17 Dec 2018
As an active, valuation focussed, long-term investor, I seek to invest in companies with strong fundamentals, that can be held for the long-term, when shares that are trading below my judgement of fair value. Correspondingly stock selection is the central tenet of my investment approach, and a superior consideration to that of the current macro-economic environment. However, I recognise that there are periods where factors coalesce to drive down the valuations of good quality companies within a particular sector or region. In this sense, macro-economic pressures can influence portfolio construction at the stock selection level.
The EU Referendum result has generated such an occurrence. Protracted negotiations, political uncertainty and confusion, have clouded the outlook for the UK economy. The result has been an indiscriminate de-rating of domestically exposed businesses. This phenomenon can be illustrated through the value ascribed to UK sourced revenues. Figure 1 plots the price/earnings (PE) multiple of UK derived revenues within global equity indices, against US derived revenues within those same indices. As the chart illustrates, global markets are placing a sharp, and sustained discount on UK derived earnings, despite broad stability in underlying earnings relative to the US. This suggests the market is concerned at the future margin potential for UK earnings, or even that it expects UK revenues to collapse.
Source: Invesco and Factset as at 30 September 2018. PE ratios have been derived from global indices (FTSE All-Share Index, S&P 500, MSCI Europe ex UK, MSCI Emerging Markets, Nikkei).
As an investor seeking undervalued investment opportunities UK domestics look very interesting. Whilst sterling accounts for c.25% of the revenue exposure of the FTSE All-Share Index, almost 40% of the portfolios under my management are exposed to UK sourced earnings. 1 This exposure is a result of opportunities found at the stock level, rather than a decision to expose the portfolios to UK domestics. One area where I have found some quality companies trading at attractive valuations is the Leisure sector.
1 Ciaran is named portfolio manager of Invesco Income Growth Trust plc and the Invesco Income & Growth Fund (UK).
In the UK Leisure industry, the quality of the product or service provided is crucial to a company’s survival. It is a highly competitive sector, where consumers have readily available alternatives. Two notable investments I have made within this sector are Whitbread, the owner of Costa Coffee and Premier Inn, and Young & Co.’s Brewery (Young’s), which operates a portfolio of pubs within the UK. Both businesses are, I believe, best-in-class, with the scale and quality of offering to consolidate and dominate their markets. However, both are vulnerable to changes in the domestic economy, as their operations are predominantly focused in the UK. Geo-political pressures have placed pressure on overall valuations within the sector. Against an uncertain and challenging backdrop, both companies exhibit the core qualities that I seek; shareholder friendly management, a good quality, competitive offering and strong fundamentals. These characteristics differentiate both businesses from market competitors.
The attitude of a company’s management towards shareholders is one of the most important considerations for a long-term investor, particularly those seeking to generate income. A management team’s motivations can impact decisions from short term capital expenditure to strategic acquisitions. Correspondingly I am looking for businesses where company executives are aligned to generating a sustainable, growing return for shareholders, Young’s founders retain a high level of ownership, whilst Whitbread’s management have a history of aligning the long-term interests of shareholders with strategic decisions. This most recently resulted in the spin-off and sale of its Costa Coffee business to Coca Cola. The majority of the £3.9 billion proceeds are to be returned to shareholders.
A competitive, good quality offering can prove the differentiator in a large and dislocated market such as Leisure. Young’s operates a broad suite of wet-led pubs; the focus is on drink, not food. This has proven a differentiator for the business, allowing it to withstand the proliferation of high-street casual dining, which has eaten into the clientele of Young’s food-focussed peers. Whitbread’s Premier Inn business meanwhile, benefits from its scale in a highly fragmented market. Premier Inn offers a consistent, replicable experience for travellers on a budget, and due to its locations across the UK can convert a higher number of travellers (particularly business travellers) in to repeat customers. Around 50% of Premier Inn’s earnings come from business travellers, where a multi-location offering and predictability of service are priorities. In my view, unbranded and smaller chains cannot compete on either front.
Both Young’s and Premier Inn have low gearing, relative to peers, and benefit from a high level of asset ownership. Young’s owns the majority of its pub estate, of which 84% is freehold. Management have a track record of investing in the company’s real estate portfolio, making sensible acquisitions and disposals. Through selective acquisitions Young’s has successfully tapped in to the affluence of London and the surrounding counties, 81% of its pub-estate is located within the M25. Whitbread similarly has a high proportion of freehold properties, with management focussed on further acquisitions to promote growth. Premier Inn has now launched hotels in Germany, where there is no existing large-scale provider of budget accommodation. The companies’ relatively low debt and high asset levels are attractive characteristics, particularly during periods where the outlook for the UK economy is less clear.
Macroeconomic pressures make the UK equity market an increasingly obvious place for the value conscious investor to seek opportunities. However, my investment process highlights the importance of looking underneath headline data, to focus on the company fundamentals at play. In remaining conservative in my investment approach, and seeking not only attractively priced investments but companies with attractive fundamentals, I am aiming to insulate the portfolios under my management from the ongoing political and macroeconomic uncertainty. I do not believe that the heightened uncertainty and negativity can perpetuate, as market mispricing presents opportunity. However, focus must remain on purchasing good quality companies with strong fundamentals whose prospects are not solely dependent on an improving economic outlook.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
The use of borrowings may increase the volatility of the NAV and may reduce returns when asset values fall.
The fund may use derivatives (complex instruments) in an attempt to reduce the overall risk of its investments, reduce the costs of investing and/or generate additional capital or income, although this may not be achieved. The use of such complex instruments may result in greater fluctuations of the value of the fund. The Manager, however, will ensure that the use of derivatives within the fund does not materially alter the overall risk profile of the fund.
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