How we’re approaching the software sell-off

Concerns over the impact artificial intelligence (AI) advancements will potentially have on the digital economy prompted a sell-off for certain shares and sectors. Mike Fox, fund manager of Royal London Sustainable Leaders C Acc, explains his approach to the situation, given the fund has holdings in RELX (LSE:REL), London Stock Exchange Group (LSE:LSEG) and Experian (LSE:EXPN).

Fox also discusses healthcare holdings, his stance on banks, and explains that the key reasons for performance lagging the index in recent years is due to the strong rally for sectors it cannot own, such as defence companies.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to our latest Insider Interview. Today in the studio, I have with me Mike Fox, who manages a range of funds for Royal London Asset Management that have a sustainable remit. Mike, thank you for your time today.

Mike Fox, fund manager of Royal London Sustainable Leaders: You’re very welcome.

Kyle Caldwell: So Mike, we’re going to focus this video on Royal London Sustainable Leaders Trust. It’s a fund that invests in UK companies that have some sort of sustainable remit. To kick off, could you explain how the fund invests?

Mike Fox: The idea of the fund is to try and deliver high single-digit compounding returns over a long period of time, so we tend to want to invest in better-quality companies, but then also companies that help transition to a cleaner, healthier, safer, more inclusive society, which is really the link into sustainability.

Kyle Caldwell: In terms of sectors, I assume given the sustainable remit, you’re drawn to certain areas?

Mike Fox: Definitely. So, areas like healthcare, technology, engineering, chemistry, certain types of infrastructure tend to have much better alignment than things like armaments, defence, tobacco, and sectors of that kind. So, over time we do have sectorial biases which we think make sense, but as always sectors can come in and out of it.

Kyle Caldwell: There aren’t that many UK funds that have a sustainable remit. What makes this fund different?

Mike Fox: It’s interesting because in some respects sustainability started in the UK. The UK remains at the forefront of corporate governance, environmental and social practices, so the fact that there’s fewer funds than maybe there has been in the past is quite an interesting observation.

But I think what makes the fund unique is how long we’ve been doing this for, so this is my 23rd year of running the fund and the fund has been around since 1990. I think it’s that heritage and understanding how to integrate sustainability, of market and economic cycles, which is really quite powerful.

Kyle Caldwell: You’ve been managing money for over 20 years and you’ve proven in that time that you can make very good returns out of investing sustainably. However, in more recent times, over the past couple of years, the fund has underperformed the FTSE All-Share index. What are the main reasons behind that? Are there any particular culprits that you pick out?

Mike Fox: Yeah, it’s an interesting question, so when we look at the objective, which is the high single-digit compounding returns, the last few years have been very much in line with that and last year the fund was up, I think, 16.4% after fees.

So, bottom up we see the fund progressing quite well. Top down, it’s a very fair challenge to say that there’s been parts of the market - defence would be the classic one, I think - that have done extremely well that a fund like this won’t typically access.

More recently, there’s been some kind of concerns over AI and the digital economy, which we may come on to. But, really, when you look back over the last few years, it’s really been things like armaments that have been the biggest difference between us and the index.

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Kyle Caldwell: So, has it been a case of the companies that you can’t own being the reason for that underperformance rather than the companies you do own?

Mike Fox: Yeah, I think it’s primarily so. We’re sitting here at a point in time where there’s quite a lot of uncertainty around the digital economy, which I think is quite an interesting factor for sustainable funds, because we quite like the digital economy for a number of reasons.

I think if you took the last couple of months, it’s been some things that we can own that have been a little bit weaker. But I certainly think if we looked [at] the last few years, it’s typically things that we don’t [own] for sustainable reasons.

Kyle Caldwell: Over the past couple of months, the fund has had its fair share of software-related pain. I can see in your top 10 holdings, you own London Stock Exchange Group and Relx. What has this done to change your conviction in the sector?

Mike Fox: I think it’s important to keep an open mind on what’s going on with AI at the moment. There is a real fixation over AI and its impact almost on every sector and every part of society. I think the faith in the digital economy being an area where companies can build franchises and grow profits over time has definitely weakened in the last few months, mainly because of all these kind of Anthropics and OpenAIs, which are putting out new products.

Our view is that the companies that we own [have] very unique datasets and very strong franchises and therefore may even benefit from AI, but I do think it’s become a more complicated area than it has been. So, I think it is really important when new developments come along that you do keep an open mind as to what might happen next. But you’re right, at the moment, we do own those businesses.

Kyle Caldwell: Have you been using the pick-up in volatility as an opportunity to take advantage of lower share prices for them?

Mike Fox: For those no, to be blunt. I think we need to accept that the environment for some of these companies has changed. I think sometimes it’s right to wait.

While the default can be something has fallen, something is cheaper, you should buy more, I think, actually, a lot of the time that’s correct. But I worked through the internet era, I worked through the financial crisis, and Covid. You get these periods of time where the fundamental construct of markets and sectors begins to be challenged and sometimes you’re just better off waiting to see what happens next and at that point you can buy the shares tomorrow or the week after - there’s no pressure to have to do something today.

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Kyle Caldwell: We’ve seen the UK stock market have a very strong run of late. Where are you finding the best value opportunities?

Mike Fox: Yeah, it’s a fascinating question. For pretty much all the time I’ve run this fund, growth stocks with better growth prospects and higher returns have been at a premium. Whereas now, they’re not. They’re actually trading at a discount to the kind of market average.

