After some difficult years for value investors, Hugh Sergeant, head of Value & Recovery strategies at River & Mercantile, believes the good times are just round the corner. Listen to his argument in favour of value, and discover which stocks he’s been buying and selling for his portfolio.
Lee Wild, head of equity strategy, interactive investor:
Hello, today I have with me Hugh Sergeant, who manages a number of the River and Mercantile funds, which includes the ES R&M UK Recovery Fund that appears in the interactor investor list of rated funds. Hello Hugh.
Hello, good afternoon.
At River and Mercantile you run the popular UK and global recovery funds, could you just explain to our viewers how you define a recovery stock and what you look for in one that might make your portfolio?
Yes, of course, I mean we define recovery shares as those that have, first of all, a strong underlying business franchise, a depressed level of profits and as a result of that, a depressed share price, but are showing clear signs of recovering those profits to a more normal level. The profits of a recovery share are usually depressed due to either economic or sector dislocation, or perhaps poor management decisions. Or maybe a combination of both.
Now, the catalysts for recovery are most often either self-help, which is often encouraged by a new management team coming along, or economic and sector stabilisation, or a combination of both. It might be worthwhile just going through a couple of examples, just to illustrate recovery investing.
A good example in the UK would be Vistry (LSE:VTY), the old Bovis Homes, historically a good quality housebuilder, but it has struggled during the Covid pandemic, and this has caused the share price to fall to a big discount to its historic valuations. But it’s implemented a self-help plan and is now starting to deliver ahead of expectations and the shares are starting to cover.
And then, looking globally, The Walt Disney (NYSE:DIS) would be another good example, a global leading content business, but one that’s also suffered during the pandemic clearly as its theme parks, they have been impacted by the requirement for social distancing.
So, this impact has left the shares unloved, because profits are a bit depressed, and cheap in the context of attractive recovery potential over the next few years, and also the exposure to a couple of quite strong growth dynamics.
Value and recovery strategies have underperformed in recent time as investors have flocked to growth, and it’s especially true during the pandemic. Could you just explain why, and how your UK and global recovery funds performed?
It’s obviously been a difficult time for us as value investors over the last few years, and in particular, it’s been quite extreme during the pandemic period. Us and fellow value managers have struggled versus the benchmark and versus more growth or quality-oriented managers.
That said, we have done better than many of our value peers. I hope I’ve stayed in the game for the good times, which we expect to be just round the corner. And our funds have recovered strongly since the Covid crisis peaked back in March and April. And actually, the UK recovery strategy is now ahead of its benchmark over the vast majority of relevant time periods.
Over the summer, it’s interesting that you issued a 10-point checklist for a value revival, and as you say, value has been out of favour for a while. So, you said all the boxes were ticked, so is that still the case, and do you remain as optimistic as you were then, given the second wave of the pandemic?
That’s a very good point, I mean, the great thing as we sit today is that we’ve got good visibility in terms of vaccine, that seems to work well, and the result of that, I think we’re even more optimistic than we were back in the summer, with Covid cases peaking hopefully in the current quarter, I think we can look forward to strong economic growth in 2021 and 2022.
A very robust recovery in company profits, in particular led by our recovery type of stocks, and this combined with really low valuations for the portfolios that I run, so UK Recovery trades are only just over 1 x book value, and then it’s got a double digit, normalised earnings and free cash flow yield. Then we’ve got a bottoming out of the value cycle, which has been against us for the last 12 years.
And then what we also hope for is a broader market, particularly for the global fund, not one that’s just dominated by mega cap tech stocks. So, all this in combination makes me positive about our ability to generate strong, absolute and relative returns.
And then does the recent improvement in share prices that we saw at the beginning of the past week really, does that encourage you further? What’s your reaction to the share price rally in response to Pfizer (NYSE:PFE) possible vaccine?
It is encouraging, it’s great that other investors can see the virtue behind buying companies when they’re lowly valued versus their potential profits and cash flow versus their historic valuations, etc., etc., and not just be focused on the expensive stocks that have done well over the last few years, it had admittedly delivered better on very full valuations.
So, yes, it’s great to see other investors waking up to the attractions of lowly valued stocks, and that’s because they’ve become incrementally more confident about the outlook, and therefore prepared to look at recovery value type stocks, companies which may have short term not executed as well as some of the leading tech stocks, but which have very strong underlying business franchises on very low valuation.
So, it’s reassuring and hopefully that’s that start of a lot of great things from a rally in recovery type stocks.
And following the first outbreak of the pandemic back in late February, March, had you adjusted your portfolio at all, or have you adjusted it at all since then, I mean are there any stocks that you’ve got your eye on, as potential recovery plays or a particular sector that you’re interested in?
I suppose there’s been different phases since then. I mean initially when it was clear the kind of pandemic, well we were moving into a pandemic, that Covid was moving around the world, and we kind of had to look pretty closely at the portfolio, in particular the stocks, the stock that will be most impacted by the inevitable economic downturn and requirement for social distancing.
Especially when those stocks had a combination of operational gearing, so profits that would be hit by the economic downturn, and then some financial gearing. So, those two together would have been dangerous, so we did exit one or two stocks because of that work.
An example might have been Carnival at the time. We then looked at whether there was some really attractive quality franchises, which were being hit short term by the pandemic, but where the business franchise would very much remain intact, as new potential opportunities.
Stocks that have fallen too aggressive during the panic period, we bought into some of those, so examples would be Auto Trader (LSE:AUTO) in the UK and Walt Disney that I already mentioned listed in the US and also Booking, a very good example, a global leading, online travel agent with a great, great franchise, but clearly impacted short term by the pandemic, but equalling an opportunity to buy those attractively.
And then more recently, as we’ve become more confident, the 10 tests that you’ve talked about, more confident that we were towards the bottom of the cycle, the interest rate cycle in particular, we’ve been adding to some of the interest rate sensitives so that would include the banks in particular, who are very much geared to an upward movement in interest rate expectations.
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