A top fund full of dull and boring stocks

Hugh Grieves, co-manager at the Premier Miton US Opportunities Fund, explains how he outperforms the US market, why he doesn’t own tech stocks, and a share that could do well in a market crash.

Lee Wild, head of equity strategy, interactive investor:Hello. With me today, I’m lucky to have Hugh Grieves, co-manager of the Premier Miton US Opportunities Fund. Hello Hugh.

Hugh Grieves, co-manager of the Premier Miton US Opportunities Fund: Good morning. How are you?

Lee: Very well, thank you. It’s typically more difficult for active managers to consistently beat Wall Street, but you’ve outperformed your benchmark over multiple time periods. How do you do it and has it become harder to achieve as stock markets hit record highs, and valuations become more stretched?

Hugh: Look, I mean, obviously, we could go into huge amounts of detail, but at the very basic level, we’re very selective and importantly, we’re very patient. And what do I mean by that? We only invest in a small subgroup of the market, which is those few companies that are able to deliver very consistent and very predictable returns that can steadily compound over times. And then we wait very patiently until we’re able to buy those companies at a valuation which, on one hand, gives us good margin of safety if we’re wrong, but on the other hand, offers significant long-term upside if we’re right. 

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And then once we’ve bought a stake in this company, we hold it for a very long time and we only sell, really if the investment thesis changes, or if the valuation that the market offers us is so high that we can’t really resist selling and moving capital onto another opportunity.

Lee: OK, well your portfolio’s largest weighting currently is to industrials, but consumer discretionary and financials are very close behind.  Could you just explain the thinking behind this sectoral exposure?

Hugh Grieves: Sure. So in short, it’s really, industrials, consumer discretionary and financials are the main cyclical parts of the market. Those sectors which benefit most from a stronger economy, and it’s a sector that’s been out of favour for so many years now. What we’ve seen over recent years is, everyone’s concentrated on technology, on secular growth, because that’s where, almost exclusively, the earnings growth has been over recent years. So now, within the market, we’ve reached a crazy situation where tech – which include Amazon (NASDAQ:AMZN) and Google and Facebook (NASDAQ:FB) and Tesla (NASDAQ:TSLA) as tech – is now 40% or so of the S&P 500.  Going back in time, the S&P 500 used to basically reflect corporate America about what was going on in the US economy. Now, you’ve got almost – well, 40%, almost half really reflects what’s going on in Silicon Valley rather than US economy.

So going back, what’s changing now is, as we come out of this pandemic, US economic growth is accelerating as the economy reopens. And so we’re now in a position where the US economy is about to experience several years of above-trend growth – some of the best growth that we’ve seen for several decades, really. And so the sectors that are most going to benefit from that are the industrials or stocks in the industrials and the consumer discretionary sector and the financial sector. And on top of that, you’ve got the benefit of, because these stocks, these sectors, have been so out of favour for so long, the valuations of these companies now look really attractive.

Lee: But you don’t own any FAANG stocks at all – the big tech companies, as you mentioned, like Facebook and Apple (NASDAQ:AAPL). Why is that?

Hugh: Look, I mean, these are all great businesses. I’m not going to try and take anything away from them. They have grown very consistently for a long period of time and they have become these behemoths. The problem is, is what do you pay for these stocks?  Everybody owns them, they’re the largest holdings in everybody’s, obviously, passive funds, active funds, global funds, thematic funds, ESG funds, whatever. And everyone’s crowded into these stocks and bid the valuations of these companies now to a point where there’s, if you like, priced for perfection. But from here, these companies have grown to such a large state where growth has to slow from here, because of the scale that they’ve reached.

On top of that, valuations are really dependent on bond – on the discount rate you use and bond yields, which look as though they’re going to be moving higher from here on in, which is going to put pressure on multiples. And then finally, the regulatory tide has definitely turned, both from restricting what these companies are able to do in terms of takeovers and businesses that they can come into, and also in terms of tax. I mean, people have got fed up with these companies not paying any tax for long periods of time and you’re now seeing global steps to make sure that these companies pay their fair share.  

So for all of these reasons, the tide is really starting to turn. All those big tailwinds that you’ve seen for the last five years – which has propelled these valuations to extremely high levels – now look as though the air might be starting to come out of this bubble a little bit.

Lee: OK, but we’re hearing stories at the moment, and we’re looking at all these quarters of profit recovery. Do you think we’re approaching peak earnings growth for US companies? And if so, what does this mean for stock prices?

