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A top fund manager explains his investment process, why he sold Starbucks, and why he loves US banks.

17th January 2020 10:02

by Lee Wild from interactive investor

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Fund manager Freddie Lait explains his investment process, reveals why he still likes Starbucks despite selling at a record high, and why he can’t find a better opportunity than the US banks.    

[Video filmed on 17 December 2019]

Lee Wild, head of equity strategy at interactive investor:    

Did the makeup of your portfolio change in the months leading up to the general election, were you buying, selling anything, positioning the portfolio with a particular result in mind?

Freddie Lait, manager of the Latitude Horizon Fund:

Not really, we trade very infrequently on our stocks, we take a very long-term view, so we haven't added anything in the UK for a number of years. In the US we've added a couple of stocks over the last couple of years.

We did have some slightly long duration inflation-linked bonds in the US, and we shortened that duration dramatically. And our belief is that as political uncertainty eases around the world, bond yields will rally and there will be a sort of reflation trade around the world. 

In that instance you don't want to own a lot of duration. So, we took our average duration down from nearly 10 to about four [years] in the portfolio, which is quite a big change for us.

Lee Wild:    

I was reading your market commentary recently, and, interestingly, you mention there are about five to 10 stocks in the sweet spot of your investment process, but you suggest they're too expensive just at the moment. Could you name the stocks, or some of them, for us, and also explain the investment process that identifies those stocks?

Freddie Lait:    

So, I'm afraid we can't tell you the names, that would be telling; that's the secret sauce of what we do here. But the key thing, and that's part of our reference to” hunkering down” at the moment. We found these great ideas, we've been analysing them for a couple of years in some cases, or six to 12 months in others. 

They're really interesting businesses, they're great, possibly misunderstood, or possibly well understood by the market. But, at the moment, given global stock markets have rallied 20% or more this year, they are all too expensive. 

And we are just taking a very patient approach to investing in them. Our main investment process falls onto two strands, but it's all trying to judge how well that business can do over the next five to 10 years. We believe share prices will follow operating performance of a business in the long-term. 

And the two strands are; how well is that business positioned within the industry, and what are the ingredients at that business, does it have great management, great balance sheet and things like that. 

And the second one is assessing the industry itself. Is this an industry where you truly believe there's going to be a growth in addressable market, higher margins in a strong capital cycle for the next three to five years? 

If so, you've got two advantages at your back when you're thinking about investing.

Lee Wild:    

Are you keeping, perhaps an unusual level of cash back, an untypical level of cash that you might otherwise not hold in different circumstances, that is ready to deploy?

Freddie Lait:    

Yes, it is. We don't love holding cash, but I think from time to time it's the wise thing to do. It’s the ‘if there's nothing smart to do, don't do anything’ kind of argument. So, we do hold a decent level of cash in the portfolio at the moment, and we will take more opportunities if volatility comes in the market.

Lee Wild:    

You had a 12% allocation to gold earlier this year, over the summer. Interestingly, you haven't got that now, so you've exited that trade. It would be really interesting to get an idea around the thinking behind the entry, and also the exit, and perhaps what you think of gold now.

Freddie Lait:    

Gold is still a reasonable investment now, but we have exited it because we actually think there's a meaningful risk that you could lose a decent amount of capital in gold at this stage in the cycle.

We invested around a year and a half ago, we put about 10% of the portfolio in, which went up about 20%, leaving us with a 12% position when we exited. 

And we invested when stock markets were at highs again at the end of last year, and rate expectations around the world were very high. Bond yields in America were three-point-something percent, they're now one and a half. Everyone was expecting rate rises around the world, whereas now everyone's expecting a return to zero. 

And what you saw was in that change, in that move to lower bond yields and actually 25 to 30% of global government bonds yielding negative yields, which is an amazing statistic. Gold, in terms of relative value, shot up. But now at this stage in the cycle, we see a number of scenarios where gold actually won’t act to protect in your portfolio.

If we see a return of inflation for example, if we see higher yields, I imagine there's an environment where actually equity markets could de-rate at the same time as gold falling.

And what we're really trying to do with gold and bonds and our other investments, is to reduce the risk of those equities. And I think those speculating on gold at this phase may actually be doubling up their risk rather than reducing it.

Lee Wild:    

Another interesting trade is Starbucks (NASDAQ:SBUX). You once owned quite a large stake, it looks like you've halved that over the summer. Again, what was the strategy behind the entry and the exit of that percentage of the stake?

Freddie Lait:    

Coming back to our patient approach to investing, we stumbled across Starbucks, obviously a well-known business, but still takes a little bit of analysis, about three years ago. 

And the stock has been going sideways for around three years, prior to when we bought it in Q4 last year, which was during a big bout of market weakness. The stock had gone sideways, but earnings were up 60%, and this was this incredible feature where actually people are nervous about Starbucks because it's got a lot of China exposure.

And for the last few years people have just been selling things blindly because of China exposure. But, actually, it's a fantastic business, it makes nearly 100% return on incremental capital for every store it launches - it spends $100,000, then makes $100,000 in operating profit every year from that store.

Quite a phenomenal thing, and I've never seen it in retail or restaurants around the world before. So, I love the Chinese business for the long-term. In the short-term we'll take some hits on market performance and perhaps currency. But a long-term story to get access to a stock like that at such a cheap valuation was incredibly attractive for us and worth the patience. 

What happened over the next year was the stock, very successfully, almost doubled? It went from around $54 when we bought it to $100, and we cut back the position substantially in the 90s.

So that's just good portfolio discipline. We still like the story, but, given it had doubled and was becoming an even more meaningful part of the portfolio, we had to trim it back down.

Lee Wild:    

Staying in the US, you own some US bank stocks, and some other US stocks as well. Are you still bullish on the US banks and North America, US presidential election year as well; that must feed into your thinking? 

Typically, a good year for equity markets, is a Trump election victory necessary to keep the rally going?

Freddie Lait:    

It depends who he's up against. I think if Warren wins, for example, it would be a little bit more scary for the markets, and certainly when you see Elizabeth Warren's ratings going up, you do see the market rating coming down.

But if it's Biden or someone like Bloomberg, or someone more centrist that comes into the Democratic nomination, I don't think it will be as dependent on a Trump victory for market stability. 

In terms of the US banks, yes, we’re still very keen. We invest globally, so we’ve looked at the Japanese banking sector, the European banking sector, the UK and the US to see where we found the most attractive opportunities. 

And really, I can't find a better opportunity set than the very largest US banks. Highly capitalised, very high-quality assets to be supported by that capital, they're doing 10 to 15% returns on capital, returning all of that to shareholders. 

You're making a 10 to 12% yield as a client through buy backs and dividends each year, in some of the best franchises in the world. So, I truly believe the US banks have, again, a number of years ahead of them. 

Lee Wild:    

Once again, US markets likely to lead the rest in 2020?

Freddie Lait:    

It feels like it, there may be a catchup from the UK, but I would fade that catchup if it was more than 15 or 20%.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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