Where I’m finding opportunities beyond AI

James Thomson, manager of growth-focused Rathbone Global Opportunities, explains why the fund focuses on developed markets, what sets it apart in a world dominated by the single theme of AI, defensive stocks, and more.

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Dave Baxter, senior fund content specialist at interactive investor: Hello and a very warm welcome back to our Insider Interview series. I’m Dave Baxter here at ii and today I’m joined by James Thomson, lead manager of Rathbone Global Opportunities Fund S Acc (BH0P2M9). James, thank you very much for joining today.

James Thomson, lead manager of Rathbone Global Opportunities Fund: Thank you for having me, Dave. 

Dave Baxter: The fund is now more than 25 years old. Many people will be familiar with it, but what actually sets it apart from the competition in these AI-driven markets? What’s making it stand out? 

James Thomson: Yes, you’re right. I’ve been running the fund for 23 years now. Very proud of it. It’s one of the longest-standing funds in the global sector, and it’s one of the top-performing funds in that sector over the last 20-plus years, with an average annual return of over 12% per year.

But I think you’re right. In a world that’s dominated by machines, automation and tracking, I think probably what will differentiate us in the next crisis is our human instincts, our courage to be a little bit different and potentially swim against the stream.

At its core, this fund is a global growth fund investing in developed markets companies. Companies that are doing something a little bit different, shaking up their industry, but growing with resilience, reliability, and repeatability. That’s quite unusual in a world that is heavily dominated by a single theme at the moment. In that world where there’s such concentration, we actually go back to our roots and embrace balance and diversity. 

Dave Baxter: Looking at where markets are, there are some big debates going on, for example, about whether we’re in an AI bubble and so on. What’s your broad outlook? What kind of view is guiding the portfolio? 

James Thomson: Well, global economic growth is strong and accelerating. There are challenges to that, of course, whether it’s geopolitics, war, or potential interest rate increases and inflation. So, there are challenges, but overall the foundation of the global economy is strong.

But I do think that the AI story, in some ways, is becoming a bubble. It’s different, though, to the dot-com bubble that I started in this industry in. That was very much a valuation-driven bubble. I think it’s different this time, its more earnings-driven. A lot of companies are over-earning at the moment, and what’s important is to invest in companies that have repeatable earnings streams, and that don’t run the risk of a severe normalisation moment.

So, that’s something that investors need to be cautious about. The market has become very concentrated because of the movement into passives and tracker funds. Something like only 25% of stocks in the last few months have outperformed the market.That’s multi-decade lows level of contribution to the overall market.So, I think there is an argument for a broadening out of market returns into different sectors that can make a greater contribution to an overall balanced and diversified portfolio. 

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Dave Baxter: The fund has a pretty big allocation to the US, but if we look at its sector allocations, it has maybe less in information technology than some of its rivals. What sectors are standing out and what kind of companies are standing up there? 

James Thomson: Yes, I mean, it is a very actively run fund. Analysts look at the tracking error of a fund, and this fund has a consistently high tracking error. So, we are making quite significant bets against some of those benchmark weightings. I think that’s what I’m here to do, to take a view and use our industry skills and expertise to find the very best opportunities that are out there.

We’ve got about 25% of the fund in information technology, which feels like a meaningful allocation, I think, to most. But if you look at the big super-sectors in the market, technology now can be up to 60% allocation for some indices. The Magnificent Seven alone is about a 24% weighting in seven stocks. For me, that is too aggressive. I think we’re here to run a more balanced portfolio than that. So, we meaningfully reduce our exposure to that technology sector while still having significant skin in the game.

But as you said, we have significant exposure outside some of those sectors. I mean, some of the best companies in the world are in the consumer-related sectors or the industrial-related sectors. I’ve just seen the management of TK Maxx (TJX Companies Inc (NYSE:TJX)) recently, the discounted apparel retail business. They worked with 21,000 vendors every quarter to get their excess inventory, reduce the price for us, offer significant discounts, and a kind of treasure hunt-type approach when you go into one of their stores.

At the other end of the spectrum, I own Compagnie Financiere Richemont SA Class A (SIX:CFR), which is the luxury goods company [with brands including] Cartier, Van Cleef. Really appealing to ultra-high net worth clients that rarely experience a personal recession. So, quite protected in those growth credentials as well, and very high brand desirability for a lot of their key brands.

Then, on the industrial side of the argument, we have significant exposure there playing into some very important themes at the moment, whether it’s electrification, re-industrialization, bringing back of the manufacturing base to lots of different countries, the roll-out and improvement of our grids, increasing our power infrastructure, which is a vital ingredient for the roll-out of AI.

So, we’ve got companies there from Amphenol Corp Class A (NYSE:APH), an industrial connectors business, to Parker Hannifin Corp (NYSE:PH) to Caterpillar Inc (NYSE:CAT), the machinery business. There are some outstanding businesses, some of whom have been left behind as all the oxygen has been sucked out of the room by the AI story.

But I think it’s in many ways creating some hugely exciting opportunities for investors outside that single theme. 

Dave Baxter: The fund’s literature likes to talk about a sweet spot where you invest in mid-cap shares. But if we look at recent history, you’ve actually tended to steer more towards large caps. You’ve worried that we can’t really compete with these very well-entrenched companies. How’s that looking now? 

James Thomson: Yeah, you’ve done your homework. I think you’re right. Historically, we did have more exposure to mid-caps. But remember that a lot of the companies that we invested in that were mid-caps have grown up over the years, and they’ve graduated out of that basket and now become large-cap companies. But we still own some very successful mid-cap companies in the fund.

