This week marks the first real surge of corporate reporting in the UK’s 2014 reporting season. We have had a number of companies get out of the gates early, and the general sense so far has been that 2014 ended pretty much as expected, and the prospects for 2015 are so far unchanged. This is certainly the message we have taken from the small sample of our portfolio companies that have reported numbers so far. Indeed, almost without exception, share prices of those reporting have risen on the day of the announcement, suggesting that even if there has been little of substantive profit upgrades so far, at least the threat of material downgrades is receding.
Indeed, the trading statements from portfolio companies so far this year have been pretty much in keeping with the nature of trading statements over the last three years – we have managed to maintain a portfolio of companies that have by and large delivered on earnings and profit expectations. In the last 24 months, of our portfolio companies that we were holding at that point in time, only AGA Rangemaster suffered a material reduction in its profit expectations for its current trading period.
Bearing this in mind, we are disappointed to be writing this with a share price on the fund that is virtually unchanged from this time last year, whilst the major UK indices are modestly higher over the same period. It is disappointing because we have always stuck by the mantra that avoiding disasters is more important than trying to pick the next Apple, and history has borne out that through good performance in periods where we have avoided the market’s many pitfalls.
So what is different about the year just past? There are probably three main factors to consider. The first is that we need to look at it in the context of what went before. Our three year numbers are very strong, driven by robust gains in 2012 and 2013. With hindsight (and it is always easy with hindsight) short term valuation levels in certain stocks had run too far, needing better than forecast results to maintain these prices, rather than simply hitting targets. It is no longer in the portfolio, but James Fisher & Sons is a good example of this feature.
The second reason is more thematic in nature. The Revera UK Dynamic’s performance over the last year has correlated pretty closely to that of the FTSE Small Cap index. For those who have followed us for a decade or more might not be hugely surprised by that fact, but it is worth bearing in mind that at no point over that period have smaller companies accounted for any more than 1/3rd of the underlying asset exposure. Instead, the close correlation has more to do with the underlying thematic exposures we have taken over the period. We have had a high exposure to UK domestic earnings, and have had a high exposure to capital goods businesses – both of which are strong thematic drivers in the smaller companies index. In the UK orientated business that we own, earnings expectations were overwhelmingly met and in most cases exceeded. That share prices did not respond to the better profit environment is partly to do with the aforementioned rerating in 2012/3 that anticipated that growth, and also the reciprocal fear associated with the fact that such domestic strength must inevitably lead to rising interest rates and a possible reversal of that growth. With inflation fears being pushed further into the distance, that fear is now receding and domestic companies are now performing in line with the improved outlook. The capital goods businesses we own did suffer more in the way of earnings downgrades, as recovery in the Euro region failed to take off, and Sterling strength reduced the value of US Dollar and Euro earnings of those operating abroad. Our view over this period has been that these are short term and transient features of what has been a strong underlying operating performance across these businesses, and ultimately that quality will make itself felt in the numbers.
The last reason has been the recent spike in European exposed businesses, post the eventual announcement of QE action from the ECB. We have had little in the way of direct European exposure over the last three years, and whilst we believe that there is long term upside in the region, as QE should make necessary reforms more palatable to the plebeians. Yet, this is a long term project, and the potential for chaos from the Greek situation remains very real. In the short term, when the momentum in the UK and US is so strong, we see better risk/reward situations elsewhere. We would re-iterate, though, that this is a shorter term consideration.
Overall, in a year characterised by carnage in the food retailing industry, a sharp reversal in fortunes in oil services businesses, a number of “dot.com” and “buy & build” type propositions going the way of the last lot a decade and a half ago, we stuck true to our principles of buying established, cash generative businesses, with identifiable competitive advantages, whilst always keeping an eye on the price we are being asked to pay, and therefore ensuring that we always have scope to make our expected returns from each investment in the portfolio. This may have resulted in a more subdued performance last year, but it very much gives us the sense this year of a portfolio that is in very good shape, yet is pregnant with investment performance that should have been delivered last year.
The evidence is close to being conclusive that the UK and the US economies have finally reached “escape velocity”, whilst the Europeans have a more decisive plan to get to a similar place. This will bring with it its own challenges – not least when it comes to finally raising interest rates. But it also means that companies, not politics will determine investment returns.