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Hugh: And again, I think this goes back to what I was alluding to earlier, where the S&P 500 or the US market is two markets in one now.  You’ve got the Silicon Valley market and then you’ve got the sort of Main Street America market. And I think, definitely, within the Silicon Valley Tech complex part of the market, growth rates are probably at or close to peaks and things decline from here, for all the reasons I just mentioned earlier. But on the other hand, you’ve got growth rates in Main Street America where, for a variety of reasons, because GDP growth is accelerating from here, these companies have probably got several years of above-average growth ahead of them. And I’m not sure that that’s completely baked into valuations as they stand today.

Lee: But, I mean, there are whispers that equity markets might be headed for a mid-cycle correction later in the third quarter, early in the final three months of the year. So Fed tapering, possibly, of the bond-buying programme could be the trigger. We’ll see. But is this plus the threat of persistently high inflation a risk for investors? And if so, what should they do? What would you do and what is the event that you think might signal that we are heading lower?

Hugh: Sure. So the market is very nervous of a repeat of  the so-called ‘Taper Tantrum’ that we experienced back in 2013, when the Fed came out and said that they were going to reduce bond purchases as part of the QE programme. And the market freaked out and bond yields went up and the equity markets went down. And I think, this time round, Jerry Powell and the rest of the Fed is really aware of what happened and they don’t want to repeat it. So they are being very clear on their messaging in terms of indicating to the market what is going to happen and making sure that there are no surprises.

Having said all that, there is always the risk of a surprise, and what that surprise could be is some sign that inflation is accelerating sharply above what the market was expecting. And that that would force the Fed to tighten more quickly than people anticipated. So, you know, if we start to see a series of data points coming out that shows inflation is coming in much, much stronger, then investors are right to be really, really nervous.  And that will affect both parts of the market. The growth parts of the market will get upset because bond yields are going up, which affects the discount rates, which pulls down valuations, and the Main Street America part of the market. It’s not great if we’re at the beginning of the tightening cycle, because that will reduce economic growth. 

In terms of finding anywhere to hide, it’s going to be really hard to find any winners out of this scenario. I mean, stocks that could do better than others. I mean, clearly, things like consumer staples or utilities, which have good pricing power and are able to raise prices above the rate of inflation without really being affected by what’s going on with the macro would probably do better.  But, I mean, it all comes down to a relative game, really. It’d be very hard to insulate a portfolio entirely.

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Lee:  And your approach to this would typically be, during these periods or any particular period of any rough times, you sit tight. Is that right?

Hugh: Yeah. The way that we work the portfolio is, we don’t turn the portfolio over a lot and we tend to be long-term holders of the stakes of the companies that we invest in. If we start the year with 40 holdings in the portfolio, probably 30 of those names are still in the portfolio at the end of the year. So only 10 stocks go in and out of the portfolio through a year, so we don’t move the portfolio around dramatically. Having said that, you know, we have skewed the portfolio – perhaps beginning of the year – more towards a stronger recovery. And we’ve taken advantage of some opportunities that have presented themselves to build some stakes in some really great businesses that can benefit from a good economic environment. But will also be able to pass through price increases to their customers, and not have to accept a hit to their margins, which is going to be the big problem for a lot of companies. Now here, we’re coming into earnings season. It’s going to be really interesting to see which companies can pass on price and which ones can’t.

Lee: Are you able to name a couple of those stocks, Hugh?

Hugh: So one holding that we initiated earlier in the year is a company called Beacon Roofing (NASDAQ:BECN), which is the third largest distributor of roofing supplies to contractors. It’s a really dull and boring business. I’m sure they won’t mind me saying that. But as a portfolio, that’s what we do. We invest in lots of dull and boring businesses that no one’s ever heard of, and probably never will. But, you know, these businesses generate lots of cash, they grow steadily, they can pass on prices, and we can buy them at a good opportunity, we hope. So Beacon is benefiting from supplying roofing contractors in the US, which are very busy at the moment because of the strength in the housing market. You’re seeing the beginning of a pick-up in the commercial market.

And because of the tightness of supplies, you’re seeing price increases going through on a regular basis, which Beacon can pass on. And then a final bonus that they’re going to get, more recently, which we didn’t expect  – you may have been aware of the heatwave that’s happening in North America at the moment, especially on the West Coast and Canada. That’s not good for roofs. So the roofing contractors are going to be very busy fixing those for the next couple of months, which is going to be an unforeseen tailwind for that business.

Lee: Hugh Grieves, thank you very much for joining me today.

Hugh: Thank you, Lee.