UK investment: a cheerful and fearful fund manager forecast

Nick Train of Finsbury Growth & Income outlines why there’s cause for optimism on UK investment prospects, while Gervais Williams of Diverse Income trust explains his gloomy prognosis.

August 1, 2019

Nick Trains reasons to be cheerful

What do Admiral, Autotrader, Experian, Flutter, Just Eat, Ocado, Rightmove and Scottish Mortgage investment trust have in common? The answer is they are all doing things with digital technology that would not have been possible as recently as 25 years ago; indeed, you’d have struggled back in 1994 even to conceive of what they do. But today they are also all constituents of the UK’s FTSE 100 index.

Now, no question it is both a shame and a conundrum that the UK stockmarket cannot boast a single FAANG – a truly global, mega-billion cap technology leader. It’s a conundrum because the UK economy has a good long-term record in innovation. Moreover, if we’re thinking about industries of the future, you might also regard it as a shame that three of the top 10 biggest companies in the UK still include two oils and a tobacco giant.

Repopulation of the UK stockmarket

But as evidenced above, the UK stockmarket is gradually repopulating with, let’s call them, 21st-century businesses. And from an investor’s point of view this is good news, for two reasons.

First and obviously, because these younger companies may have a longer growth runway so therefore have more opportunity to create value for their owners.

But second and more profoundly, their emergence confirms the UK economy as a space where ambitious and talented people can experiment with new ideas financed by individuals and institutions: new ideas that deliver social benefits as well as financial returns. And what is more, that is an observation which could have been made with justice at any time over the last couple of centuries.

On this idea of index regeneration, think about this anecdote. When Alan Jope, the new chief executive of Unilever, joined the company 33 years ago, only 8% of Unilever’s revenues derived from its beauty and personal care division. Today that proportion is 40% and growing more quickly than the rest of the company.

In other words, the brands that were paying Unilever’s dividends 33 years ago are not the same ones that pay today’s dividends. And the likelihood is that the insights that Unilever has into consumer tastes around the world and the cash its business generates today will allow the company to create new brands over time, that in turn will pay the dividends of 2052.

This is why it’s tricky to value any company, including Unilever, on its current earnings. You have to factor in its potential to respond to unknown opportunities in the future – opportunities that may well dwarf those of previous decades. And if that is true of individual businesses, it is even more so for a collection of them, like the FTSE All-Share index.

Value validation

That index was first compiled back in 1962, with a starting value of 100; today it stands at 4055. That represents an annualised compound return of 6.7%. And that’s just the capital gain, excluding any dividends. But the fact is that the founding constituents of 1962 did not create all that subsequent value, just as today’s are unlikely to remain relevant through to 2076.

So, when you make a case for investing in the UK equity market, it is a mistake to base that case solely on a consideration of the prospects for today’s companies. Instead, it’s important to make a judgement about the culture and entrepreneurial spirit of the whole economy on which the stockmarket is built. And the truth is that the UK is an entrepreneurial society that responds quickly to technology change.

The overwhelming majority of UK business people are energetic, ingenious and committed to sharing the rewards of their ideas and energy with shareholders and stakeholders alike. Bolstered by regulation, the probity of British business is probably as high as it has ever been. It helps that we speak English natively. When you take it all together, that’s a very attractive set of cultural characteristics for any long-term investor to consider committing to.

It is not trite to conclude that so far as the FTSE All-Share index is concerned, the best is yet to come.

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Gervais Williams reasons to be fearful

Markets have risen on a decade of ultra-low bond yields, as well as plentiful market liquidity. Meanwhile, while economic growth may have been patchy, China has bucked the wider trend, which has helped us all out.

The big question is, can we expect the past trend to persist? Global equity markets have turned more unsettled recently. Note the correlated pullback of nearly all stockmarkets at the end of 2018, for example.

Unfortunately, in my view, it is possible to have too much of a good thing. Take Europe, and the fact that government borrowing costs have fallen into negative territory. Ultra-low interest rates have been a feature of Japanese markets for decades, and their experience implies that ultra-low or negative interest rates come with perverse effects. They are a sign of stagnation, of absence of the vibrancy needed to generate future growth. Ultimately, negative bond yields sap their economies of the ability to put capital to work productively.

No more relying on China

But can’t we rely on the ongoing growth of China to help us out? I don’t think so. In my view, the adverse trend in bond prices is the market telling us that the decades of supernormal growth of China are now moving into the past. It also implies that the prior trend of easy market liquidity is becoming more sporadic. If this is correct, then there is a risk of overconfidence and of getting caught out. During downturns, those businesses with too much debt and those that are persistently loss-making will suffer disproportionately. It’s no use hoping that exciting growth stocks will buck the trend. Enthusiasm for loss-making mega-growth stocks can work both ways. Remember how precipitously the share prices of dotcoms fell in the end.

Dividend cuts to come

Meanwhile, the lion’s share of stockmarket dividends are reliant upon a relatively limited number of mainstream companies that operate in an even more narrowly based range of sectors. After years of squeezing dividend cover lower, some mainstream stocks have now reached the point where the only way forward involves a dividend cut. Vodafone has cut its dividend recently, and Marks and Spencer cut its dividend when it raised additional capital to fund the Ocado home delivery service. Some speculate there’s a dividend cut in the post yet to come from BT.

The nature of the problem is that the past virtuous spiral could turn a little vicious. Generally, the risks are most acute for those with substantial debt, especially when that debt becomes due for repayment at a time when the geopolitical events are unhelpful. In that case, they precipitate additional emergency fund raisings, dividend cuts and a rise in corporate bond defaults.

Furthermore, many mainstream quoted businesses still have major pension liabilities from the past. These were tolerable when assets were projected to grow significantly over the next couple of decades. However, a rise in corporate bond defaults, and or prospective dividend cuts, would destabilise the balance. Even minor mismatches in projected returns would add up to much greater pension deficits. Since the pension regulator isn’t likely to take a soft line on this, it too could lead to yet more emergency fundraisings and dividend cuts.

In a word, the reason to be fearful is correlation. All sorts of asset prices peak out at times. Our collective problem is that recent market downturns have become synchronised. One of the adverse side effects of the three decades of globalisation is that it’s happened everywhere. For example, the UK stockmarket may be dominated by several very successful oil and pharmaceutical majors, but these types of companies have been successful elsewhere too.

Going forward, investors will need to use their fearfulness to evolve their strategies. It is no use just holding stockmarket indices and expecting them to rise. All of us will need to be more selective. We (as active fund managers) need to use our intellect to identify companies able to sustain good and growing dividends, as opposed to those that lose out as globalisation fades into nationalism.

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Interesting article

‘Ultimately, negative bond yields sap their economies of the ability to put capital to work productively.’ Interesting point, but also worth pointing out that while Japans economy overall may have tracked sideways for a long time, there are also outstanding growth stories in this ‘stagnant’ market. One only has to look at trusts like BGS in small caps and BGFD I’m larger ones to see this story. Ironically Lindsell Trains Japanese Equity also shows this long term growth bucking the stagnation message. Like Train I see no reason this long term trend should not continue, even if short term valuations are arguably stretched and there will be short sizeable downs.

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