It almost caught us by surprise ourselves, but by the end of next week we will have gone a full three months without effecting a single trade on behalf of the S&W Revera UK Dynamic Fund. Although we couldn’t back this up in court, Stephen and myself are pretty sure we have never gone so long without making even minor changes to a portfolio we’ve been running. That is not to say that the UK Dynamic Fund hasn’t changed over that period. Inflows have meant that the level of cash in the portfolio has risen from £3m (or 8% liquidity) to £5.3m (13% liquidity) over that same period.
So what is the reason behind this inactivity – lack of ideas?, fear of market valuations?, sheer indolence?
Whilst in the past we might have been accused of all of these things, it is not the case now. In many ways it simply reflects that we are content with the portfolio that we refined over the early part of the year to take on more UK domestic facing exposures. But it also reflects that since the summer months, we have been clear that we are moving to a position where “markets” will influence returns less, and the results of individual companies will be much more important. Against that backdrop, we feel it is right to be patient and considered when deciding what to do with the liquidity building up. Particularly at this time of year.
Late November and into December, marks the point that management teams who are “hoping” to meet market expectations of profitability, rather than “expecting” to meet them, are normally forced to face up to reality. The culprits are typically contracts or orders expected in the current year, but euphemistically “move to the right”. Or not happening yet, in the vernacular. A number of contracting businesses have already had to own up this month. Software providers are also similarly vulnerable given the very high gross margins on software licence deals. Just one deal slipping into next year can have a big impact on profit expectations for the current period. To our mind, equity valuations have reached a level that can be justified with the seamless execution of economic recovery in to profit growth; but don’t offer any forgiveness in the event of disappointment.
What we are seeing in recent corporate reporting is the manifestation of what aggregate earnings revisions have long been telling us. Profit expectations for this year have been too high. Yes, economic growth in the developed world is on the turn, but it is not yet feeding into profits. That does not mean it won’t, but we haven’t yet worked through the time lags.
In this environment, we find it amazing that the IPO market is so hot. Long established (and generally high quality) businesses that the investment community knows well are flagging that whilst the world isn’t dire, it is still a big ask to generate sales and profit growth. So what is it about the influx of new companies to market that makes investors think they can buck this trend? We cannot see any defining feature that unifies these share issues, other than the fact that the last one seemed to go well, so it is reasonable that the next one must also. However, the recent performance of the newly floated enhanced annuity businesses is case in point. How much can you really know about a business after a one hour meeting with management?
In our portfolio, the last three months have offered a roughly even balance of upgrades and downgrades to profit expectations for the current financial year. The upgrades have been largely a function of a stronger UK domestic economy. The downgrades have been modest, and mainly driven by the translation of overseas earnings into a strong Sterling rate (which of course is a function of a stronger UK domestic economy). Underlying, the vast majority of the businesses we have in the portfolio are trading to plan. Currency adjustments are simply that – we can no more predict short term currency moves than our Marketing Director can pick the winner of any of next year’s golfing Majors. It does not change the fundamental strengths, weaknesses, opportunities or threats of any of the companies we invest in.
The next six weeks will go a long way to recalibrating expectations of profitability for 2014. Our guess is that this will offer a solid platform for investment markets to build on a global economic recovery that (albeit slowly) continues to gather momentum. It is likely to be time to put that liquidity to work.