Generally so far in 2014 (and specifically over the last three months), the performance tree for UK equity funds has been well and truly shaken. Whilst the average fund has barely changed in value over both of these periods to date (at time of writing), there has been a marked difference between the average and worst performing funds. This has been characterised by a reversal of many of the trends that persisted through much of 2012 and 2013. A number of themes – some of which are interrelated – have turned. The very strong outperformance of the FTSE250 Index has turned into modest underperformance. Companies exposed to the UK domestic economy enjoyed super share price rides in the past two years, but have come slightly unstuck in 2014 as the spectre of rising interest rates puts downward pressure on valuations and expectations for future profit growth. Similarly, the trend of backing share price momentum can only take a fund manager so far; eventually valuations can stretch no more, and some of the stock market’s darlings have come crashing down to earth.
We have not been immune to these factors ourselves, and we have slightly underperformed the average fund over both these short time periods, but maintained a strong performance track record over all other periods. In part we have reacted to these changing events by making some modest changes to the portfolio; however, in part we have also accepted some small short term set backs as we see them as being temporary in nature.
Where we have not been inclined to make changes to the portfolio is where share prices have been impacted by the direct (and indirect) impacts of a stronger UK economy and the consequences of normalising both monetary policy and the drivers of growth against that backdrop. This falls into two categories. First, the risk that the direct measures policy makers need to take to cool down the London residential property market will hurt what is still only a fragile recovery in the rest of the country. In response we believe that the Bank of England realises that interest rate rises are the wrong tool to address the London market, and it will take other policy measures to meet the specific requirements of the London market without compromising recovery elsewhere. The second is the indirect impact that the strengthening UK economy is having on the value of Sterling, and then by extension, the impact on the value of profits earned by businesses with overseas operations. In our view, Sterling has appreciated relative to other currencies due to the fact that its economy is emerging quicker from intensive care than others. We do not believe that it reflects a long term shift in the terms of trade between the UK and other countries. Therefore, this trend is likely to stabilise and ultimately reverse as time passes. So what is currently a headwind for many companies will turn into a tailwind again.
However, we have made significant changes to the portfolio. We have undoubtedly mitigated some of the pain associated with the last few months by substantially increasing liquidity in the portfolio. We are always acutely aware of the price we pay for an investment, and by extension the value we can realise for investors if valuations get stretched. In three instances we have critically appraised the value of a business we own, and concluded that we are likely to find better value elsewhere. These sales have been discussed in our monthly factsheets, but I can summarise them here; AstraZeneca, where the excitement over the new drug pipeline and corporate activity in the sector has over compensated for the risk involved in delivering new drugs and the pain associated with key blockbuster drugs coming off patent over the next three years. Victrex, where the valuation of the shares reflected the traditional operational gearing in the business, but we have concerns that the actual growth in profits might lag behind what the market as a whole is expecting. Smiths Group, where we are increasingly sceptical that the conglomerate nature of the business will be unwound, therefore the shares look fully valued without structural change to crystalize value.
All of this leaves us with a little under 20% of the portfolio’s value in cash. There may have been some upside in sitting with cash as markets feel pressured. More importantly for us, the shake out in valuation of many of the types of businesses we have described above has left us with a myriad of investment opportunities. In the instances where we are putting a lot of our research efforts, share prices may have only fallen by 10% to 20%, rather than a catastrophic collapse in value; but that is enough to make valuations more realistic. It is either 10% or 20% more upside for our investors, or it is 10% or 20% more downside protection if market uncertainty drifts into the Autumn.
All other things being equal, we are likely to have used a substantial amount of this cash by the end of the summer. Whilst we won’t flag what it is we are likely to buy, it is fair to say that our new investments will counterbalance some of the portfolio’s existing biases. We are likely to add some smaller companies to balance the weight we have in large and mid caps. We are also likely to add a better geographic balance to a portfolio that has a lot of UK domestic earnings. We will also look to build up exposure that is less sensitive to changes in UK interest rates than we already have.
In summary, we have (perhaps perversely) enjoyed the last three months. We have been more active with potential new investment ideas than at any time since the start of 2012. Let’s hope that history repeats itself.