Well, if the rest of the market were willing to pay what the Canadians are paying, then we wouldn’t have a problem. Which again, and that’s the thing, Darius, I mean, when these bids happen, they don’t come in at a 10% premium. They’re 50% higher, you know? This is … the listed… the prices on the screen and not close to the real industrial values of these businesses. So …

DM: Maybe then in sort of close, and I know you’re a stock guy rather than a macro guy, but you must have to think about 2023 and the rate environment and what that means for stocks and discount rates, and how you value companies and all that sort of thing?

So, maybe if we could close with some thoughts on the outlook for 2023. I think we’ve already touched on some of it, which is, you know, UK stock market unliked by traditional investors, but maybe liked by different types of investors… what’s your thinking there and are there any areas from a sector basis or – and feel free to not mention stocks that you’re short of, I appreciate that’s not possible – but describe maybe some of the characteristics of a stock that you’re short of.

CK: Oh wow. Yeah. Funnily enough, at the moment, I mean, this partly answers the question, we, [at] the risk of sounding naive, we are feeling a lot more constructive about the longs and the shorts in that …

[DM: That’s a nice way to be <laugh>]

CK: … Well, I mean, again, we sort of play what’s in front of us, without oversimplifying it. We feel this year we’ve had very significant gains in the short book, ie. the shorts have fallen very severely. And our mission, over the last couple of .. [a] month or so, ever since, to be honest, ever since the change of government… there’s a lot happened in the last six weeks, which is better … which is more conducive to risk-taking on the positive side.

And so, we have been reducing the short book, ie. taking profit where we’ve made very decent gains in a very short space of time. And the portfolio on the long side…and so, the overall direction of the portfolio has been pivoting at the margin, to UK domestics, which became extremely oversold during, I guess, the Kwasi Kwarteng – Liz Truss, the short era of those two. There was effectively capitulation selling in UK risk at that point. So, what we are looking for in [the] UK is winners.

And this is not particularly us saying we believe the UK is suddenly a great place to invest or there’s a sort of a step change in the UK economic outlook, although it’s obviously better as interest rates come down, which is what’s happening. It is much more … ‘rain in the desert’ is my favorite theme for the UK –  businesses that have competitive advantages, that are able to take advantage of the weakness of their competition, take market share and emerge from this crisis relatively stronger.

I mean, probably the poster child for that, I don’t know if you want to talk about stocks, but you know, it’s something like a Whitbread [Whitbread PLC]. It is so clear that the competitive environment in which they are operating, the competitors are falling by the wayside at a faster rate than ever before. Whitbread is well capitalised, the lowest cost operator, they have an opportunity to move forward. You’re already seeing this in the way that the room pricing is improving, and they have an opportunity to expand their estate as others are retrenching. Something like that is really interesting to me. You know, they’ve got a well-financed business with a strong proposition, good business model, [it’s a] quite interesting time for them to move forward. So, things that can do relatively better in a tough environment.

DM: Yeah. Well, I was just going to say balance sheet, you touched on it there. I think balance sheet is going to be an important factor in 2023 with higher rates than have been in the marketplace for the last 15 years.

CK: Yes. I don’t think you can [be] over-rewarded for financial risk next year. So yeah, strong taking advantage of weak competition moving forward. The other thing that I’m quite interested in is kind of what’s going to happen to what you might call long duration assets or bond proxies. I think at the margin, I probably am in the camp that the dollar has peaked, inflation has peaked, interest rate expectations, has peaked. And as these rates come down, you might start to see multiple expansion in long duration assets. So, it might be a time to revisit defensive growth. That’s been quite a tough space over the last year or so, having been very, very strong for a number of years. So, I think if you can buy a solid defensive growth company, at multiples below the 10-year average – which you currently can – you might see the opportunity for those earnings to grow in what remains a tough environment, but also a little bit of multiple expansion as well. And then you’re not taking too much risk there because you’re buying sound companies fundamentally. So, that as a theme is quite interesting to me.

DM: Chris, thank you so much for your time. That’s been a really interesting whistle stop through UK equities – why they’re liked or disliked, who’s buying them and some interesting stocks and areas to look at for 2023. So, listen, if you’ve enjoyed today’s podcast, please do like and subscribe. And if you’d like further information on the CT UK Extended Alpha fund, please do visit FundCalibre.com.

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.