So, some of the companies we’ve talked about already, you can buy them at discounts to the UK market. This would have been unheard of a few years ago. Then, on the other side, you mentioned defence, but banks and other areas have done extremely well. So, if you can get comfortable with AI in the digital economy, what’s going on there?

That’s the big question to answer. The real value part of the market now is what people thought would have been growth three years ago, and the real growth part of the market is what people thought was value three years ago.

So, you’ve had this complete inversion of what’s performed, and that’s got quite interesting implications for what might perform going forward as well.

Kyle Caldwell: And are there any particular companies that you would point to that you hold?

Mike Fox: Yeah, you mentioned one, Relx. We had the chief executive come in last week and clearly he’s quite a frustrated individual because he’s just upgraded his revenue and profit guidance for the year ahead and his shares have been really weak. And you know he would say AI will be an accelerant for their business, it’ll allow them to do things they haven’t been able to do previously and it trades on a multiple now that is not that far away from what you’d pay to own a bank, and they’re very different industries.

I appreciate that would be a good example of a company that’s significantly derated, but the reasons for it are quite unclear as to whether that’s correct or not.

There are others as well. Experian is a good example of that, and London Stock Exchange is a good example. But they are today’s value stocks, and the growth stocks are now the BAE Systems (LSE:BA.) and Rolls-Royce Holdings (LSE:RR.), and so on and so forth.

Kyle Caldwell: Healthcare is an obvious hunting ground for a sustainable fund. I can see that AstraZeneca (LSE:AZN) is a top 10 holding. Could you talk us through other exposure you have to that sector?

Mike Fox: Yeah, so we own GSK (LSE:GSK), or GlaxoSmithKline as it used to be called, and Convatec Group (LSE:CTEC), which is a chronic care company.

These are quite interesting businesses. If you look at how narratives build in markets at the moment, over the last couple of years there’s been dot, dot, dot is dead. So, two years ago, China’s dead, China’s investable. Six to nine months ago, it was healthcare’s uninvestable because what was going on with Trump, now it’s software is un-investable.  Only time will tell us whether these narratives are right or not.

But healthcare’s gone from being uninvestable 12 months ago when Trump was elected, to being AI resilient and an AI beneficiary.

So, AstraZeneca and GlaxoSmithKline have performed particularly well, Convatec a bit less so for operational reasons, but we think they’ll be resolved in time. So, healthcare is definitely having something of a renaissance as a sector.

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Kyle Caldwell: Financials is a key area of focus for the fund. Could you talk us through your exposure to that sector?

Mike Fox: Yeah, so most of our exposure we put in in 2022, which is really when the interest rate environment adjusted.

We did own banks before that, but in much less quantity and we own Lloyds Banking Group (LSE:LLOY), NatWest Group (LSE:NWG), HSBC Holdings (LSE:HSBA), Standard Chartered (LSE:STAN) and also Prudential (LSE:PRU), which is more life assurance.

They are all businesses that performed extremely well. I think it’s one reason why the fund has been able to compound at the rate it has, even though the growthy side of the portfolio has been more challenged for reasons we’ve talked about, having a big proportion of it in banks has done really, really well.

The big debate now is whether that has played out effectively and whether the banks ultimately that have benefited with the higher rate environment, but we all know that now. So, the question, really, is whether it’s time to recycle money out of banks into other areas.

Kyle Caldwell: In regards to interest rates, is there a certain level that you’re looking for? So, let’s say, for example, UK interest rates fall to a certain point, will that cause you to reduce your exposure to UK banks?

Mike Fox: Below 3%, I think, is the level that the banks would say it gets more difficult. At 3%, they can still make a good spread on the loans and there’s actually demand for credit.

One of the problems with higher rates has been that demand for credits has been really absent. But you get below 3%, and I think the reasons for that would be if AI truly is as disruptive as some people believe and creates unemployment, then interest rates would have to be cut. So, that’s not necessarily our scenario.

It was pretty observable in a world of 1% to 2% interest rates that the bank business model was challenged. And even though we think the sector is better quality, we think it would still be quite hard in that environment for them.

Kyle Caldwell: For the more growth-focused part of the portfolio, which you’ve mentioned, there have been some companies that have struggled in the prevailing macroeconomic environment.

Could you give us a flavour of some examples of companies that you own in that area that you think, on a long-term view, should recover their poise?

Mike Fox: Yeah, I do think that there’s a real lack of granularity to the software narrative. I think what LLMs, as they’re called, large language models, these AI tools, do really well is these generic workflows, where you don’t need any sector expertise or data.

But what they don’t do so well if you’re a healthcare physician or if you’re lawyer working in a industry that’s regulated and the impact of your decisions being wrong are quite material, they don’t work very well in that environment because they don’t have the context, they don’t have the data and so on and so forth, so we do think that that’s a reasonable case for some of these businesses repairing their past glories if you like.

There’s other ones as well, businesses like Compass Group (LSE:CPG), which is a really high-quality compounder that does a lot of catering in businesses and industry, and they’ve been tagged a little bit with this ‘AI loser’ [label] if there’s going to be fewer people in the workforce.

So, I think if the AI narrative just becomes a little more balanced, there’s quite a few companies in the portfolio that could actually perform pretty well from here.

​​​​​​​Kyle Caldwell:Mike, thank you for your time today.

Mike Fox: Thank you.

​​​​​​​Kyle Caldwell: That's it for our latest Insider Interview. For more in the series, do hit the subscribe button and hopefully I’ll see you again next time.