Iain Pyle, Investment Director at Shires Income PLC, shares his views on how to navigate uncertainty by building resilience.
- The outcome for the UK economy is uncertain and resilience is likely to prove important.
- Keeping a balance between high growth and higher yield, and between domestic and international builds resilience.
- Income is likely to be a driver of returns in a low-growth environment.
Uncertain times can leave investors exposed, particularly those who have neglected to build resilience into their portfolio. As the economic cycle matures and the outcome for the UK economy appears more uncertain, what strategies can help shore up a portfolio?
It is easy to paint conflicting scenarios for the UK today. There is plenty of economic uncertainty, as GDP and consumer spending figures deteriorate. On the other hand, the economy has remained resilient and were there to be some resolution to Brexit, it is easy to see how it could start to improve.
With this in mind, it seems like a foolhardy moment to take binary bets on the domestic economy, assuming that one or other scenario will come to pass. It is a moment to ensure that a portfolio is resilient in either outcome, rather than having to worry which way the wind is blowing.
How can you build this resilience into a portfolio? Certainly, income is important. Even if the stock market has further to run, and the economic cycle can continue a little longer, this particular expansion is closer to the end than the beginning. There is less growth on offer and income is likely to become a more important part of an investor’s potential return.
At Shires Income Trust, we shore up our income stream with the use of preference shares. While the capital performance is unlikely to deliver significant returns, they aim to pay a steady 6-8% income. Companies generally don’t issue them anymore, which helps sustain demand.
Having a high income from the preference shares gives us freedom in the remainder of the portfolio. This has proved important in recent years as investors have favoured high growth equities, at the expense of higher yielding equities. Historically we have been able to hold some successful higher growth, lower yielding companies, which have supported capital performance.
Today, we believe holding a balance between these two types of company is vital: while valuations for high growth stocks look high, if interest rates stay low it is not clear that this situation will change. Higher yielding and ‘value’ stocks look cheaper, but are likely to provide less capital growth over the long term.
As such, being able to hold a balance is a way of building resilience into portfolios. We don’t want to incorporate significant style bias into the portfolio. There is always a danger that income managers simply load up on the oil majors and healthcare and their portfolio becomes poorly diversified and vulnerable to specific risks.
We also aim to be diversified by sector, by geography and by source of revenue. For this reason, our top five holdings provide 20% of our income, rather than the top five holdings providing 35% if an investor buys the FTSE All Share.
Another way to build resilience into a portfolio is to focus on quality. We are looking for companies with good, defendable market positions, which give them pricing power. Or we want to see innovation – again, this gives companies pricing power in an otherwise undifferentiated market.
Ideally companies should make a high return on the capital they invest and have low levels of debt, plus a skilled management team. All of these factors can make a meaningful difference when the economic environment changes.
More recently, we have been looking for companies that are not as dependent on the economic cycle. We are keeping a balance between domestic and international companies: on the one hand domestic companies are cheap, but on the other, there are real risks to the UK economy. This has seen us move away from companies with exposure to, say, high street spending, and towards companies that can win market share and sustain their earnings even if there is a broader economic downturn.
These are companies such as fund manager Ashmore. Ashmore specialises in emerging market debt funds. Generally, we are wary of the fund management sector, because earnings tend to ebb and flow with financial markets. If markets drop, revenues fall. Or a key manager will leave and take the funds with them. This makes it a little unpredictable.
However, Ashmore does one thing and does it well. It has managed to build up a loyal client base, who are aware that the asset class is cyclical. Looking at their fund flow data, client assets seem to be very sticky. When emerging market debt markets go up, we have seen them win a disproportionate amount of business, and when they fall, they have historically retained more than their peers.
The economy appears to be entering a late cycle phase. There may still be growth to come, but the economic data is weakening and in the UK, we need to contend with a populist prime minister, who has not always been business-friendly. There is enough reason to believe a more cautious view is warranted. We want to keep a balance in the trust, ensuring that it remains resilient, whatever the economic weather.
- The value of investments and the income from them can fall and investors may get back less than the amount invested.
- Past performance is not a guide to future results.
- Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
- The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
- The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
- The Company may charge expenses to capital which may erode the capital value of the investment.
- There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
- As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
- Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.
- With funds investing in bonds there is a risk that interest rate fluctuations could affect the capital value of investments. Where long term interest rates rise, the capital value of shares is likely to fall, and vice versa. In addition to the interest rate risk, bond investments are also exposed to credit risk reflecting the ability of the borrower (i.e. bond issuer) to meet its obligations (i.e. pay the interest on a bond and return the capital on the redemption date). The risk of this happening is usually higher with bonds classified as ‘sub-investment grade’. These may produce a higher level of income but at a higher risk than investments in ‘investment grade’ bonds. In turn, this may have an adverse impact on funds that invest in such bonds.
- Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.
- Aberdeen Standard Investments is a brand of the investment businesses of Aberdeen Asset Management and Standard Life Investments.
Other important information:
Issued by Aberdeen Asset Managers Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered Office: 10 Queen’s Terrace, Aberdeen AB10 1XL. Registered in Scotland No. 108419. An investment trust should be considered only as part of a balanced portfolio. Under no circumstances should this information be considered as an offer or solicitation to deal in investments. You should obtain specific professional advice before making any investment decision.
Find out more at: www.shiresincome.co.uk
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*As at 30 June 2019