One of the longest-standing investments is a German company called Rational AG (XETRA:RAA). They make commercial ovens, so there’s a 54% chance if you eat outside your home that a Rational oven has cooked it. They have ovens in the White House, in Buckingham Palace, in every airport, hotel, restaurant, prison, hospital, just about every commercial setting for commercial ovens, they dominate.

We also own another mid-cap business in the UK, Howden Joinery Group (LSE:HWDN). One of the best management teams I’ve seen globally, they make our kitchens that we put into our homes. So, not commercial settings but private. It’s one of best businesses, I think, in that industry and there seems to be a food theme developing [with] my mid-cap exposure here. 

So, excellent companies but I think you’re right, over the last few years as interest rates have gone up, inflation has gone up. I think it’s probably more of a world where the strong get stronger. The large-cap companies can actually use that size as leverage in order to maintain and even increase their share.

It becomes harder when financing costs are higher for small and medium-sized companies to muscle their way in. So, I think you’re right. 

For the foreseeable future, we’re probably going to lean more large cap in the fund. But that original heartland where we found so many great ideas over the years, we still want the flexibility and the adaptability to go back there. 

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Dave Baxter: And very roughly, how much of the fund is in mid-caps at the minute? 

James Thomson: I mean, you’re looking at less than 10% of the fund in mid-caps now, the majority is in large caps. We don’t have any small-cap exposure due to the fund [being] about £3.5 billion in assets under management. In order to build a meaningful position in a small-cap company, you are probably limiting your liquidity there. So, small caps are off the menu for us. 

Dave Baxter: You tend to keep a defensive bucket of companies. What’s in that bucket right now? And how do you feel about the idea of defensive? We’ve seen some sectors like software getting disrupted and perhaps that definition is changing over time. 

James Thomson: So, the genesis of this more defensive sleeve of the portfolio was actually 2008, the great financial crisis. We sort of pulled up the drains at the end of that crisis and said that I needed to get better at this.

One of the things that I clearly wasn’t as focused on was managing risk, and so after 2008, we put in this defensive or weatherproof part of the portfolio to give us a bit of defensive protection during dislocations in markets. It has been very useful over the years to reduce the volatility of the fund and make it more of an all-weather fund.

But it hasn’t helped in recent years. The market is so growth-focused at the moment and singular theme-focused on AI that it’s sucking the oxygen out of some of these defensive parts of the market. So, actually, the defensives have been underperforming consistently, so they still deserve a place there.

Because it’s very hard to predict when the next dislocation will come, and you want a bit of protection to create a fund that’s suitable for all different economic environments. So, at the moment, it’s about 20% of the fund. We give ourselves some flexibility to range between 15 and 25%.

You’re right - some of the defensive companies have changed over the years, but the characteristic that they consistently have are companies that are less highly correlated to economic growth. But occasionally you get thrown a curveball. So, one of the companies that we sold recently, the defensive part of the fund, is a telecoms business that is rumoured to be about to engage in some significant M&A, which I think distracts from the core defensive part the business. So, we have sold that telecoms business.

But we have bought two new companies in the defensive part of the portfolio in recent years. We bought an energy drinks business, one of the fastest-growing categories within consumer staples and beverages, and we bought a beauty business that does everything from skincare to shampoo and haircare, fragrances and make-up. I mean, it’s hard to look like this! You need to constantly invest. So, I think we can find interesting ideas for quite fast-growing businesses within even a defensive part of the portfolio.

Dave Baxter: So, there are still some pockets that potentially have defensive qualities?

James Thomson: Oh, absolutely. But the market at the moment isn’t focusing on defensive. It really wants the most high-beta, leveraged expression of AI upside. So, actually the defensive part of the market is being a source of funds for investors as they look to reallocate more. But the underlying qualities of those companies haven’t changed, it’s just the valuation multiple that investors put on it when you have a noisy brother who’s getting all the attention. 

Dave Baxter: You are a developed market fund. You invest in the US, in Europe, and the UK, but you don’t invest in Japan and you don’t invest in emerging markets. You’ve already noted that that has hurt performance in recent history. Are there ways you’re getting around that? Are you, for example, managing to tap these regions in a more indirect manner? 

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James Thomson: Yes, it’s been a headwind. By investing exclusively in developed markets, when you have a Korean market that’s up 100% year-to-date, when you have a Japanese equity market that is up 40% year to date, a lot of it boosted by the AI trade, as they have very significant exposure to AI technology memory, then simply by not having exposure to those markets, you’re already facing an uphill battle. 

But the reason I don’t invest in those markets is because I don’t think I have the skills or the expertise to do it. I think there are a lot of nuances. It’s not always a level playing field. And I think you’re better going to a different fund manager who really has the skills and the expertise to do it, and there certainly are a lot of very skilled and expert fund managers who invest directly in emerging markets and Japan. 

But you’re also right. I mean, this is still a globalised world. You can invest in developed markets, companies which have significant exposure to emerging markets, and they are the people who are the experts and best placed to do it.

You can get exposure to emerging markets by companies in the developed world, which source from emerging markets or sell into emerging markets. So, think of a lot of companies in the industrial world, whether it’s Caterpillar or machinery and equipment companies. Think about the beauty business L'Oreal SA (EURONEXT:OR). A lot of our retailers source from emerging markets.

So, I think it’s an important part of the portfolio, even at the headline level you can’t see. 

Dave Baxter: Well James, many thanks for your time. 

James Thomson: Thank you, Dave.

Dave Baxter: And thank you for watching. As ever, please do let us know what you think in the comments. Hope you find it useful. And if you’re a fan of this series, do hit the like button and the subscribe button. Thanks and take care.